Aggregate Supply: Short Run, Long Run and Supply-Side Shocks
Aggregate supply (AS) is the total quantity of goods and services that all firms in an economy are willing and able to produce at each price level, over a given time period.
Before you start
Make sure you're comfortable with these topics first:
Method
- Draw SRAS as upward sloping and explain why, using the fixed-input-cost argument.
- Draw LRAS in both the classical form (vertical at potential output, Yfe) and the Keynesian form (horizontal, then upward sloping, then vertical), and know when a question expects each.
- Distinguish a movement along SRAS, caused by a change in the price level, from a shift of SRAS, caused by a change in a cost of production, e.g. wages, raw material prices, the exchange rate affecting import costs, or indirect taxes and subsidies.
- Distinguish a shift of SRAS, a temporary or reversible cost shock, from a shift of LRAS, a genuine change in the economy's productive capacity: the quantity or quality of labour, capital, land, enterprise, or technology.
- Learn named negative supply shocks, e.g. a sharp rise in global oil prices, a natural disaster, or a sudden shortage of a key raw material, and named positive supply-side changes, e.g. improved education and skills, infrastructure investment, technological innovation, or deregulation.
- For any question, state whether the event is short run (shift SRAS) or long run/permanent (shift LRAS), then read off the effect on the price level and real output at the new equilibrium.
- Evaluate using time lags, since supply-side policy can take years to raise LRAS, whether the shock is temporary or permanent, and which view of LRAS, classical or Keynesian, the question is set against.
Worked example
The world price of oil rises sharply and is expected to stay high for the next year. Explain the short-run effect on a country's price level and real output, using an AD/AS diagram.
- Oil is a key input cost for firms (transport, energy, some raw materials), so a sharply higher oil price raises firms' costs of production across the economy.
- Since this is a change in a cost of production, it affects short-run aggregate supply, not aggregate demand or long-run aggregate supply directly.
- Higher costs at every price level mean firms are only willing to supply the same amount of output at a higher price, so the SRAS curve shifts leftward, from SRAS1 to SRAS2.
- At the new intersection with AD, which has not moved, the price level rises from P1 to P2.
- Real output falls from Y1 to Y2, because higher costs make some previously profitable output no longer worth producing at the old price level.
- This combination of rising prices and falling output is called stagflation, and is a classic negative supply-side shock.
Practice questions
Try each question, then tap to reveal the answer.
Q1Why does SRAS slope upward?Show answer
Answer: Because in the short run, input costs such as wages are assumed fixed, so a higher price level raises firms' profit margins and encourages them to raise output.
Q2What determines the position of the classical LRAS curve?Show answer
Answer: The quantity and quality of the economy's factors of production and the level of technology, its productive capacity, not the price level.
Q3Give one example of a negative short-run supply shock.Show answer
Answer: A sharp, temporary rise in the world price of a key commodity such as oil, or a natural disaster disrupting production.
Q4Give one example of a change that would shift LRAS rightward.Show answer
Answer: A sustained rise in labour productivity, or investment in infrastructure, or an increase in net migration of working-age people, or technological innovation.
Q5State whether a rise in the national minimum wage shifts SRAS, LRAS, both or neither.Show answer
Answer: SRAS, leftward or up, since it raises a cost of production for firms in the short run; it does not directly change the economy's long-run productive capacity.
Q6In the Keynesian model of LRAS, what happens to the price level if AD rises while the economy is on the horizontal section of LRAS?Show answer
Answer: Nothing - real output rises but the price level stays the same, because there is significant spare capacity in the economy.
Q7State one difference between a shift of SRAS and a shift of LRAS.Show answer
Answer: A shift of SRAS reflects a change in costs of production that can reverse, e.g. a temporary rise in commodity prices, whereas a shift of LRAS reflects a more permanent change in the economy's productive capacity.
Exam-style questions
Written in the style of a A Level Economics exam paper, with a full mark scheme.
Explain, using a diagram, the short-run effect of a fall in the exchange rate on a country's aggregate supply.
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Assess the view that supply-side shocks, rather than changes in aggregate demand, are the main cause of short-run fluctuations in a country's price level and output.
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