1.3 Aggregate supply

DEFINITIONS:

1. Short-Run Aggregate Supply (SRAS): how much output firms would be prepared to supply in the short run at any given overall price
2. Long-Run Aggregate Supply (LRAS): the amount of output an economy can produce when using all their factors of production. Aggregate supply (AS) represents the total quantity of goods and services that producers in an economy are willing and able to supply at a given overall price level in a given period.

The AS curve shows the relationship between the price level and the quantity of real GDP produced by firms.

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Explain

1.3.1 Aggregate supply

Aggregate Supply (AS) refers to the total quantity of goods and services that all firms in an economy are willing and able to produce at different price levels, over a given period of time. It represents the economy's productive capacity.

Explain, with the aid of a diagram

1.3.2 the relationship between aggregate supply and price level in the short run and long run

Short Run Aggregate Supply (SRAS)

The short run aggregate supply curve (SRAS) is upward sloping, indicating that as the price level rises, the quantity of goods and services firms are willing to produce increases. This positive relationship between price level and real GDP in the short run is due to several factors:

3. Sticky Wages and Prices: Wages and prices of some inputs are sticky or slow to adjust to changes in economic conditions. As the price level rises, firms can charge higher prices for their output without a proportionate increase in input costs, leading to higher profits and increased production.
4. Misinterpretation of Price Signals: Firms may initially interpret an increase in the price level as an increase in the relative price of their own output compared to others, encouraging them to produce more.
5. Menu Costs: The costs associated with changing prices (menu costs) can lead to firms maintaining higher prices for longer periods, thus producing more at these higher prices. Diagram of SRAS

Long Run Aggregate Supply (LRAS)

There are 2 predominant views about the LRAS: the neo-classical and Keynesian perspectives:

Neo-Classical LRAS Curve

The neo-classical economists argue that the markets ought to adopt a laissez-faire ('allow to do') approach, where the economy could be left alone and eventually return back to equilibrium.

Therefore meaning that all factors of production would be fully and efficiently employed in the long run, where the diagram is displayed as follows:

Diagram of LRAS

• Y-axis: Price Level
• X-axis: Real GDP
• LRAS Curve: Vertical line at the full employment level of output

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The neo-classical LRAS curve can shift to the right or left due to changes in the quantity or quality of factors of production.

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The Keynesian LRAS curve:

Adopted by John Maynard Keynes, he challenged neo-classical economists during the 1930s Great Depression, arguing that the economy does not always automatically self-adjust to full employment.

Neo-classical	Keynes
when wages fall, there is a greater incentive for firms to hire workers, allowing labour to be fully utilised once again	wages may not fall in the first place (a phenomenon where wages are 'sticky downwards'), and unemployment remains. Such can be seen through trade union power and contracts put in place to stop a fall in wages.

The Keynesian LRAS curve illustrates the relationship between the price level and the quantity of real output (real GDP) that firms are willing to produce in the long run.

It is characterized by three distinct segments:

6. Keynesian Section: At low levels of output, the curve is horizontal, indicating that there is substantial spare capacity in the economy. Here, increases in aggregate demand (AD) can lead to higher output without causing any upward pressure on prices. This reflects high levels of unemployment and underutilized resources.
7. Intermediate Section: As the economy approaches full capacity, the curve starts to slope upwards. In this range, increases in AD lead to both higher output and higher prices. This occurs because some sectors start to face constraints in supply, causing costs to rise as firms increase production.
8. Classical Section: At full employment output, the curve becomes vertical. In this segment, the economy is at full capacity, and any increase in AD only leads to higher prices (inflation) rather than an increase in output. This reflects the maximum sustainable level of output, where all resources are fully employed. The Keynesian LRAS curve, therefore, incorporates the idea of price and wage stickiness in the short run, leading to the possibility of persistent unemployment and underutilization of resources even in the long run, contrasting with the classical view that the economy always returns to full employment.

Shifts in SRAS and LRAS (Neo-classical and Keynesian)

1. SRAS Shifts: the only factor that determines whether or not firms can supply more at any given price level is the change in the costs of production These are determined by:

FACTOR	EXPLANATION
Cost of raw materials	An increase in the cost of raw materials raises production costs, causing the SRAS to shift left as firms produce less at any given price level. Conversely, a decrease in raw material costs lowers production costs, shifting the SRAS right.
Wages	Higher wages increase production costs for firms, leading to a leftward shift in the SRAS as firms reduce output. Lower wages reduce production costs, resulting in a rightward shift as firms increase output.
The exchange rate	A stronger domestic currency makes imported raw materials cheaper, reducing production costs and shifting the SRAS to the right. A weaker domestic currency makes imports more expensive, increasing production costs and shifting the SRAS to the left.
Government intervention	Increased taxes or regulations raise production costs, shifting the SRAS left as firms reduce output. Conversely, subsidies or reduced regulations lower production costs, shifting the SRAS right as firms increase output.
Protectionism	Tariffs or quotas on imports increase production costs by raising the prices of imported inputs, causing the SRAS to shift left. Reduction of trade barriers decreases costs of imported inputs, shifting the SRAS to the right.

• Rightward Shift: when costs fall, firms are more able to produce more goods and services
• Leftward Shift: when costs increase, firms are less able to produce goods and services

2. LRAS Shifts: caused by an increase in the quality of quantity of factors of production in the long term

• Rightward Shift: Technological advancements, increases in capital stock, better education and training, favourable government policies.
• Leftward Shift: Decreases in the labour force, capital destruction, long-term environmental degradation.

Diagram of Shifts in SRAS and LRAS

• SRAS Shift: Illustrated by shifting the SRAS curve left or right.

• LRAS Shift: Illustrated by shifting the LRAS curve left or right.