3. Aggregate Supply

Aggregate supply distinguishes current production costs from long-run productive capacity.

Must know

• SRAS responds to unit costs.

• LRAS reflects productive potential.

• Classical and Keynesian models differ in their adjustment assumptions.

Must know definitions

Aggregate supply (AS) — the total amount of goods and services (real output) produced and supplied by an economy's firms at a particular price level over a period of time.

Short-run aggregate supply (SRAS) — the relationship between the price level and real output supplied while nominal wages and some input prices have not fully adjusted; usually upward-sloping.

Long-run aggregate supply (LRAS) — the relationship between the price level and real output after wages and input prices have adjusted; its shape depends on the model’s assumptions.

Classical LRAS — a vertical curve at sustainable potential output (Yfe). Flexible wages and prices restore this output in the model’s long-run equilibrium.

Keynesian LRAS — an LRAS curve with a horizontal section (spare capacity), an upward-sloping section, and a vertical section (full employment), reflecting the view that the economy can remain below full-employment output for extended periods.

Spare capacity — underused labour or capital that can allow output to rise with limited extra inflationary pressure.

Full-employment output (Yfe) — sustainable potential output with resources used at normal capacity. Frictional and structural unemployment can remain; actual output may temporarily exceed this level.

Productivity — output per worker per hour worked.

"Red tape" — a colloquial term for excessive government regulation that raises firms' costs of compliance and can reduce AS.

Explain and apply

Mechanism in brief: Higher energy costs increase firms' costs at each output, shifting SRAS left. Better skills can increase potential production and shift LRAS right, but only after training is completed and skills are used productively.

Distinguish: A shift in LRAS does not mechanically guarantee an immediate shift in SRAS; Keynesian AS has different sections.

Use the extract: Distinguish a change in current production costs from a change in productive capacity; identify the resource or technology affected.

Definition reminder: Aggregate supply (AS)

The AS curve

SRAS is upward-sloping in the short-run AD–AS model. The Keynesian AS model below is a separate, continuous curve with a flat region, a rising region and a near-vertical full-employment region.

• With upward-sloping SRAS, a higher price level encourages more real output at given input costs. The response on Keynesian AS varies with spare capacity.

Figure 2.9 Movement along SRAS

Why SRAS slopes upward: at a higher price level, firms can earn higher profits (assuming costs are relatively fixed in the short run) → firms are willing and able to supply more output → upward-sloping SRAS.

Movement along vs shift of AS

→ Change in AD → new equilibrium PL → movement along the AS curve (NOT a shift)

→ Change in firms' costs of production or supply conditions → shift of the entire AS curve

Figure 2.10 Shifts of SRAS — Increase

Figure 2.11 Shifts of SRAS — Decrease

Common mistake: a very common mistake is treating a change in AD as if it shifts the AS curve.

Remember

AD changes cause movement along AS (a new equilibrium point); only changes in the conditions of supply (costs, technology, regulation) cause AS itself to shift.

Short-run aggregate supply (SRAS)

Factors influencing SRAS

• SRAS shifts when firms' costs of production change at every price level.

Cost of employment (wages)

Mechanism: ↑ wages → ↑ firms' costs of production → firms supply less at each PL → SRAS shifts left

Arrow chain: ↑ wages → ↑ costs → ↓ SRAS (shift left)

Labour productivity

Mechanism: ↑ productivity → same output for lower unit labour cost → ↓ costs per unit → SRAS shifts right

Arrow chain: ↑ labour productivity → ↓ unit costs → ↑ SRAS (shift right)

Commodity / raw material prices

Mechanism: ↑ price of oil or key raw materials → ↑ input costs → SRAS shifts left

Arrow chain: ↑ commodity prices → ↑ costs of production → ↓ SRAS (shift left)

Exchange rate (for imported inputs)

Mechanism: ↓ exchange rate (depreciation) → imported raw materials become more expensive → ↑ costs → SRAS shifts left

Arrow chain: ↓ exchange rate → ↑ cost of imported inputs → ↓ SRAS (shift left)

Indirect taxes

Mechanism: ↑ indirect tax (e.g. VAT, excise duty) → ↑ effective cost of supplying goods → SRAS shifts left

Arrow chain: ↑ indirect tax → ↑ costs → ↓ SRAS (shift left)

Subsidies

Mechanism: ↑ government subsidies to firms → ↓ effective cost of production → SRAS shifts right

Arrow chain: ↑ subsidies → ↓ costs → ↑ SRAS (shift right)

Government regulation ("red tape")

Mechanism: ↑ regulation (environmental laws, business compliance costs) → ↑ costs of compliance → SRAS shifts left; deregulation → ↓ costs → SRAS shifts right

Arrow chain: ↑ regulation → ↑ compliance costs → ↓ SRAS (shift left)

Exam tip: Notice that SRAS shifters are almost entirely cost-side factors.

