Shifts and movements in aggregate supply

Aggregate supply

Aggregate supply is the total output of goods and services produced by an economy's firms at a given price level and over a specific period of time.

It is important to distinguish between aggregate supply in the short run and the long run.

The basic model for short run aggregate supply

The basic model to explain and understand aggregate supply in the short run measures supply against the general price level.

In macroeconomic theory, the short-run is defined as:

The period when general prices can change in response to changes in aggregate demand and aggregate supply, but wages and other input costs do not change.

Although not a 'perfect' model, the assumption is supported by real data - namely that changes in the price level happen frequently, while changes in wages are far less frequent, perhaps only once a year.

From the short run model, we can explain the two fundamental ways aggregate supply can change:

  1. Through a direct change in the price level, assuming the price of inputs and wages remain constant - when this happens, there is a movement along the existing aggregate supply curve, and:
  2. By a change in 'other determinants', such as input prices and wages, assuming the price level remains constant - when this happens, the positions of the short run aggregate supply curve will shift.

Movements along the short run aggregate supply curve

Movements along an AS curve reflect how current output in the economy responds to changes in the general price level.

We shall assume that the price level rises:

    Real wages fall

    The effect of a rise in the general price level is that, if money wages remain constant in the short run, real wages will fall. Real wages are money (or nominal) wages adjusted for inflation and represent the real purchasing power of money wages. The assumption that money wages are constant in the short run is central to what is called 'sticky wage theory'.

    If real wages fall while the general price level rises, firms have the incentive to hire additional workers, and expand output.

    The same principle applies to all input costs - assuming they are fixed in the short run, a rise in the general price level means that the return on production will increase.

    In short, the expected cost of inputs has fallen relative to the expected price of outputs.

    This means that producers can expect to gain higher profits and are encouraged to increase output - along the SRAS curve.

    EXAMPLE

    For example, let us assume that a US mobile phone producer has a production plant in China, and that the general price level increases by 2% in the US, and that the prices of mobile phones for sale in the US rise by the inflation rate - so a $1000 mobile phone will now sell for $1020. If we assume that production costs in China, including wage costs, shipping costs and so on are fixed at $400 in the short-run, through wage contracts and contracts to supply, the US producer with take advantage of the short-term gain by increasing production.

    At the old price level (and an individual price of $1000), $600 profit is derived, and at the new price level, and price, $620 profits are possible. At this point, pre-existing contracts and wage agreements will not be changed. This assumes there is some slack in the Chinese labour market, with increased employment possible. It also assumes, critically, that mobile phone prices inflate at the same rate as the general inflation rate.

    If full capacity is reached, and no more output can be increased, the SRAS curve becomes vertical.

    Gradient of the short run aggregate supply curve

    The gradient gets steeper

    At first, the slope of the SRAS curve is relatively flat given that at low levels of output firms have spare capacity. As firms increase output they get near to full capacity, with possible shortages in the supply chain, and suppliers push to increase their prices. As this happens, the slope of the SRAS curve gets steeper and increasingly higher price levels are required to encourage firms to produce.

Shifts in the SRAS curve

If we hold the price level constant, changes in the underlying determinants of aggregate supply, such input costs, will shift the position of the SRAS curve.

    Causes of shifts to the right:

  1. Lower raw material prices [assuming no change in the price level] will mean that producers can use more raw materials to producer more output. Changes in oil prices are a common cause of a shift in the SRAS, with lower prices encouraging output across the economy.
  2. A fall in other energy prices, which can reduce production costs.
  3. Similarly, lower money wages [assuming a constant price level] reduces real wages and makes labour cheaper - hence more is hired and output increases.
  4. Lower taxes on business, including a lower rate of Value Added Tax (VAT), a reduction on tariffs on imported materials and capital equipment, and lower environmental charges, such as carbon taxes.
  5. Increases in labour productivity will reduce the cost of labour and encourage firms to increase output.
  6. A stronger currency, which puts downward pressure on the cost of imported raw materials.
Shifts in the position of the aggregate supply curve

    Causes of shifts to the left:

  1. Higher raw material prices [assuming no change in the price level] will mean that producers use fewer raw materials and producer less output. Increases in oil prices are a common cause of a shift in the SRAS.
  2. An increase in other energy prices, which can increase production costs.
  3. Similarly, higher money wages [assuming a constant price level] increase real wages and makes labour more expensive - hence fewer workers are hired and output decreases.
  4. Increased business taxes, such as VAT and environmenal taxes.
  5. Reductions in labour productivity will increase the cost of labour with firms reducing output.
  6. A weaker currency, which puts upward pressure on the cost of imported raw materials.

