Aggregate Supply: Long-Run and Short-Run Analysis

Aggregate Supply

Introduction to Aggregate Supply

Aggregate supply (AS) represents the total quantity of goods and services that firms in an economy are willing and able to produce at different price levels. It is a key concept in macroeconomics, helping to explain how output and prices are determined in the short run and long run.

• Long Run: A period in which wages and prices are flexible and can adjust to changes in economic conditions.

• Short Run: A period in which some wages and prices are 'sticky' and do not adjust immediately to changes in economic activity.

• Sticky Price: A price that is slow to adjust to its equilibrium level.

• Sticky Wage: A wage that is slow to adjust to its equilibrium level.

Long-Run Aggregate Supply (LRAS)

Definition and Characteristics

The long-run aggregate supply curve shows the relationship between the price level and the quantity of real GDP supplied when all prices, including wages, are fully flexible. In the long run, the economy operates at its potential output (also called full-employment GDP), where all resources are used efficiently.

• Potential Output (GDP): The level of output an economy can achieve when labor is employed at its natural level.

• LRAS is typically represented as a vertical line at the potential GDP, indicating that changes in the price level do not affect the long-run quantity of real GDP supplied.

Key Determinants of LRAS:

• Quantity of Labor

• Capital Stock (human and physical capital)

• Natural Resources

• Technology

In the long run, changes in the price level do not affect the number of workers, the capital stock, or technology. Therefore, the LRAS curve does not shift due to price level changes but only due to changes in these determinants.

Shift vs. Movement Along LRAS

• Movement Along LRAS: A change in the price level does not impact the level of long-run aggregate supply; the economy remains at potential output.

• Shifters of LRAS:

  • Change in Quantity of Labor

  • Change in Capital (human and physical)

  • Change in Natural Resources

  • Change in Technology

Example: If a policy increases the education level of the workforce (such as making two years of college free and universal), the economy's human capital increases, shifting the LRAS curve to the right.

Short-Run Aggregate Supply (SRAS)

Definition and Characteristics

The short-run aggregate supply curve shows the relationship between the price level and the quantity of real GDP supplied when some prices, especially wages, are sticky and do not adjust immediately to changes in economic conditions.

• Sticky Wages: Wages tend to respond slower than do changes in business performance due to contracts and adjustment lags.

• Sticky Prices: Prices do not tend to adjust throughout a given period, often due to menu costs or "wait and see" approaches.

Shift vs. Movement Along SRAS

• Movement Along SRAS: If the price level changes but other variables are unchanged, the economy moves up or down along a stationary SRAS curve.

• Shift of SRAS: If any variable other than the price level changes, the SRAS curve will shift.

Variables That Shift the Short-Run Aggregate Supply Curve

• Change in the Availability of Factors of Production: An increase in the labor force or capital stock shifts SRAS to the right because more output can be produced at every price level.

• Improvements in Technology: Increases productivity and shifts SRAS to the right as costs of producing output fall.

• Expected Future Price Level: If workers and firms expect higher prices in the future, SRAS shifts left as wages and prices increase.

• Adjustment to Underestimated Price Level: If workers and firms realize they previously underestimated the price level, SRAS shifts left as they adjust wages and prices upward.

• Supply Shock: An unexpected event (e.g., a sudden increase in oil prices) that causes SRAS to shift left due to higher production costs.

Table: Main Shifters of SRAS

Variable	SRAS Shift Direction	Reason
Increase in labor/capital	Right	More output at every price level
Improved technology	Right	Lower production costs
Higher expected future prices	Left	Wages and prices rise
Supply shock (e.g., oil price spike)	Left	Higher input costs

Wage and Price Stickiness

Causes and Examples

• Sticky Wages: Result from wage contracts and slow wage adjustments.

• Sticky Prices: Result from menu costs and a "wait and see" approach by firms.

• Examples: Gasoline prices at the pump, posted menu prices, and grocery prices that do not change daily.

Equilibrium in the Short Run

Determination of Output and Price Level

The short-run equilibrium occurs at the intersection of the aggregate demand (AD) and short-run aggregate supply (SRAS) curves. This intersection determines the equilibrium price level and the equilibrium level of real GDP.

• Equilibrium Price Level ($P^*$): The price at which the quantity of real GDP demanded equals the quantity supplied in the short run.

• Equilibrium Output ($Y^*$): The level of real GDP at the equilibrium price level.

Class Examples

Example 1: Aggregate Supply and Demand Table

Price Level	Demand	Supply
0.50	$3,500	$1,000
0.75	$3,000	$2,000
1.00	$2,500	$2,500
1.25	$2,000	$2,700
1.50	$1,500	$2,800

• Equilibrium occurs where Demand = Supply (at price level 1.00, output $2,500).

• If aggregate demand increases by $700 at each price level, the demand curve shifts right, raising both equilibrium price and output in the short run.

Example 2: Effect of Wage Increase on SRAS

Price Level	Demand	Supply
0.50	$2,500	$1,500
0.75	$2,000	$2,000
1.00	$1,500	$2,500
1.25	$1,000	$3,000
1.50	$500	$3,500

• If nominal wages rise, the SRAS curve shifts left (upward), requiring a higher price level to produce the same output. For example, if the price level required to produce $1,500 of output rises from 1.00 to 1.50, this reflects a leftward shift of SRAS.

Key Equations

• Aggregate Supply Function (general form):

$Y = Y^* + eta(P - P^e)$

• Where $Y$ is actual output, $Y^*$ is potential output, $P$ is the actual price level, $P^e$ is the expected price level, and $\beta$ is a positive parameter reflecting the responsiveness of output to unexpected changes in the price level.

Additional info: The above equation is a simplified representation of the short-run aggregate supply curve, showing how output deviates from potential when the actual price level differs from expected.