Aggregate supply

Aggregate supply

In economics, aggregate supply is the total supply of goods and services produced by a national economy during a specific time period. There are at least three different versions of this concept.

1. Sometimes the "Z curve" in the "Keynesian cross" diagram is referred to as "aggregate supply." This curve often represents the total amount of production that corresponds to the total amount of income in a country during a specific time period. Because the sum of all income received corresponds to the sum of all production, this is drawn as a 45 degree line. In this diagram, the desired total spending line crosses this Z curve, determining the equilibrium level of production, income, and

2. In neo-Keynesian theory seen in many textbooks, an "aggregate supply and demand" diagram is drawn that looks like a typical Marshallian supply and demand diagram. The aggregate supply (AS) curve is usually drawn as upward-sloping in the short run, since the quantity of aggregate production supplied (Qs) rises as the average price level (P) rises.

There are two main reasons why Qs might rise as P rises, i.e., why the AS curve is upward sloping:

A. In neoclassical-influenced textbooks, it is necessary to raise prices to motivate profit-seeking firms to increase output. This is because of diminishing returns and thus rising marginal costs that arise because one or more of the inputs or factors of production does not change in the short run and is assumed to be fully employed at all times. Usually this is fixed capital equipment. The AS curve is drawn given some nominal variable, such as the nominal wage rate.

In the "short run", the nominal wage rate is taken as fixed. Thus, rising P implies higher profits that justify expansion of output. In the neoclassical "long run", on the other hand, the nominal wage rate varies with economic conditions. (High unemployment leads to falling nominal wages -- and vice-versa.) This is used to justify a "vertical" aggregate supply curve in the long run.

B. An alternative model starts with the notion that any economy involves a large number of heterogeneous types of inputs, including both fixed capital equipment and labor. Both main types of inputs can be unemployed. The upward-sloping AS curve arises because (1) some nominal input prices are fixed in the short run (as in the neoclassical theory) and (2) as output rises, more and more production processes encounter bottlenecks.

At low levels of demand, there are large numbers of production processes that do not use their fixed capital equipment fully. Thus, production can be increased without much in the way of diminishing returns and the average price level need not rise much (if at all) to justify increased production. The AS curve is flat.

On the other hand, when demand is high, few production processes have unemployed fixed inputs. Thus, bottlenecks are general. Any increase in demand and production induces increases in prices. Thus, the AS curve is steep or vertical.

This implies an AS curve which has the shape of a rounded backwards "L".

AS is targeted by government "supply side policies" which are meant to increase productivity efficiency and national output. For example, Education and Training, Research and Development, Breaking Trade Union Powers, Benefits Reform, Welfare Reform, Labour Market Reform.

Different scopes

There are generally three forms of aggregate supply (AS). They are:

#Short run aggregate supply (SRAS) - Within the time frame during which firms can change the amount of labor used but not capital (such as building new factories). This form demonstrates what happens to the economy under the most slack, when resources are underused. Upward shifts in SRAS generally increase output (y) but don't increase price (P). The SRAS curve is nearly perfectly horizontal. The concept is that wages (price of labor) don't change over the short run.
#Long run aggregate supply (LRAS) - Over the long run, only capital, labor, and technology affect the LRAS in the macroeconomic model because at this point everything in the economy is assumed to be used optimally. In most situations, the LRAS is viewed as static because it shifts the slowest of the three. The LRAS is shown as perfectly vertical, reflecting economists' belief that changes in aggregate demand (AD) have an only temporary change on the economy's total output.
#Medium run aggregate supply (MRAS) - As an interim between SRAS and LRAS, the MRAS form slopes upward and reflects when capital as well as labor can change. When graphing an aggregate supply and demand model, the MRAS is generally graphed after aggregate demand (AD), SRAS, and LRAS have been graphed, and then placed so that the equilibria occur at the same point. The MRAS curve is affected by capital, labor, technology, and wage rate.

In a standard aggregate supply demand model, the output (y) is the x axis and price (P) is the y axis. An increase in aggregate demand shifts the AD curve rightward, bringing the equilibrium point horizontally along the SRAS until it reaches the new AD. This point is the short run equilibrium.

There is no one single MRAS curve; rather, it comprises an infinite number of curves that progress from the SRAS curve to the LRAS curve. We can create MRAS curves for showing things more clearly. Sometimes, we skip the SRAS equilibrium altogether and go directly along an MRAS curve; the new equilibrium is where the AD and MRAS curve intersect: the medium-run equilibrium.

Finally, the long run equilibrium is at the intersection of the AD and LRAS curves. Generally, an arrow is used to indicate the progression of the equilibrium from short-run, to medium-run, to long-run positions.

Other Topics

*Aggregate demand
*Aggregation problem
*List of economics topics
*Supply shock

External links

* Elmer G. Wiens: [ Classical & Keynesian AD-AS Model] - An on-line, interactive model of the Canadian Economy.
* [ Nobelpricewinner Prof. William Vickrey: 15 fatal fallacies of financial fundamentalism-A Disquisition on Demand Side Economics]

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