Aggregate supply (AS) is the total production of goods and services in the economy. In macroeconomics, aggregate supply will behave differently in the very short run, short run, and long term, as reflected in the elasticity of its curve.
Aggregate supply curve
The aggregate supply curve is a graphical representation of the relationship between the price level and the total output of goods and services in the economy, keeping other factors constant. In economics, economists use real GDP to represent total output in the economy.
In a very short period, the curve is a horizontal line (very elastic), meaning the company will adjust output without changing prices. They only adjust working hours and the intensity of their production facilities in response to changes in demand.
In the short run, several factors of production remain, usually capital. The short-run aggregate supply (SRAS) curve has an upward slope, meaning that higher prices will encourage more supply.
In the long run, all input costs vary. The long-run aggregate supply (LRAS) curve is perfectly inelastic, meaning that the price level does not affect aggregate supply. A higher price level does not change the quantity supplied. At this level, economists say the economy is at full employment (at its potential output, potential GDP, or potential production capacity).
LRAS reflects the economy uses all of its resources. When LRAS shifts (both to the right or the left), it does not create inflationary pressure.
What causes a shift in the aggregate supply curve?
Before discussing the determinants, please note, SRAS and LRAS behave differently.
In the short term, a change in the price level causes aggregate supply to move along (not shift) the SRAS curve. The curve will shift only when production costs and the productive capacity of the economy change.
Following are detailed factors that shift the SRAS curve:
- Input price. Higher input (such as raw material and energy) prices increase production costs, shifting the SRAS curve to the left. Conversely, the SRAS curve will shift to the right due to a decrease in input prices.
- Nominal wages. Like input prices, change in the nominal wage will shift the SRAS curve. Higher nominal wages increase production costs and shift the SRAS curve to the left. In contrast, lower nominal wage shifts the SRAS curve to the right.
- Expectations of future output prices. When future prices increase, producers will increase supply to anticipate higher profit margins in the future. As a result, the SRAS curve shifts to the right. However, if output prices fall, producers cut production and thus shift to the left.
- Business tax. The SRAS curve shifts to the right when governments cut business taxes. Lower business taxes reduce production costs and vice versa; production costs increase when governments raise it.
- Government subsidies. Governments often offer subsidies to help businesses reducing their production costs, thereby shifting the SRAS curve to the right. If the subsidy is revoked, production costs increase and shift the SRAS curve to the left.
- Exchange rate. Currency appreciation makes imported raw materials and capital goods cheaper for domestic producers. It reduces production costs and shifts the SRAS curve to the right. The opposite effect applies when the exchange rate depreciates.
- Factors that affect long-term aggregate supply. Changing these factors will shift the SRAS curve. For example, improved labor quality due to advanced technology enables them to produce more output using existing input. As a result, short-run production increases and shifts the SRAS curve to the right.
In the long run, the economy uses its production capacity and produce at its potential output. During this period, input prices adjust the price level changes proportionally. Hence, changes in production costs do not affect LRAS and its curve.
Potential output changes only when the economy’s production factors also change. For example, LRAS increases when factors of production increases in quantity or improves in quality. Increased LRAS shifts its curve to the right.
The following are factors that increase LRAS and shift the curve to the right:
- Increase in labor supply
- Increase in natural resources
- Improved human capital
- Increase in physical capital
- More advanced technology