What is aggregate supply?
– Aggregate supply (AS) is the total quantity of goods and services that producers in an economy are willing and able to sell over a specified period at a given overall price level. The “price level” refers to the average of current prices across the whole economy, not the price of a single product. AS links that average price level to the economy’s real output (real GDP).
Key pieces to know (short definitions)
– Price level: average of prices paid by buyers across goods and services.
– Real GDP: total output of goods and services adjusted for inflation.
Short-run versus long-run aggregate supply
– Short-run aggregate supply (SRAS): the relationship between the price level and real output when at least one input price is fixed in nominal terms (commonly wages). In the short run, SRAS is upward sloping: higher price level raises firms’ revenues faster than some costs, so firms increase output.
– Long-run aggregate supply (LRAS): the relationship after all prices (including wages) have fully adjusted. In most models LRAS is vertical at potential output (also called natural output or full-employment output): changes in the overall price level do not change real GDP in the long run.
Why SRAS slopes up (intuitively)
– Sticky wages: nominal wages adjust slowly because of contracts, institutions, or norms. If the price level rises faster than wages, real wages fall and firms hire more labor, increasing output.
– Sticky prices and menu costs: some firms do not change prices immediately; relative price changes can alter output allocation.
– Misperceptions: producers may misread a general price rise for higher relative demand for their product and temporarily expand output.
What shifts AS versus what moves along the curve
– Movement along SRAS or LRAS: caused by a change in the overall price level, holding other factors constant.
– Shifts of SRAS or LRAS: caused by non-price-level factors that affect productive capacity or costs. Common shifters:
– Resource quantities: labor force size, capital stock.
– Productivity/technology improvements.
– Input prices: wages, commodity prices (e.g., oil).
– Institutional and policy changes: taxes, subsidies, regulations.
– Expectations of future prices (affects wage contracts and pricing).
– Supply shocks: natural disasters, pandemics, geopolitical events.
Worked numeric example (simple linear AD-SRAS model)
Assumptions:
– Represent SRAS and aggregate demand (AD) as linear price-output relationships.
– Variables: P = price level index, Y = real GDP (output).
Let initial equations be:
– SRAS: P = 40 + 0.06·Y
– AD: P = 200 – 0.10·
Y (completing the AD equation): AD: P = 200 − 0.10·Y
1) Find the initial short-run equilibrium (set SRAS = AD)
– SRAS: P = 40 + 0.06·Y
– AD: P = 200 − 0.10·Y
Set them equal:
40 + 0.06·Y = 200 − 0.10·Y
Collect Y terms:
0.06·Y + 0.10·Y = 200 − 40
0.16·Y = 160
Solve for Y:
Y = 160 / 0.16 = 1,000 (real GDP, units consistent with model)
Find P by substituting back:
P = 40 + 0.06·1,000 = 40 + 60 = 100 (price-level index)
Interpretation: initial short-run equilibrium is (Y = 1,000; P = 100).
2) Example A — negative supply shock (SRAS shifts up)
A negative supply shock (higher input costs, disruption) raises the SRAS intercept. Let new SRAS be:
SRAS’ : P = 60 + 0.06·Y (intercept increased from 40 to 60)
Find new equilibrium with the same AD:
60 + 0.06·Y = 200 − 0.10·Y
0.16·Y = 140
Y = 140 / 0.16 = 875
P = 60 + 0.06·875 = 60 + 52.5 = 112.5
Result: output falls from 1,000 → 875 and price level rises from 100 → 112.5. This is the classic short-run stagflationary effect of a negative supply shock: lower output and higher prices.
3) Example B — expansionary demand shock (AD shifts right)
Suppose fiscal stimulus increases AD intercept from 200 to 220:
AD’ : P = 220 − 0.10·Y
Keep the original SRAS (P = 40 + 0.06·Y). Solve:
40 + 0.06·Y = 220 −
0.10·Y → 40 + 0.06·Y = 220 − 0.10·Y
Bring Y terms to the left and constants to the right:
0.06·Y + 0.10·Y = 220 − 40
0.16·Y = 180
Y = 180 / 0.16 = 1,125
Find the price level:
P = 40 + 0.06·1,125 = 40 + 67.5 = 107.5
Result: output rises from 1,000 → 1,125 and the price level rises from 100 → 107.5. This is the short‑run demand‑pull effect of an expansionary demand shock: higher output and higher prices.
