Aggregate Supply (AS) Curve

The aggregate supply curve depicts the quantity of real GDP that is supplied by the economy at different price levels. The reasoning used to construct the aggregate supply curve differs from the reasoning used to construct the supply curves for individual goods and services. The supply curve for an individual good is drawn under the assumption that input prices remain constant. As the price of good X rises, sellers' per unit costs of providing good X do not change, and so sellers are willing to supply more of good X‐hence, the upward slope of the supply curve for good X. The aggregate supply curve, however, is defined in terms of the price level. Increases in the price level will increase the price that producers can get for their products and thus induce more output. But an increase in the price will also have a second effect; it will eventually lead to increases in input prices as well, which, ceteris paribus, will cause producers to cut back. So, there is some uncertainty as to whether the economy will supply more real GDP as the price level rises. In order to address this issue, it has become customary to distinguish between two types of aggregate supply curves, the short‐run aggregate supply curve and the long‐run aggregate supply curve.

Short‐run aggregate supply curve. The short‐run aggregate supply (SAS) curve is considered a valid description of the supply schedule of the economy only in the short‐run. The short‐run is the period that begins immediately after an increase in the price level and that ends when input prices have increased in the same proportion to the increase in the price level.

Input prices are the prices paid to the providers of input goods and services. These input prices include the wages paid to workers, the interest paid to the providers of capital, the rent paid to landowners, and the prices paid to suppliers of intermediate goods. When the price level of final goods rises, the cost of living increases for those who provide input goods and services. Once these input providers realize that the cost of living has increased, they will increase the prices that they charge for their input goods and services in proportion to the increase in the price level for final goods.

The presumption underlying the SAS curve is that input providers do not or cannot take account of the increase in the general price level right away so that it takes some time–referred to as the short‐run–for input prices to fully reflect changes in the price level for final goods. For example, workers often negotiate multi‐year contracts with their employers. These contracts usually include a certain allowance for an increase in the price level, called a cost of living adjustment (COLA). The COLA, however, is based on expectations of the future price level that may turn out to be wrong. Suppose, for example, that workers underestimate the increase in the price level that occurs during the multi‐year contract. Depending on the terms of the contract, the workers may not have the opportunity to correct their mistaken estimates of inflation until the contract expires. In this case, their wage increases will lag behind the increases in the price level for some time.

During the short‐run, sellers of final goods are receiving higher prices for their products, without a proportional increase in the cost of their inputs. The higher the price level, the more these sellers will be willing to supply. The SAS curve—depicted in Figure (a)—is therefore upward sloping, reflecting the positive relationship that exists between the price level and the quantity of goods supplied in the short‐run.

Long‐run aggregate supply curve. The long‐run aggregate supply (LAS) curve describes the economy's supply schedule in the long‐run. The long‐run is defined as the period when input prices have completely adjusted to changes in the price level of final goods. In the long‐run, the increase in prices that sellers receive for their final goods is completely offset by the proportional increase in the prices that sellers pay for inputs. The result is that the quantity of real GDP supplied by all sellers in the economy is independent of changes in the price level. The LAS curve—depicted in Figure (b)—is a vertical line, reflecting the fact that long‐run aggregate supply is not affected by changes in the price level. Note that the LAS curve is vertical at the point labeled as the natural level of real GDP. The natural level of real GDP is defined as the level of real GDP that arises when the economy is fully employing all of its available input resources.

Changes in aggregate supply. Changes in aggregate supply are represented by shifts of the aggregate supply curve. An illustration of the ways in which the SAS and LAS curves can shift is provided in Figures (a) and (b). A shift to the right of the SAS curve from SAS ¹ to SAS ² of the LAS curve from LAS ¹ to LAS ² means that at the same price levels the quantity supplied of real GDP has increased. A shift to the left of the SAS curve from SAS ¹ to SAS ³ or of the LAS curve from LAS ¹ to LAS ³ means that at the same price levels the quantity supplied of real GDP has decreased .

Like changes in aggregate demand, changes in aggregate supply are not caused by changes in the price level. Instead, they are primarily caused by changes in two other factors. The first of these is a change in input prices. For example, the price of oil, an input good, increased dramatically in the 1970s due to efforts by oil‐exporting countries to restrict the quantity of oil sold. Many final goods and services use oil or oil products as inputs. Suppliers of these final goods and services faced rising costs and had to reduce their supply at all price levels. The decrease in aggregate supply, caused by the increase in input prices, is represented by a shift to the left of the SAS curve because the SAS curve is drawn under the assumption that input prices remain constant. An increase in aggregate supply due to a decrease in input prices is represented by a shift to the right of the SAS curve.

A second factor that causes the aggregate supply curve to shift is economic growth. Positive economic growth results from an increase in productive resources, such as labor and capital. With more resources, it is possible to produce more final goods and services, and hence, the natural level of real GDP increases. Positive economic growth is therefore represented by a shift to the right of the LAS curve. Similarly, negative economic growth decreases the natural level of real GDP, causing the LAS curve to shift to the left.

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Combining AD and AS Supply Curves

When the aggregate demand and SAS (short-run aggregate supply) curves are combined, as in Figure , the intersection of the two curves determines both the equilibrium price level, denoted by P ^*, and the equilibrium level of real GDP, denoted by Y ^* .

If it is further assumed that the economy is fully employing all of its resources, the equilibrium level of real GDP, Y ^*, will correspond to the natural level of real GDP, and the LAS curve may be drawn as a vertical line at Y ^*, as in Figure .

Consider what happens to this situation when the aggregate demand curve shifts to the right from AD ¹ toAD ², as in Figure .

