Aggregate Supply

Aggregate Supply

• Aggregate supply, similar to aggregate demand, is the macroeconomic equivalent of supply.
• It represents the total output that firms will produce and sell.
• It is split into long-run and short-run aggregate supply when using the neoclassical model.

Short-Run Aggregate Supply (SRAS)

• Total quantity of real output (real GDP) offered at different possible price levels in the short run.
• It slopes upward similar to a normal supply curve.

Shifters of SRAS

• The shifters of the SRAS curve generally occur due to the movement of the AD curve, but factors such as government policies can also cause a shift in the curve.

• A change in wage rates. An increase in wages causes increased production costs and shifts SRAS left, and vice versa.
• A change in the costs of raw materials. Increase in costs shifts SRAS to the left and a decrease shifts SRAS to the right.
• A change in the price of imports. An increase in import prices will decrease SRAS, depending on how many firms use imported materials in production. A decrease in import prices causes SRAS to shift right.
• A change in government indirect taxes or subsidies. Subsidies increase SRAS and taxes decrease SRAS.

Long-Run Aggregate Supply (LRAS)

• Aggregate supply that is dependent upon the resources and technology in the economy, thus being dependent on the price level.
• It is a vertical line at the level of potential output.
• It can only be increased by improvements in the quantity and/or quality of factors of production as well as improved technology.

Graphs

• Short-Run Aggregate Supply Graph
• Similar to a normal supply graph in microeconomics.
• SRAS is an upward sloping curve.
• Price level in Y-axis and real GDP or equivalent in x-axis.
• LRAS is a vertical curve that cuts through the equilibrium.

Shifters of LRAS

• The shifters of LRAS are similar to the shifters of a PPC curve, as both represent the possible economic output of a nation.

• Change in quality or quantities of factors of production
• Technological improvements
• Increase in efficiency
• Changes in institution
  

Factors That Influence the Quality/Quantity of Factors of Production

• The factors of production are land, labor and capital and entrepreneurship.

Land

Increase in Quantity

• Land reclamation
• Increased access to supply of resources
• Discovery of new resources

Increase in Quality

• Technological advancements that allow for increased access to resources or the discovery of new resources.
• Fertilizers
• Irrigation

Labor + Entrepreneurship

Increase in Quantity

• Increase in birth rate
• Immigration
• Decrease in the natural rate of unemployment

Increase in Quality

• Education
• Training
• Re-training
• Apprenticeship programs

Capital

Increase in Quantity

• Investment

Increase in Quality

• Technological advancements that contribute to more efficient capital
• Research and development

Natural Rate of Unemployment

• The rate of unemployment that occurs when the economy is producing at its potential output or full employment level of output (Yf).
• Natural unemployment exists because there is still some unemployment at the full employment.
• Some people might be switching jobs, or be in training for example.

SRAS Non-Price Determinants

Costs and Availability of Resources

• Wage rates
• Costs of raw materials
• Price of imports (exchange rates changes)

Government Intervention

• Subsidy
• Taxes
• Regulation

Supply Shocks

• An event that drastically alters supply such as a natural disaster or war.

Neoclassical Model of Aggregate Supply

• Neoclassical economics was founded by Milton Friedman in the 1870s.
• General equilibrium approach is based on the school of neo-classical economics.
• Assumes prices are always flexible in the long-run.
• This diagram didn't do well at prediction as prices and wages tend to be less flexible.
• Enforces the idea that the market will fix it self and return to equilibrum (full employment).

• In the neoclassical model, the supply curve will move in response to changes so that LRAS is always cutting through the equilibrium.
  

Keynesian Model of Aggregate Supply

• Founded by John Manyard Keynes in the 1920s/30s.
• The Keynesian model was a response to the neo-classical models which couldn't fix the great depression.
• States that wages are "sticky" and are slow to change due to labour laws, contracts, salaries, etc.
• Argues that the economy gets stuck in a short-run position.
  Only one aggregate supply curve, no distinction between LRAS and SRAS.

