Aggregate Supply Model

Aggregate Supply: Short-Run and Long-Run Perspectives

Aggregate supply (AS) describes the overall volume of goods and services that producers are willing to produce and sell at every given price level. There is a fundamental difference between short-run and long-run aggregate supply, and this distinction is key to understanding macroeconomic dynamics.

Long-Run Aggregate Supply (LRAS)

In the long run, the volume of production is determined by real factors—capital stock, quantity and quality of labor, technologies—and does not depend on the price level. The long-run aggregate supply curve (LRAS) is vertical and located at the level of potential GDP. Potential GDP is the maximum sustainable level of production at full employment of resources without accelerating inflation. It is defined by the fundamental characteristics of the economy: technologies, capital, labor, institutions.

A shift in LRAS signifies a change in the productive potential of the economy. Shift factors include capital accumulation (investment), growth of the labor force (demographics, migration), technological progress (innovation, R&D), and improvement of institutions (property rights, rule of law).

Short-Run Aggregate Supply (SRAS)

In the short run, there is a positive relationship between the price level and the volume of production: as prices rise, producers are willing to increase output. The short-run aggregate supply curve (SRAS) has a positive slope. The positive slope of SRAS is explained by several mechanisms.

The sticky wage model: nominal wages are fixed by contracts, so an increase in prices reduces the real wage, making it profitable to hire more workers.

The sticky price model: some prices are fixed due to menu costs or contracts, and an increase in the general price level raises the relative price of goods with flexible prices.

The imperfect information model: producers confuse a rise in the general price level with an increase in the relative prices of their own products and increase output.

Factors Shifting SRAS

Changes in production costs at a constant price level lead to a shift in SRAS. An upward (leftward) shift means an increase in costs and a reduction in supply at every price level. A downward (rightward) shift means lower costs and increased supply.

Prices of raw materials and energy sources are the most important factor shifting SRAS. Rising oil prices increase production costs across the entire economy and shift SRAS upward—this is a negative supply shock. A decrease in the price of raw materials has the opposite effect—a positive supply shock.

Wages affect SRAS through labor costs. Growth in nominal wages not accompanied by productivity growth shifts SRAS upward.

Inflation expectations influence SRAS through the channel of wages and price formation. Rising expected inflation is built into wages and prices, shifting SRAS upward.

Labor productivity affects SRAS: productivity growth reduces unit costs and shifts SRAS downward, allowing more to be produced at the same price level.

Supply Shocks

Supply shocks—unexpected changes in production conditions—play an important role in economic dynamics.

Negative supply shocks (rising oil prices, crop failures, natural disasters, pandemics) shift SRAS upward, causing both prices to rise and production to contract—stagflation.

Positive supply shocks (technological breakthroughs, falling prices of raw materials, favorable weather conditions) shift SRAS downward, letting the economy grow while inflation falls or remains stable.

Application for Investors

The distinction between demand and supply shocks is critically important for investment decisions.

A positive demand shock (stimulus) accelerates growth and inflation—good for stocks, bad for bonds.

A negative supply shock (oil crisis) slows growth and accelerates inflation—bad for most assets, good for commodity producers.

Positive supply shocks (technology, globalization) create a favorable environment of low inflation and sustainable growth—the so-called “Goldilocks economy”—which is favorable for financial assets.

Factors affecting LRAS determine the long-term economic potential and are important for strategic allocation. Countries with favorable demographics, high investment, and innovative potential have a higher potential growth rate.