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Aggregate Supply

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Today we are learning

• Define short run AS (SRAS)• Illustrate SRAS• Explain what causes shifts in the SRAS• Distinguish between short run AS and LRAS

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Aggregate Supply

• Is the amount of goods and services that all industries in the economy will produce at every given price level.

• It is essentially the sum of the supply curve from all industries in the economy.

• We distinguish between S.R and L.R. AS curves.

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Short Run Supply curve.

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SRAS• Upward sloping showing positive relationship between the

price level and the output of the economy• Short run is the period of time in which factors of production

do not change. Assume the wage rate is fixed. • If a larger level of output is to be produced firms will face

higher costs of production. • This can be achieved through the use of overtime wages. • H/L as Wages in crease the law of diminishing returns sets in,

in the SR because Average costs will increase. • Firms will pass on the higher cost in the form of higher prices .• This explains why the AS curve is upward sloping as an

increase in output will be accompanied by an increase in prices.

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Shifts in the SRAS

• SRAS shows relationship between price level and the level of National Income under the ceteris paribus assumption. i.e. we are assuming that factor costs remain constant.

• A change in anything other than price will cause the SRAS curve to move. – “Supply Shock”.

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Shifts in the AS curve

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Examples of supply shocks

• A change in wage rates • Change in the cost of Raw materials• A change in the price of imports. • A change in government indirect taxes and

subsidies.

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Complete Student workpoint 15.1

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Combining AD and AS in S.R. Economy will operate where AD=AS – At this price level all the output produced by the country is consumed.

No incentive for producers to increase output or raise prices.

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Long Run AS Curve

• There is great debate concerning the long run AS curve.

• Keynesians and Classical Economists have different views.

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Classical AS Curve

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Branches of Classical Economics

• Austrian School• Supply side economists• Monetarists.

• All believe in the efficiency of market forces and the view that there should be very little government intervention in the economy.

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Classical Economists

• Believe LRAS is perfectly Inelastic.• Economy is always at the full employment level of

output.• This is the level of output that would exist if the

economy operated at full output. • (full employment does not mean zero unemployment) • LRAS is viewed to be independent of the price level .• Price level might rise from P1 to P2 but the level of

output does not change.

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Keynesian AS Curve

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Keynesian AS

1. AS curve will be perfectly inelastic at low levels of economic activity. Producers can raise level of output without raising the level of costs because of the existence of spare capacity.

2. As economy approaches potential output prices are bid up as spare capacity gets used up. Wages increase, and costs of production rise. These costs are passed on to consumers in the form of higher prices.

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3. When the economy reaches full capacity (y1 it is impossible to increase output any further because all factors of production are fully employed. LRAS is perfectly inelastic at this point and government policy to increase output in the form of increased AD will be ineffective.

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Shifts in the LRAS curve

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Increase in productive potential of Economy

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Shifts in LRAS

• An outward shift in LRAS indicates that the economies productive potential has improved. Same as a PPC curve

• Increase in labour productivity• Increase in qty of factors of production• Either may be affected by improvements in

technology.