Short‑ and long‑run interpretation (assumptions stated)
– Assumptions: linear AD and SRAS functions, SRAS slope = 0.06, AD slope = −0.10, initial equilibrium at Y = 1,000 and P = 100, wages and some input prices are “sticky” in the short run.
– Short run (what we computed): AD shifts right; firms increase output and raise prices; employment and output temporarily exceed potential.
– Long run (wage/price adjustment): higher demand raises nominal wages and input costs, shifting SRAS left (SRAS intercept rises). Output moves back toward potential (assumed 1,000), and the price level ends up higher than in both the original and short‑run equilibria.
Worked long‑run numeric illustration
– After the demand shock AD’ at Y =
Worked long‑run numeric illustration – After the demand shock AD’ at Y = 1,000 (AD shifts right; in our numeric example the AD intercept rises from 200 to 220), the short‑run equilibrium was:
– SRAS: P = 40 + 0.06Y (unchanged in the short run)
– AD’: P = 220 − 0.10Y
– Short‑run equilibrium: solve 40 + 0.06Y = 220 − 0.10Y → 0.16Y = 180 → Y_SR = 1,125
– Short‑run price: P_SR = 40 + 0.06·1,125 = 107.5
Long run (wage/price adjustment)
1. Economic logic. Wages and some input prices, initially “sticky,” are assumed to adjust upward in response to the higher price level and tighter labor market. That raises firms’ marginal costs and shifts SRAS left (the SRAS intercept increases). Output returns to its potential (assumed Y* = 1,000) while the price level settles at the level consistent with the new AD’.
2. Compute the long‑run price and new SRAS intercept.
– Price consistent with AD’ at potential output:
P_LR = AD'(Y*) = 220 − 0.10·1,000 = 120
– SRAS must pass through (Y* = 1,000, P_LR = 120) with the same slope 0.06, so its intercept C’ satisfies:
C’ = P_LR − 0.06·Y*
C’ = 120 − 0.06·1,000 = 120 − 60 = 60.
So the long‑run short‑run aggregate supply (SRAS) line after wage/price adjustment is:
P = 60 + 0.06·Y.
Check (verification):
– At potential output Y* = 1,000, P = 60 + 0.06·1,000 = 60 + 60 = 120, which matches the long‑run price consistent with AD’.
– AD’ and the new SRAS intersect at (Y = 1,000, P = 120) — output is back at potential, only the price level has changed.
Interpretation (economic logic, brief):
– In the short run, sticky wages and input prices can let output deviate from potential. Over time, nominal wages and some input costs adjust upward when labor markets tighten and the price level rises.
– Those cost increases shift the SRAS curve left (higher intercept C’) until real output returns to potential (Y*). The adjustment changes the equilibrium price level but not long‑run output under the model’s assumptions (fixed Y*).
– Key assumptions here: wage/price adjustments are complete in the long run; AD’ is correctly specified as linear and unchanged in slope; potential output Y* is exogenous and constant.
Step‑by‑step checklist to compute the new long‑run SRAS after an AD shift (useful template):
1. Identify the new aggregate demand function AD'(Y) (e.g., P = a + b·Y).
2. Evaluate the long‑run price at potential output: P_LR = AD'(Y*).
3. Use the known SRAS slope (m). The SRAS line form is P = C’ + m·Y.
4. Solve for the new intercept: C’ = P_LR − m·Y*.
5. Write the new SRAS: P = C’ + m·Y and verify it passes through (Y*, P_LR).
Worked numeric recap (from this example):
– AD'(Y) = 220 − 0.10·Y → P_LR = 220 − 0.10·1,000 = 120.
– SRAS slope m = 0.06; Y* = 1,000 → C’ = 120 − 0.06·1,000 = 60.
– New SRAS: P = 60 + 0.06·Y; equilibrium at (1,000; 120).
Limitations and caveats:
– This is a simple linear example for clarity. Real economies have non‑linearities, expectations dynamics, and sectoral differences.
– The model assumes full long‑run wage/price flexibility and a fixed potential output; relaxing these assumptions changes outcomes (e.g., hysteresis, persistent unemployment).
Educational disclaimer:
This explanation is for educational purposes only. It is not individualized investment or policy advice.
Further reading:
– Investopedia — Aggregate Supply: https://www.investopedia.com/terms/a/aggregatesupply.asp
– Khan Academy — Aggregate demand and aggregate supply (macro): https://www.khanacademy.org/economics-finance-domain/macroeconomics
– Federal Reserve Bank of St. Louis — Aggregate