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What it’s: Aggregate supply (AS) is an economy’s total goods and services. It behaves differently in the very short run, short run, and long run, each with a different elasticity. Short-run aggregate supply determines actual real GDP when its curve intersects the aggregate demand curve (called short-run macroeconomic equilibrium). Meanwhile, long-run aggregate supply determines potential GDP (also called potential output) and is equal to actual real GDP when the short-run equilibrium is right on the long-run aggregate supply curve.
Short-run aggregate supply is determined by short-run factors (such as the price level, input prices, and price expectations) and long-run factors (such as technology and increases in physical capital). However, it is not the other way around. Short-run factors don’t affect long-run aggregate supply.
Understanding the aggregate supply curve
The aggregate supply curve graphically represents the relationship between the price level and aggregate output, assuming other factors are constant. Economists divide them into three categories based on how each behaves in response to changes in the price level. They are:
- Very short-run aggregate supply (VRAS)
- Short-run aggregate supply (SRAS)
- Long-run aggregate supply (LRAS)
Very short-run aggregate supply (VRAS)
The aggregate supply curve is a horizontal line in the very short run. It shows perfectly elastic where prices and costs are fixed. It represents the first part of the Keynesian model (we discuss it below).
In the very short run, firms adjust output without increasing costs because they have idle capacity. Instead, they simply adjust working hours and intensify their production facilities in response to changing demands.
Short-run aggregate supply (SRAS)
In the short run, the aggregate supply has an upward-sloping curve. Thus, a higher price level will increase aggregate output. In contrast, a lower price level leads to a decrease in aggregate output. And the change in output occurs along the curve. In other words, a change in the price level only causes aggregate output to move along the curve, not shifting the curve to the right or to the left.
Economists assume some costs, such as rent and wages, do not change in the short run. Thus, when the price level rises, businesses see higher profit margins, prompting them to increase output. But conversely, profit margins decline when the price level falls, prompting them to cut output.
Long-run aggregate supply (LRAS)
Long-run aggregate supply represents the economy’s potential output (potential GDP). It is the highest output an economy can achieve using existing productive resources. When real GDP equals potential GDP, we say the economy is at full employment.
Unlike aggregate supply in the short run, economists assume all input costs are variable in the long run. Thus, they change in proportion to changes in aggregate output. So, for example, when aggregate output increases, all costs increase. And conversely, when aggregate output falls, all costs also fall.
This assumption is the key to explaining the vertical long-run aggregate supply curve. The curve is perfectly inelastic. Thus, changes in the price level do not affect aggregate supply.
When the price level rises, it does not increase the profit margin because input costs will also rise proportionally. The opposite also applies when the price level falls. Thus, there is no reason for firms to change their output in response to changes in the price level.
Aggregate output only changes if long-run factors change. These factors do not affect costs in the short run. Rather, they affect the economy’s productive capacity. For example, technological advances allow the economy to produce more. As a result, the long-run aggregate supply curve shifts to the right.
Neoclassical vs. Keynesian aggregate supply curve
There are two main views of how the economy produces. First, according to Neoclassical economists, the economy operates at its productive capacity. Thus, changes in the price level do not affect aggregate supply. Their views are represented by the vertical aggregate supply curve above.
Meanwhile, in the Keynesian model, aggregate supply forms three distinct parts. The first part is represented by a horizontal, very short-run aggregate supply curve. The second part is represented by an upward-sloping short-run aggregate supply curve. The third part is represented by the vertical long-run aggregate supply curve. So, when combined, the aggregate supply curve proposed by the Keynesian model is shaped like the AS curve below:
Factors affecting aggregate supply
Short-run and long-run aggregate supply respond differently to changes in the price level and other factors. As explained earlier, changes in the price level affect short-run aggregate supply but not long-run aggregate supply. In this case, a change in the price level causes short-run aggregate output to change but lies along the curve. So, it does not cause the SRAS curve to shift to the right or left.
- An increase in the price level increases short-run aggregate supply. Long-run aggregate supply remains constant.
- A decrease in the price level lowers short-run aggregate supply. The long-run aggregate supply remains unchanged.
Other factors, in addition to the price level, also affect aggregate supply. They fall into two categories: short-run factors and long-run factors. Short-run factors generally affect input costs and, therefore, the business’s profit margins. On the other hand, long-run factors affect productive capacity and, therefore, the maximum output produced.
Determinants of short-run aggregate supply
Changes in short-run aggregate supply result from changes in short-run and long-run factors. These factors affect the cost of production and the economy’s productive capacity. Unlike changes in the price level, these factors cause aggregate supply to change and shift its curve to the right (increase in output) or to the left (fall in output).
These short-run factors include:
- Input price
- Nominal wages
- Output price expectations
- Business tax
- Government subsidies
- Exchange rate
Input price. Higher input prices (such as raw materials and energy) increase production costs, lowering profit margins. As a result, aggregate output falls as businesses cut production, causing the SRAS curve to shift to the left. Conversely, decreasing input prices causes the SRAS curve to shift to the right.
Nominal wages. Like input prices, a change in nominal wages shifts the SRAS curve. Higher nominal wages increase production costs and shift the SRAS curve to the left. Conversely, lower nominal wages shift the SRAS curve to the right.
Expected future output prices. When future prices rise, producers will increase their supply to build inventories, anticipating higher profit margins. As a result, the SRAS curve shifts to the right. But conversely, if future prices fall, producers cut production, and thus, the SRAS curve shifts to the left.
Business tax. The SRAS curve shifts to the left as the government raises business taxes. This is because higher taxes increase production costs, lowering profit margins. Conversely, a lower tax decreases the production cost, causing the SRAS curve to shift to the right.
Government subsidies. Subsidies work in reverse compared to taxes. An increase in subsidies lowers production costs, prompts businesses to increase output, and shifts the SRAS curve to the right. Conversely, if the government cuts or removes subsidies, production costs increase and shift the SRAS curve to the left.
Exchange rate. Appreciation lowers production costs because imported raw materials and capital goods become cheaper. On the other hand, depreciation makes imports more expensive. Thus, appreciation causes the SRAS curve to shift to the right, while depreciation causes the SRAS curve to shift to the left.
Determinants of long-run aggregate supply
The above short-run factors do not affect long-run aggregate supply. That’s because all costs are variable, adjusting for changes in the price level proportionally. Thus, changes in input costs have no effect.
Long-run aggregate supply only changes when there is a change in long-run factors. These factors affect productive capacity and, therefore, potential output. For example, long-run aggregate supply increases, and the curve shifts to the right if:
- Labor supply increases, allowing more people to produce output.
- Human capital improves, leading to a more qualified workforce.
- More natural resources are available, more inputs are processed into outputs.
- Physical capital increases, enabling the economy to be more productive than relying on labor.
- Technology is more advanced, improving physical and human capital quality and productivity.
To make a long story short, changes in long-run aggregate supply occur due to changes in the quantity and quality of production factors.
