1. Aggregate Supply What is aggregate supply? Short run aggregate supply
Long run aggregate supply

2. Aggregate supply definition and curve
Price
Level
Aggregate supply is the total of all industry supply
The aggregate supply curve shows total planned output in the economy at any given price level (average prices)
In the short run, the aggregate supply curve (SRAS) is upward sloping
The short run is defined as the period when the prices of factors of production are constant. In particular, money wage rates are fixed
SRAS
Real Output

3. SRAS upward sloping
The SRAS is upward sloping because costs per unit rise as firms increase output in the short run to meet increased demand:
They will ask existing staff to work longer hours, and will need to provide an incentive for them to do so – eg overtime (typically 1.5x normal wage rates)
If demand remains strong they will seek to hire staff. Hiring is expensive and staff need to be trained, so costs increase
Overall, we can say an increase in the price level acts as a signal to firms to produce more and;
Firms will only produce more if the price level is higher

4. Movements and shifts Price Level SRAS Real Output P2 P1 P3 Y3 Y1 Y2
A movement along the aggregate supply curve happens when, all else equal, the price level changes. This will happen when the aggregate demand curve shifts! P1 P3
Real Output Y3 Y1 Y2

5. Movements and shifts Price Level SRAS2 SRAS1 SRAS3 Real Output P2 P1
The SRAS curve will shift when costs change:
Wages rise or fall
Raw material prices rise or fall
Taxes (or subsidies) rise or fall
Productivity increases or declines
Price
Level
SRAS2
SRAS1
SRAS3 P2 P1
The SRAS curve will shift up from SRAS1 to SRAS2when costs increase (eg wage rates rise, raw material costs increase, taxes rise)
The SRAS curve will shift down from SRAS1 to SRAS3 when costs fall (eg wage rates fall, raw material costs fall, taxes on firms are cut, or productivity improves) P3 Y1
Real Output

6. Shifts Why do changes in costs mean a shift in SRAS?
For example, if wage rates are raised by 10%, firms’ costs of production will increase, and many will respond by raising prices, so the average price level will increase
What about productivity?
Productivity means output per unit of input. So labour productivity is output per worker (say per hour). With better technology, or a better educated worker, output per worker will increase. This means cost per unit will fall (same wages, more output)
Any sneaky ones?
How about a fall in the value of the pound – this means imported raw materials will be more expensive.

7. Movement or shift and why
Government levies a tax on firms to pay for apprenticeships (Autumn Statement 2015)
Stronger public finances means investors are more optimistic about the UK, and so the pound rises in value
Unemployment falls to 5.4%, leading to faster growth in wages (and why would this happen?)
Increased demand leads to an increase in the general price level
The conflict in the Middle East leads to higher oil prices (and why would this happen)
It is estimated that use of smartphones and tablets has raised productivity by 5% over the last year

8. Long run aggregate supply
If demand increases, firms will supply more (as long as the average price level increases)
Is there a limit to how much they can supply?
In the long run, it doesn’t matter what the price level is, since firms will run into capacity constraints – workers cannot work overtime for too long, there may be no unemployed workers to hire, all machinery will be fully and efficiently utilised
Therefore the long run aggregate supply must be fixed

9. Long run aggregate supply curve
Price
Level
LRAS
Real Output Yf

10. LRAS also means The LRAS curve is linked to or represents:
Full capacity of the economy. Resources are fully and efficiently utilised
It is possible to produce more than this for a period of time – eg workers working overtime, machinery not being maintained – but not in the long run!
The PPF. The LRAS is the level of output shown on the PPF – where all resources are fully and efficiently utilised
Trend growth (we will look at later)

11. SRAS to LRAS
The vertical long run aggregate supply curve is often referred to as the Classical long run aggregate supply curve
It is based on flexible prices particularly flexible wages, and the idea that markets always work to bring supply and demand into equilibrium
This means that prices in all markets, including the labour market will adjust to bring supply and demand into equilibrium
There can be unemployment in the short run, but this should lead to falling (real) wages, and so unemployment should only be temporary

12. SRAS to LRAS Price Level Real Output P Y Yf LRAS SRAS SRAS1 AD
Let’s say we are at the equilibrium formed by AD = SRAS, so price level P and real output Y. This is less than full employment Yf which is the LRAS
Price
Level
LRAS
SRAS
SRAS1 P AD Y
Real Output Yf

13. SRAS to LRAS Price Level Real Output P Y Yf LRAS SRAS SRAS1 AD
In the long run we assume the prices of factors of production (eg wages) are flexible, so since there is unemployment, there will be downward pressure on wages. This means firms costs will fall, which means SRAS shifts down, and we reach a long run equilibrium with full employment
Price
Level
LRAS
SRAS
SRAS1 P AD Y
Real Output Yf

14. Keynesian LRAS
If the classical view was correct, unemployment should only be temporary
Yet we can observe periods of mass unemployment, in the 1930s in many parts of the world, Greece and Spain today
John Maynard Keynes wrote on how unemployment can persist in his book, ‘The General Theory of Employment, Interest and Money’ published in 1936
There are several reasons he believed unemployment can persist, but we look for the moment at just one:
Wages are ‘sticky’, ie they do not fall – or do not fall sufficiently
This may be because of laws such as minimum wages, unions, or legal protection, or because firms do not want to demotivate their workers
This means SRAS will not shift down, and the short run equilibrium is in effect long run as well

15. Keynesian LRAS P1 P Y Yf Real Output
This shows an equilibrium with unemployment.
The only way to get rid of unemployment is therefore to increase aggregate demand, for example the government increasing spending eg on infrastructure
Price Level
LRAS P1 P
AD1
Mass unemployment AD Y Yf
Real Output

16. Keynesian LRAS and shifts in AD
AD to AD1 there are plenty of resources, with mass unemployment, so firms can increase output without raising prices
AD2 to AD3 resources become scarce, including labour, so wages and other costs increase, so firms raise prices
AD4 to AD5 the economy is at full capacity which means increases in demand lead to higher prices and no increase in output (except in the short run)
Price Level
LRAS
AD5 P
AD4
Mass unemployment
AD3
AD2
AD1 AD Yf
Real Output

17. Shifts in LRAS b)

18. Shifts in LRAS
The LRAS will shift outwards if there is an increase in the quality or quantity of factors of production
Better capital – technological advances
Better quality machinery means an improvement in capital productivity (output per machine) so an increase in output
Better labour – changes in education and skills
Improvement in education and skills means workers should be more productive, so can produce more

19. Shifts in LRAS More capital – investment by firms
As firms add to the capital stock, this will allow more production, so LRAS shifts out. Can be encouraged by government policy, such as lowering corporation tax, or reducing regulations
More labour – demographics and migration
LRAS can increase if the labour force increases
Migration, eg from the EU. UK has seen 200,000+ a year net migration
Increased participation in the workforce. Could happen with better childcare enabling more women to return to work after having children, and encouraging older workers not to retire
Demographics actually working against increased labour force in many developed countries as the population ages

20. Shifts in LRAS – other points
Government regulation
Regulations can be a burden on business. Cutting regulations may therefore encourage businesses to invest and grow
For example making it easier to set up a business encourages entrepreneurs to create companies, jobs and output, thus increasing LRAS
Competition
Government policies which encourage competition amongst firms can increase LRAS
Competition forces firms to become more efficient (producing more and lowering costs)
Competition encourages firms to innovate, introducing new products in order to beat competitors