For firms, there is demand and supply; for the economy, there is aggregate demand and aggregate supply. Aggregate supply (AS) is the total output of final goods and services produced by the domestic economy, equal to aggregate demand, and equal to real GDP. It is the interaction of aggregate demand and aggregate supply that determines how much firms will produce and at what price levels. It also determines inflation. Changes in aggregate supply respond to changes in aggregate demand, which is manifested by changing price levels. However, because many prices are sticky, and it takes time for economic agents to recognize changes in price levels, there is a difference between aggregate supply in the short run compared to aggregate supply in the long run. The short run is characterized by the transition period for price changes, which usually lasts for several years. The long run is characterized by stable price levels at the potential output or GDP.
Real GDP growth depends on steady increases in capital, workers, and technological progress. In the long run, prices do not matter, because prices will adjust until they reach a new steady state. Because prices are nominal, they do not affect real output in the long run. However, prices do affect supply, including aggregate supply, in the short run.
When a firm experiences increased demand, the firm increases output to increase profits. If marginal revenue exceeds marginal cost, then the firm will increase output until they are equal. If marginal revenue already equals marginal costs, then the firm will raise prices to increase output. However, aggregate demand differs from the demand for a firm's products, because it includes all products and services. Therefore, if the economy is already producing its potential output, then firms must increase their prices to increase production, because they must pay higher wages to motivate workers to work overtime and to compensate for the declining marginal product of capital. Thus, aggregate supply can only be increased by increasing prices, which reduces aggregate demand. This, in turn, causes firms to cut back production. Because prices are higher, and wages are higher, inflation has increased, but economic output returns to its potential output, which is the output that is sustainable, where the economy can produce without straining its resources, such as paying for overtime.
The Aggregate Supply Curve
Potential GDP or potential output, often represented as Y*, is the maximum sustainable output. Because Y* is at potential GDP, the unemployment rate will be the natural rate of unemployment. Hence, Y* sometimes called the natural rate of output or natural GDP.
Because the real GDP is unchanged by changing price levels in the long run, the graph for Y* is vertical, with real GDP on the x-axis and the aggregate price level on the y-axis. Different levels of aggregate demand will yield different price levels based on whether they intersect the vertical line for Y*, the long-run aggregate supply (LRAS) curve.
If the economy is operating at less it then its potential output, then some resources are not being used, so firms can increase production without increasing prices by using these idle resources. For instance, firms can easily hire more workers, since employment is less than its natural rate. Once idle resources are used up, then price levels increase sharply but with no corresponding increase in real GDP. Thus, the short-run aggregate supply (SRAS) curve slopes upward, becoming vertical, after the economy reaches full employment.
The use of resources can be strained, to temporarily increase output beyond potential GDP, but eventually it will return to the potential GDP. Thus, the vertical LRAS curve is slightly leftward of the vertical SRAS curve representing the short-term increase in production.
In the long run, the LRAS curve will shift rightward as the population and capital increases in technology improves, pushing the production possibilities frontier outward.
Factors Affecting the Short-Run Aggregate Supply
Any factors affecting the price of inputs or that change productivity will shift the SRAS curve. An increase in the cost resources, such as an increase in energy prices, will shift the curve leftward, while price decreases will shift the curve rightward, at least temporarily. Inflation expectations can also affect the prices of inputs. For instance, if union workers expect higher inflation, then they will ask for higher wages when their labor contract is renewed. Factors that impair productivity, such as increased regulations, strikes, or, depending on the business, bad weather, can also shift the SRAS curve leftward. On the other hand, improvements in productivity can shift the curve rightward. Because the short run is at least several years long, factors that shift the SRAS curve rightward will also shift the LRAS curve in the same direction, as economy continually grows over time.
Factors That Increase the Long-Run Aggregate Supply
The long run aggregate supply curve is vertical, but it shifts to the right over time, by the same factors that that increase real GDP, causing an expansion in the production possibility frontier. Population growth increases the supply of labor, investments increases the supply of capital, and improvements in technology increase the effectiveness of both labor and capital. So, it is natural for the long-run aggregate supply to increase with economic growth.
Price Stickiness Causes the Short-Run AS to Differ from the Long-Run AS
The long run aggregate supply curve would describe the economy in the short run, if prices were perfectly flexible. In other words, the economy reacts fast enough in the short run that it yields the same results as it would in the long run. Because wages and prices are sticky, they do not fall nearly as far as necessary to keep the economy at Y*.
The Great Depression during the 1930s demonstrated that prices were not that flexible. Starting in 1929, the real GDP declined for 4 years, falling by 1/3, while the unemployment rate climbed to 25%. The real GDP did not return to its potential until 1941. The velocity of money was also considerably lower and remained so for the remainder of the decade. Although the aggregate price level did fall, up to 30% of the wholesale level, it was insufficient to stimulate aggregate demand.
John Maynard Keynes published his book, The General Theory of Employment, Interest, and Money, in 1936, which argued that because prices were sticky in the short run, the price levels did not decline enough to stimulate aggregate demand sufficiently to return real GDP to its natural output.
Keynes argued that aggregate demand was more important than aggregate supply in moving the economy to its potential GDP. Based on this assumption, Keynes argued that the government could stimulate the economy by increasing its spending, which helped the United States economy and the economies of other countries, such as Scandinavia, to move out of the depression.
Keynes argued that the important difference between the short run and the long run was aggregate price stickiness. There are several factors that cause price stickiness.
Menu costs are the main contributor to price stickiness. Menu costs are those costs associated with changing prices. The term itself arises from the cost of changing restaurant menus. Because of the cost of printing new menus, most restaurants will wait until prices change enough to justify paying the menu costs.
Another factor that may cause price stickiness is relative pricing, where oligopolist manufacturers are reluctant to reduce prices when demand lessens, for fear that it may initiate a price war, since the firm's competitors may believe that the firm cut prices to gain market share.
Contracts also fix prices. Union wage contracts, for instance, fix the price of labor in nominal terms, but may also automatically adjust the wages upward to compensate for inflation, but this inflation adjustment is based on expected inflation, so actual inflation will not change the wage rate at least until the contract expires.
Additionally, prices take time to change because it takes time for people to recognize that price levels are rising, and it takes time for the signals to propagate through the economy.
Market power also causes prices to be sticky. Most markets are not purely competitive, where the suppliers must accept the market price and cannot change it. With imperfect competition, oligopolies, and monopolies, these firms do have the power to set their own prices somewhat, so prices will not change until they decide to change it.