Keynesian Aggregate Supply Graph

• Capacity: Maximum level of output possible.
• The Keynesian model has 3 phases.
• The Keynesian model has one AS curve that starts horizontally then curves vertically.

Horizontal Section

• A fair amount of spare capacity. Room to increase GDP without price level going up.

Upwards Sloping Section

• The graph starts to curve upwards as it transitions to the vertical section from the horizontal section.
• Still some spare capacity, yet competition for scarce resources begin.

Vertical Section

• Almost a fully vertical curve.
• Little to no spare capacity. Full employment reached.
• Price increases a lot compared to minor changes in real GDP.

Inflationary and Deflationary Gaps

Recessionary/Deflationary Gap

• When the equilibrium level of real output is less than the potential output as a result of a decrease in AD.
• The gap is the difference between the new aggregate demand curve and the aggregate demand curve at full employment.
• The deflationary gap is temporary.
• The deflationary gap can be seen on a business cycle graph as the difference between actual output and potential output.

Inflationary Gap

• When the equilibrium level of real output exceeds the potential output as a result of an increase in AD.
• The gap is the difference between the new aggregate demand curve and the aggregate demand curve at full employment.
• The inflationary gap is temporary.
• The inflationary gap can be seen on a business cycle graph as the difference between actual output and potential output.

Stagflation and Growth

• Stagflation is a decrease in real GDP and an increase in unemployment rates simultaneously.
• Stagflation is extremely undesirable for an economy.
• Typical growth may also occur in the short run.

Disequilibrium in Aggregate Supply

Short Run Equilibrium

• There can be inflationary or recessionary gaps, but will eventually return to equilibrium.

Long Run Equilibrium

• In the short run, inflationary and recessionary gaps exist.
• However, in the long run, the equilibrium point must return to the LRAS (full employment).
  

Connection to Business Cycle

• The deflationary gap can be seen on a business cycle graph as the difference between actual output and potential output.
• Graphically, it is the vertical difference between the growth-trend line and the fluctuating actual output line.
  
• Long term aggregate supply changes as the general growth trend (potential output) increases over time.
• As the economy grows over time, the LRAS curve gradually shifts to the left.
  

Connection to the PPC Curve

• Points on the PPC curve can show inflationary and deflationary gaps as well.
• A point on the PPC curve is when there is equilibrium and SRAS = LRAS = AD at the GDP at full employment.

• Points below the PPC curve represent a deflationary gap as resources are not at full employment.

• Points above the PPC curve could represent an inflationary gap as resources are beyond full inflation.
• There is a slight discrepancy with this connection, as in a PPC diagram points beyond the curve are said to be impossible.

Long-Run Equilibrium Adjustments

AD Decrease

• A decrease in AD results in a decrease in price level across the economy.
• This results in the cost of inputs (such as wages) lowering, allowing companies to hire more workers and therefore increasing SRAS.
• The new price level at the equilibrium is now lower than the original.

AD Increase

• An increase in AD results in an increase in the aggregate price level.
• This results in increased production costs (wages, materials, etc.), leading to a reduction in SRAS.
• The new price level equilibrium is now higher than the original.

Neoclassical vs Keynesian Aggregate Supply.

Neoclassical

Equilibrium

• A market in disequilibrium will always correct naturally.

Wages

• Wages are flexible and can easily change.

Intervention

• Government intervention is not needed.
  

Keynesian

Equilibrium

• A market in disequilibrium may stay in disequilibrium for extended periods

Wages

• Wages are {"sticky" and do not change easily.

Intervention

• During a recession, the government must increase government spending to correct the recession, even if it must borrow funds.

“But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.”

J.M. Keynes, 1936.

Sources

https://studymind.co.uk/notes/aggregate-supply-a-level-economics/

https://www.ezyeducation.co.uk/ezyeconomicsdetails/ezylexicon-economic-glossary/958-deflationary-output-gap.html

https://corporatefinanceinstitute.com/resources/economics/inflationary-gap/

https://www.nuffield.ox.ac.uk/Users/Cameron/lmh/pdf/m8-04.pdf