The immediate, short‐run effect is that the equilibrium price level increases from P ¹, to P ², and real GDP increases above its natural level, from Y ¹, to Y ² . The increase in real GDP is due to the fact that input prices have not yet risen in response to the increase in the price level for final goods; the economy is still operating along the old SAS curve, SAS ¹ . Eventually, however, input providers will demand higher prices to reflect the increase in the general price level. Production costs will therefore increase, and the supply of real GDP will be reduced. This is represented by the shift to the left of the SAS curve from SAS ¹ to SAS ². The end result is a higher price level, P ³, at the same, natural level of real GDP, Y ¹.

The graphical analysis presented in Figure applies only to the case where there is zero economic growth, and the economy is already at the natural level of real GDP when aggregate demand increases. In the case where the economy is not fully employing all of its input resources and has therefore not yet attained its natural level of real GDP, an increase in aggregated demand—depicted in Figure as a shift from AD ¹ to AD ²—causes both an increase in the equilibrium price level from P ¹ to P ², and an increase in the equilibrium level of real GDP from Y ¹ to Y ² .

In this case, the increase in the equilibrium price level does not necessarily lead to an increase in input prices because the economy is not fully employing all of its input resources. When unemployed inputs are available, input prices do not tend to rise. The result, in this case, is that the SAS curve does not shift left and cancel out the increase in real GDP brought about by the increase in aggregate demand.

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Aggregate Demand (AD) Curve

In macroeconomics, the focus is on the demand and supply of all goods and services produced by an economy. Accordingly, the demand for all individual goods and services is also combined and referred to as aggregate demand. The supply of all individual goods and services is also combined and referred to as aggregate supply. Like the demand and supply for individual goods and services, the aggregate demand and aggregate supply for an economy can be represented by a schedule, a curve, or by an algebraic equation

The aggregate demand curve represents the total quantity of all goods (and services) demanded by the economy at different price levels. An example of an aggregate demand curve is given in Figure .

The vertical axis represents the price level of all final goods and services. The aggregate price level is measured by either the GDP deflator or the CPI. The horizontal axis represents the real quantity of all goods and services purchased as measured by the level of real GDP. Notice that the aggregate demand curve, AD, like the demand curves for individual goods, is downward sloping, implying that there is an inverse relationship between the price level and the quantity demanded of real GDP.

The reasons for the downward‐sloping aggregate demand curve are different from the reasons given for the downward‐sloping demand curves for individual goods and services. The demand curve for an individual good is drawn under the assumption that the prices of other goods remain constant and the assumption that buyers' incomes remain constant. As the price of good X rises, the demand for good X falls because the relative price of other goods is lower and because buyers' real incomes will be reduced if they purchase good X at the higher price. The aggregate demand curve, however, is defined in terms of the price level. A change in the price level implies that many prices are changing, including the wages paid to workers. As wages change, so do incomes. Consequently, it is not possible to assume that prices and incomes remain constant in the construction of the aggregate demand curve. Hence, one cannot explain the downward slope of the aggregate demand curve using the same reasoning given for the downward‐sloping individual product demand curves.

Reasons for a downward‐sloping aggregate demand curve. Three reasons cause the aggregate demand curve to be downward sloping. The first is the wealth effect. The aggregate demand curve is drawn under the assumption that the government holds the supply of money constant. One can think of the supply of money as representing the economy's wealth at any moment in time. As the price level rises, the wealth of the economy, as measured by the supply of money, declines in value because the purchasing power of money falls. As buyers become poorer, they reduce their purchases of all goods and services. On the other hand, as the price level falls, the purchasing power of money rises. Buyers become wealthier and are able to purchase more goods and services than before. The wealth effect, therefore, provides one reason for the inverse relationship between the price level and real GDP that is reflected in the downward‐sloping demand curve.

A second reason is the interest rate effect. As the price level rises, households and firms require more money to handle their transactions. However, the supply of money is fixed. The increased demand for a fixed supply of money causes the price of money, the interest rate, to rise. As the interest rate rises, spending that is sensitive to rate of interest will decline. Hence, the interest rate effect provides another reason for the inverse relationship between the price level and the demand for real GDP.

The third and final reason is the net exports effect. As the domestic price level rises, foreign‐made goods become relatively cheaper so that the demand for imports increases. However, the rise in the domestic price level also means that domestic‐made goods are relatively more expensive to foreign buyers so that the demand for exports decreases. When exports decrease and imports increase, net exports (exports ‐ imports) decrease. Because net exports are a component of real GDP, the demand for real GDP declines as net exports decline.

Changes in aggregate demand. Changes in aggregate demand are represented by shifts of the aggregate demand curve. An illustration of the two ways in which the aggregate demand curve can shift is provided in Figure .

A shift to the right of the aggregate demand curve. from AD ₁ to AD ₂, means that at the same price levels the quantity demanded of real GDP has increased. A shift to the left of the aggregate demand curve, from AD ₁ to AD ₃, means that at the same price levels the quantity demanded of real GDP has decreased.

Changes in aggregate demand are not caused by changes in the price level. Instead, they are caused by changes in the demand for any of the components of real GDP, changes in the demand for consumption goods and services, changes in investment spending, changes in the government's demand for goods and services, or changes in the demand for net exports.

Consider several examples. Suppose consumers were to decrease their spending on all goods and services, perhaps as a result of a recession. Then, the aggregate demand curve would shift to the left. Suppose interest rates were to fall so that investors increased their investment spending; the aggregate demand curve would shift to the right. If government were to cut spending to reduce a budget deficit, the aggregate demand curve would shift to the left. If the incomes of foreigners were to rise, enabling them to demand more domestic‐made goods, net exports would increase, and aggregate demand would shift to the right. These are just a few of the many possible ways the aggregate demand curve may shift. None of these explanations, however, has anything to do with changes in the price level.

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