The Characteristics of Aggregate Supply - Aggregate Supply

Long-run aggregate supply is the total output an economy can produce when all costs (including wages) are fully flexible (1). It reflects the economy's productive capacity and depends on the quantity and quality of the factors of production, not on the price level (1).

On a diagram with the price level (P) on the vertical axis and real GDP (Y) on the horizontal axis, SRAS is drawn sloping upward from left to right (1 for a correct, labelled diagram).

It slopes upward because, in the short run, many costs — especially wages — are fixed and slow to change (1). When the price level rises while costs stay put, each unit of output becomes more profitable, so firms widen their profit margins (1). Higher margins encourage firms to raise output — using spare capacity and hiring more workers — so a higher price level is associated with more total output supplied (1).

A large fall in world commodity and energy prices reduces the cost of raw materials and fuel that firms across the economy use to produce their output. Because this lowers costs of production at every level of output — and it is not a change in the price level — it shifts the short-run aggregate supply curve rather than moving along it.

On a diagram with the price level (P) on the vertical axis and real GDP (Y) on the horizontal axis, the fall in costs shifts SRAS rightward from SRAS to SRAS₁: at any given price level, firms are now willing to supply more output.

Tracing this through against a given aggregate demand curve, the rightward SRAS shift lowers the equilibrium price level and raises equilibrium real output. In macro terms this is a favourable supply-side effect: lower inflationary pressure together with higher output and employment — sometimes described as an economy able to grow with less inflation.

Therefore a fall in commodity and energy prices, by cutting firms' costs, increases short-run aggregate supply (SRAS → SRAS₁), tending to reduce the price level while raising real output.

An increase in long-run aggregate supply means the economy's productive capacity rises, so the LRAS curve shifts rightward (on a classical diagram, the vertical LRAS moves from Yfe to Yfe₁). This requires more or better factors of production. Two factors can cause it.

Factor 1 — higher investment in physical capital. When firms and the government invest in new machinery, equipment and infrastructure, the economy's capital stock rises. More and better capital lets the same workforce produce more output, so productive capacity increases and LRAS shifts right. Investment is especially valuable because it also raises AD in the short run, giving both current and future benefits.

Factor 2 — better education and training (human capital). Improving workers' skills, knowledge and experience raises their productivity — each worker produces more per hour. A more productive, better-matched workforce raises the economy's capacity, shifting LRAS right. This is a core aim of supply-side policy and delivers sustainable long-run growth.

On a classical LRAS diagram both factors shift the vertical LRAS from LRAS to LRAS₁ (Yfe → Yfe₁), raising the level of output the economy can sustainably produce.

Oil is an input into production and transport across almost every industry, so a sharp rise in oil prices raises firms' costs of production throughout an oil-importing economy. Because costs rise at every level of output — for a reason other than the price level — this shifts the short-run aggregate supply curve leftward.

The main effect. On a diagram with the price level (P) on the vertical axis and real GDP (Y) on the horizontal axis, SRAS shifts left from SRAS to SRAS₁. Against a given AD curve, the new equilibrium has a higher price level and lower real output. This is cost-push inflation combined with falling output and rising unemployment — the classic 'stagflation' problem, which is especially awkward because inflation and unemployment worsen together.

Evaluation — how serious is the effect? The size and desirability of the effect are uncertain, for several reasons.

First, it depends on the economy's oil intensity and whether firms can substitute away from oil. An economy with efficient energy use, or good alternatives (renewables, gas), will see only a small SRAS shift; a heavily oil-dependent economy will be hit hard.

Second, it depends on whether the rise is temporary or permanent. A short-lived spike shifts SRAS left only briefly, after which it can shift back; a permanent rise embeds higher costs and may even, over time, dampen investment and so touch LRAS.

Third, it depends on second-round effects. If workers respond to higher prices by demanding higher wages, a wage–price spiral can shift SRAS left again and again, making inflation persistent; if wage expectations stay anchored, the effect is a one-off rise in the price level.

Judgement. A sharp rise in oil prices in an oil-importing economy will most likely raise the price level and lower real output in the short run, by shifting SRAS left. But the severity depends on the economy's oil dependence and ability to substitute, whether the rise is temporary or permanent, and whether it triggers a wage–price spiral. The effect is therefore best judged in context, and policy should focus on limiting second-round effects and, over the long run, reducing oil dependence to protect capacity.

An economy's output can be raised in two broad ways: by boosting aggregate demand (using existing capacity more fully) or by supply-side improvements that raise productive capacity and shift LRAS to the right. Whether supply-side improvements are the best route depends heavily on which model of long-run AS applies and on the economy's circumstances.

The case for supply-side improvements. In the classical model, LRAS is vertical at potential output, so in the long run demand cannot raise real output — an increase in AD only raises the price level. On this view, the only way to raise long-run output is to shift LRAS right by improving the quantity and quality of the factors of production: more investment in capital, better education and training (human capital), higher productivity and technology, and reforms to incentives and competition. Crucially, supply-side improvements can deliver non-inflationary growth — output rises and the price level tends to fall — and they raise the economy's sustainable capacity rather than giving a temporary boost. For an economy already near full capacity, they are the only lasting option.

The case against — why demand can matter more. First, in the Keynesian model the LRAS curve is flat where there is spare capacity, so in a deep recession with mass unemployment, boosting aggregate demand (through fiscal or monetary policy) can raise real output quickly and with little inflation — supply-side reforms would leave idle resources idle. Second, supply-side improvements are typically slow and work only over the long run: building human capital or infrastructure takes years, whereas a demand stimulus acts within months. Third, they are costly and uncertain: investment in education or R&D may not pay off, and deregulation can have side-effects (e.g. weaker worker protection or environmental harm). Fourth, supply and demand are interdependent — investment raises LRAS and AD, so the two approaches are complements rather than rivals.

Evaluation and judgement. Whether supply-side improvements are 'best' depends on the time frame and the state of the economy. When the economy is at or near full capacity (the classical case), supply-side improvements are indeed the best — arguably the only — way to raise output sustainably and without inflation. But when there is large spare capacity (the Keynesian case), demand-side policy is faster and more effective at raising output in the short run, and relying on supply-side reform alone would waste idle resources. The most defensible conclusion is that supply-side improvements are the best route to long-run, sustainable, non-inflationary growth, but they are not sufficient on their own and are often too slow for short-run problems: the ideal is usually a combination — demand management to close a short-run output gap, and supply-side reform to raise capacity over time. The 'best' policy therefore depends on whether the constraint on output is a lack of demand or a lack of capacity.