• Rising input prices may shift SRAS left, but a shock can affect demand as well as supply. A weaker currency can raise imported-input costs and also influence net exports; business-tax changes may affect investment. Identify each channel supported by the extract.

Long-run aggregate supply (LRAS)

• There are two competing views of the shape of the LRAS curve — classical and Keynesian. The spec requires you to understand both, and to know when each is more appropriate to use.

Classical LRAS

Classical economists believe the LRAS curve is perfectly (vertical) inelastic.

• They argue that in the long run, all markets clear (wages and prices are flexible), meaning there can be no output gap in the long run — the economy always returns to producing at its maximum potential level of output.

Figure 2.12 Long-run aggregate supply

Key implication: because LRAS is vertical, a shift in AD only changes the price level in the long run — it has no effect on real output.

This is a critical exam point

classical economists believe demand-side policy (e.g. fiscal stimulus) cannot increase output in the long run, only prices.

→ Classical view: ↑ AD (long run) → ↑ PL only → no change in real GDP (output is fixed at Yfe)

Keynesian LRAS

Keynesian economists believe it is possible to have long-run equilibrium where markets do not clear, so there can be spare capacity in the economy even in the long run.

• The Keynesian LRAS curve has three distinct sections.

Figure 2.13 Long-run aggregate supply

Exam tip — this is a high-value evaluation point: the Keynesian LRAS shows that the effect of an AD-side policy (e.g. expansionary fiscal or monetary policy) on inflation vs growth depends entirely on how much spare capacity the economy has.

• An economy in a deep recession (lots of spare capacity) can expand AD with little inflation risk; an economy near full employment will see mostly price rises from the same policy.

Classical vs Keynesian LRAS comparison

Common mistake: don't apply the classical "demand-side policy can't raise long-run output" conclusion to a Keynesian LRAS with spare capacity — the two models give opposite policy implications, so state which view you are using.

Factors influencing LRAS

• LRAS shifts when the quantity or quality of the factors of production changes — this is equivalent to shifting the economy's PPF outward.

Technology

Mechanism: ↑ investment in technology → firms produce more output from the same inputs, or improve quality → ↑ LRAS

Arrow chain: ↑ technology → ↑ productive capacity → ↑ LRAS (shift right)

Productivity

Mechanism: ↑ output per worker per hour worked → same labour force produces more → ↑ LRAS

Arrow chain: ↑ productivity → ↑ potential output → ↑ LRAS (shift right)

Quantity/quality of factors of production

Mechanism: ↑ capital stock, ↑ number of workers, or ↑ quality of resources (e.g. more fertile land, better machinery) → ↑ LRAS

Arrow chain: ↑ quantity/quality of factors → ↑ LRAS (shift right)

Education and skills

Mechanism: ↑ investment in education and training → ↑ quality of human capital → workers more productive and versatile → ↑ LRAS (long time lag)

Arrow chain: ↑ education/skills → ↑ quality of labour → ↑ LRAS (shift right)

Government regulation

Mechanism: ↓ excessive regulation ("red tape") → ↓ compliance burden on firms → firms can be more efficient → ↑ LRAS; ↑ regulation → ↓ LRAS

Arrow chain: ↓ regulation → ↑ efficiency → ↑ LRAS (shift right)

Competition policy

Mechanism: ↑ effective competition policy → firms forced to be more efficient/productive to avoid being competed out of business → ↑ LRAS

Arrow chain: ↑ competition → ↑ efficiency → ↑ LRAS (shift right)

Demography and net migration

Mechanism: ↑ net inward migration (especially of working-age people) → ↑ size of labour force → ↑ LRAS

Arrow chain: ↑ net migration (working-age) → ↑ labour force → ↑ LRAS (shift right)

Exam tip: LRAS shifters are almost always supply-side policy territory (education, infrastructure, deregulation, competition policy, migration policy).