Long run aggregate supply (LRAS)

Once full employment has been reached at the economy's natural rate of output the long run aggregate supply (LRAS) curve becomes relevant. The natural rate of output exists at the level of income here unemployment is also at its 'natural' rate - in other words, the only unemployment that will exist is temporary and frictional and the economy is as close to full employment as possible. Of course, the LRAS curve may never be reached if an economy persistently operates below its natural rate of output.

The long run aggregate supply curve - LRAS

The LRAS indicates what can be produced once it is assumed that full capacity is reached, and wage rates will adjust at the same pace as changes in the price level. At this point, both the wage rate and the price level become irrelevant for determining real output, and other factors come into play. These are the factors that determine the natural rate of output.

The position of the LRAS curve is more theoretical and cannot directly be measured. It can be deduced by looking at the long run trend for an economy - for example, it may be that each year, the economy's capacity to produce can increase in real terms by 2%. This can then help set a target for the future. It is also possible to construct a production function where LRAS can be estimated based on changes in the amount of capital available in the economy.

Shifts in both the SRAS and LRAS

Many changes in the determinants of supply can shift both the short and long run curves, including:

  1. Increases in the size of the effective labour force - output can be increased in the short run, and the capacity of the economy to produce will increase. This could be as a consequence of natural population growth, migration, or increased participation in the labour market.
  2. An increase in the quality of human capital - for example, a better trained workforce will be more productive, which reduced costs, and the potential output of the economy will increase.
  3. Shifts in the position of the SRAS and LRAS curves
  4. Advances in technology can result in lower short run costs, but also enable more to be produced from the existing stock of factors of production.
  5. An increase in the capital stock of an economy.
  6. Effective supply-side policy which can increase incentives and improve productivity, as well as reduce costs.

It is common to contrast the Classical interpretation of LRAS with the Keynesian perspective.

The above analysis adopts the 'Classical' approach for aggregate supply in the long run - that the LRAS is vertical at the natural rate of potential output. This contrasts with the Keynesian interpretation, which focuses much more on the short run, and indeed, much more on aggregate demand.

This is not really about which interpretation is 'correct' but more to do with how economic theory reflects the current economic context, and the lessons learned from how policy makers have used macroeconomic theory to try to achieve desirable objectives. Keynes, and the Keynesians were most concerned with understanding why aggregate demand might not be sufficient to achieve full employment. In this respect, attention was focused on short-run equilibrium, the role of aggregate demand, and why an economy might not automatically adjust to create a stable, full employment, equilibrium.

Given that full employment might not be reached, the Keynesian approach does not accept that the LRAS is vertical over its whole length. It is entirely possible for output in the long run to be below full employment output.

The Keynesian long run aggregate supply curve has three phases which are best understood by seeing aggregate supply as responding to changes in aggregate demand, and the price level, and not being 'independent' from it - as assumed in the classical [or neo-classical] model.

Phase one, where aggregate supply can increase in response to an increase in aggregate demand, and where there is no upward pressure on the price level. Over this range from zero to Y, the aggregate supply curve is perfectly elastic and horizontal.

The Keynesian aggregate supply curve

Phase two, exists when bottlenecks in supply begin, and the gradient becomes steeper. Increases in aggregate demand (from AD1 to AD2, X to Y) will trigger increases in prices as shortages of products and labour drive up their prices. However, full employment is not automatically reached.

Phase three begins when full capacity is reached, at Y2, and no more output and employment is possible, given the current quantity and qualify of factors of production. Further increases in aggregate demand (AD2 to AD3) simply drive up prices, but have no effect on output and employment.

If we reverse the movements in aggregate we can get a clearer understanding of what the Keynesians were driving at. It we start at full employment, at Y2 in the diagram, and aggregate demand falls (say, as a result in a collapse in consumer confidence, or as a consequence of a Pandemic, from AD2 to AD1) wages are 'sticky' on the way down, and firms are forced to reduce costs by reducing employment (rather than by reducing wages). The result is that output and employment fall (to Y1) and the aggregate supply curve 'enters phase two'.

Further reductions in aggregate demand (AD1 to AD) will only reduce output and employment further, with no effect on the price level as the aggregate supply curve becomes horizontal. This last point can be disputed given that price deflation does tend to occur in a deep recession.

The pragmatic solution to the 'two curves' problem is to use a Keynesian short run version, and a classical long run version. In this way, output gaps can be conveniently shown (e.g. Yf to Y1, and Yf to Y2), and it is possible to show an equilibrium where full employment may not be automatically established.

Showing both the SRAS and LRAS curves

Consumer spending

Consumer spending and aggregate demand

Consumer spending
Investment spending

What determines export spending?

Investment
Supply-side policy

How effective is supply-side policy?

Supply-side policy