Aggregate Supply

Definition and Basics of Aggregate Supply

  • Aggregate Supply (AS) defines the total amount of goods and services that firms in an economy are willing to sell at a given overall price level.
  • It’s plotted on a graph with real output or real Gross Domestic Product (GDP) on the horizontal axis and the overall price level on the vertical axis.
  • AS is split into two segments: short run aggregate supply (SRAS) and long run aggregate supply (LRAS).

Short Run Aggregate Supply (SRAS)

  • SRAS refers to the level of supply achieved in the short term, where the prices of resources (e.g., labour) are fixed.
  • Changes in SRAS can occur due to changes in costs of production (raw materials, wages), changes in government policy (taxes, subsidies), changes in firms’ expectations about future price levels, and supply shocks (e.g., natural disasters).

Long Run Aggregate Supply (LRAS)

  • LRAS defines the level of output an economy can produce when resources such as capital and labour are used to their full potential.
  • The Classical view suggests that in the long run, the economy will be operating at full employment. The LRAS curve is therefore perfectly inelastic (vertical) at the level of potential output.
  • The Keynesian view argues that the economy can operate below full employment in the long run. This results in a LRAS curve that is perfectly elastic (horizontal) at low levels of output, becoming perfectly inelastic (vertical) at potential output.
  • Changes in LRAS can occur due to changes in the factors of production (labour, capital, land, entrepreneurship), improvements in technology, and changes in efficiency or productivity.

Factors Shifting Aggregate Supply

  • Shifts in the AS curve can be caused by changes in the factors of production, changes in wage rates, changes in raw material prices, changes in the state of technology, and changes in government policy.
  • Any change that increases potential output will shift the AS curve to the right, highlighting an increase in AS, and any change that reduces potential output will shift the curve to the left, indicating a decrease in AS.

Interactions between Aggregate Demand and Aggregate Supply

  • Where the AD and AS curves intersect gives the equilibrium level of real output and the overall price level in the economy.
  • If AD increases (shifts to the right) it leads to a higher level of real output and a higher overall price level. If AD decreases (shifts to the left) it leads to a lower level of output and a lower overall price level.

Remember that understanding the key concepts, diagrams, and impacts of aggregate supply will provide a strong foundation for your economic analysis and evaluation skills.