Aggregate supply

Aggregate supply

Author

Institution

Aggregate supply is a measure of the volume of commodities and services that an economy has a capacity to produce at a certain price level. The short run aggregate supply curve depicts the amount of output that an economy is capable of producing in the short term at various price levels. The short run aggregate supply curve is upward sloping because input prices tend to adjust at a slower rate than that of the final goods; this leads to higher profit, which makes firms to increase production. Besides, the short run aggregate supply curve is upward sloping since some firms tend to adjust prices at a slower rate than others (Mankiw, 2008). This makes such firms think their sales are increasing and thus increase their production. On the other hand, the long run aggregate supply curve depicts the volume of commodities and services produced by an economy in the long term in relation to different price levels. Unlike the short run aggregate supply curve, the long run aggregate supply curve slopes vertically rather than sloping upwards. In this assignment, short run aggregate supply curve and long run aggregate supply curves together with variables that move them will be discussed. In addition, the macroeconomic equilibrium in the long run and short run will also be discussed.

The short run aggregate supply curve shows a relationship between the volume of commodities and services and price levels that an economy is capable of producing, in the short term. This curve is upward sloping; as the price level rises, firms increase the quantity of commodities and services supplied. Alternatively, as the level of price drops, firms tend to decrease the volume of commodities and services supplied (Mankiw & Taylor, 2006).

Reasons Why the Short Run Aggregate Supply Curve is Upward Sloping

One of the reasons why the short run aggregate supply curve is upward sloping is because of sticky wages. Some economists have a perspective that wages are inflexible, or sticky. This is based on the opinion that wages become locked in for some years because of the labor contracts entered into by employees and management. For instance, the management and labor may reach an agreement of locking in wages for the following one to three years because they may see this as being for their best interest. The management has an idea regarding the cost of labor during the period of the contract while; on the other hand, workers have a sense of security since they know that their wages will not become lowered during the contract period. Besides, wages may also become sticky because of perceived notions of fairness or certain social conventions. When there is a change in the economy, the wages paid to workers, do not adjust immediately because of the contract that exists (Mankiw, 2008). So, when price level increases, the nominal wage remains fixed while the real wage falls since the real wage is based on the purchasing power associated with the wage. A fall in the real wage implies that labor becomes relatively cheaper than before. Firms choose to hire more workers, when labor becomes cheaper which increases their level of production. Therefore, when there is an increase in the price level, output increases due to sticky wages.

Another reason for the upward sloping nature of the short run aggregate supply curve is because of worker mis-perception. The amount of work that a worker wills to supply is usually based on the real wage that is expected; the workers are always willing to supply more work at a higher real wage. So, when the price level increases, there is an assumption that firms have more information than workers, which will lead to firms increasing the nominal wage. However, because workers are not aware whether the price level increased, they believe that their real wage has also increased. Workers tend to work more, when they believe their real wage has increased, which leads to an increase in production. Therefore, an increase in price, increases the level of output because of worker mis-perception.

Imperfect information is another explanation for the upward sloping nature of the short run aggregate supply curve. When there is an increase in the level of price, producers take it for a relative price level increase (Mankiw, 2008). The real wage earned by the producers rises as relative price increases; this makes producers to supply more labor leading to an increase in the output produced.

Variables That Move The Short Run Aggregate Supply Curve

Expected Changes in the Future Price Level

The short run aggregate supply curve shifts in order to reflect firm and worker expectations of future prices. When workers and firms expect the price level to increase, they adjust their wages by the same amount that the price increases. Keeping all other variables that affect the aggregate supply, the short run aggregate supply curve shifts to the left when the future price levels are expected to rise. A graphical representation of this is as illustrated.

Price Level                                                                                  SRAS2

SRAS1

P2

P1

Output

When the price level is expected to rise from P1 to P2, the short run aggregate supply curve shifts to the left from SRAS1 to SRAS2.

Capital Stock or Labor Force

An increase in the capital stock or labor force implies that firms are capable of producing more output at each price level (Mankiw & Taylor, 2006). Therefore, an increase in the capital stock or labor force will shift the short run aggregate supply to the right as illustrated; the short run aggregate supply curve will shift from SRAS1 to SRAS2.

Price level                                                                SRAS1

SRAS2

Output

Productivity

The quantity of output produced determines the cost utilized in producing an output; the lower the productivity, the higher the cost of producing the output and the converse is true. Therefore, an increase in productivity will shift the short run aggregate to the right since it will lower the cost of producing the output. The illustration is as shown; the short run aggregate supply curve will shift from SRAS1 to SRAS2.

Price level

SRAS1        SRAS2

Output

Expected Price of a Vital Natural Resources

The price of producing a certain output is based on the cost of the input. When the price of an input increases, the cost of producing an output also increases. Therefore, when the cost of a vital natural resource is projected to rise, firms are likely to increase the price level of the output; this will have an effect of shifting the short run aggregate supply curve to the left since the cost of producing an output is also expected to rise. Therefore, if the price of a vital natural resource is expected to rise, the short run aggregate supply curve will shift from SRAS1 to SRAS2 as depicted in the illustration.

SRAS2                    SRAS2

Price level

Output

The Long Run Aggregate Supply Curve

The long run aggregate supply curve shows the level of real output at every possible price level. The long run aggregate supply curve is vertical in nature since, in the long run, prices of resources have already adjusted to the price changes, which implies that there is no room left for incentive for firms in the long run to change their output. Therefore, price is assumed to have fully adjusted in the long run and thus the price has no effect on the volume of output produced.

Variables That Move the Long Run Aggregate Supply Curve

Any change in the economy, which alters the natural rate of output is deemed to shift the long run aggregate supply curve. Shifts of the long run aggregate supply curve is deemed to be caused by the following variables; capital, labor, technological knowledge and natural resources.

Labor

An increase in labor implies that there is an increase in output. For instance, .............