• If a question asks about "long-run growth" or "increasing potential output," it is asking about LRAS shifters, not AD components.

SRAS vs LRAS comparison

Relationships between LRAS and SRAS shifts

• A productivity improvement may shift both LRAS and SRAS right: it raises potential output and lowers unit costs. However, do not assume every change in long-run capacity produces an immediate short-run cost change. State the mechanism and timing. A temporary input-price change can shift SRAS without changing LRAS.

A change in productive capacity can affect current costs as well, but its effect on SRAS depends on when new resources become usable and on what happens to input prices and productivity.

Example

↑ productivity (an LRAS shifter) → workers produce more output per hour → ↓ unit labour cost → firms' short-run costs also fall → SRAS shifts right too

Example

↑ investment in technology → potentially ↑ productive capacity as the technology becomes usable → if it also lowers unit costs, SRAS shifts right. The timing and scale of the two effects may differ.

→ SRAS shift ≠ LRAS shift (not necessarily true): a change in short-run production costs does not change the economy's underlying productive capacity

Example

↓ oil price (a SRAS shifter) → ↓ firms' short-run costs → SRAS shifts right → but the economy's quantity/quality of factors of production (labour, capital, technology) is unchanged → LRAS does NOT shift

Example

Currency appreciation causing cheaper imported inputs → SRAS shifts right → but this is a temporary cost change, not a change in the economy's productive potential → LRAS unaffected

Common mistake: don't assume every SRAS shifter also shifts LRAS. A temporary input-cost change can shift SRAS without changing productive capacity. A change in the quantity or quality of factors of production can shift LRAS and may also shift SRAS, depending on its effect on unit costs and when the resources become usable.

Exam tip — this is a strong evaluation point: when asked to assess a policy's impact on AS, always check whether it changes underlying productive capacity (technology, quality/quantity of factors) as well as costs.

A policy that only lowers costs (e.g. a fuel subsidy) gives a temporary SRAS boost but does NOT raise the economy's long-run potential output — whereas a policy that raises productivity or invests in capital/education raises both, giving a more sustainable increase in AS.

Exam explanation stems: aggregate supply

Use these ready-made stems to explain AS in exam answers:

SRAS shift via costs

↑ price of oil (a key commodity) → ↑ firms' costs of production → firms supply less output at each price level → SRAS shifts left → ↓ real GDP and ↑ price level (stagflation risk).

SRAS shift via exchange rate

Depreciation → imported raw materials become dearer in domestic currency → firms’ production costs rise → SRAS shifts left, raising the price level and reducing real output, other things equal.

Classical LRAS — a vertical curve at sustainable potential output (Yfe). Flexible wages and prices restore this output in the model’s long-run equilibrium.

Because classical economists view LRAS as vertical, an increase in AD (e.g. from expansionary fiscal policy) can only raise the price level in the long run — it cannot raise real output beyond Yfe. Use this to evaluate demand-side policy as a long-run growth tool.

Keynesian LRAS — spare capacity argument

If the economy has significant spare capacity (operating on the horizontal section of Keynesian LRAS), an increase in AD can raise real output with little to no increase in the price level. This justifies demand-side stimulus during a recession without much inflation risk. As the economy approaches full employment, the same AD increase becomes increasingly inflationary.

LRAS shift via supply-side policy

↑ government spending on education and training → ↑ quality of human capital (long time lag) → ↑ productivity → ↑ LRAS → economy can sustain higher real GDP at every price level without additional inflationary pressure — a more sustainable route to long-run growth than demand-side stimulus alone.

LRAS vs SRAS shift — distinguishing genuine capacity growth from a temporary cost shock: ↑ productivity raises LRAS (more potential output) AND lowers unit costs, so SRAS shifts right too — a durable improvement in AS. By contrast, a fall in oil prices only shifts SRAS right (lower costs), leaving LRAS unchanged, because the economy's underlying productive capacity has not increased. Use this distinction to evaluate whether a policy or shock produces a temporary or a permanent improvement in AS.

Rapid recap

SRAS shifts with current production costs; LRAS shifts with resources, technology and productive capacity. A price-level change alone causes movement along the relevant supply curve.

Diagram cue: distinguish an SRAS cost shift from an LRAS capacity shift.

Related chapters: Unit 2 chapter 4 (p. 55) · Unit 2 chapter 9 (p. 90)