Aggregate Supply – The Supply Side Story

Aggregate Supply – The Supply Side Story

Ever tried baking 500 cupcakes with one oven and a slightly unreliable electric whisk? That’s basically the short-run aggregate supply (SRAS) curve in action.

In economics, aggregate supply (AS) represents the total output firms are willing and able to produce at different price levels. And just like your cupcake operation, what a country can supply depends on costs, capacity, and the occasional meltdown of the mixer (E.g. The global supply chain crisis).

SRAS: When Costs Take Centre Stage

The short-run aggregate supply curve slopes upward because higher prices usually tempt firms to produce more. Why? Because more profit sounds better than less profit, obviously. But this is all under the assumption that key things - like wages and technology - stay constant and remain the same.

Now, what really shifts the SRAS curve? Just two villains:

• Rising production costs

• Higher indirect taxes

Let’s call them the LITRE Gang:

• Labour costs: Higher wages? SRAS shifts left.

• Interest rates: If borrowing gets expensive, firms might hold back.

• Transportation: Sky-high shipping costs post-COVID? Classic SRAS shift.

• Raw materials: Energy price shocks, like those in 2022, slam SRAS leftward.

• Exchange rate changes: A weaker pound? Imported inputs cost more. SRAS takes another hit.

And don’t forget indirect taxes (like VAT). They quietly creep into production costs and mess with supply decisions - even if businesses try to pass some of the cost on to consumers.

Long-Run Aggregate Supply: Where Economists Start Arguing

There’s the short run, and then there’s the long run - the stuff economists debate at conferences over bad hotel coffee.

The Monetarist (New Classical) View

Monetarists believe the LRAS curve is vertical. Why? Because in the long run, the economy’s output isn’t about prices - it's about resources and productivity.

• The economy produces at full employment output (YF).

• AD may rise, but if you’re already using all your resources, the only thing that changes is… you guessed it, inflation.

Example? Think of Germany’s 2022 economy: low unemployment, strong output. When demand surged, prices jumped - not production.

The Keynesian View: Three Sections of Drama

Keynesians say: hold on. The economy doesn’t always hit full capacity on its own. Recessions happen. Unused factories exist. People lose jobs. So, they give us a more refined AS curve:

1. Horizontal (spare capacity): Think of Spain post-2008 - factories idle, workers jobless. Demand could rise without prices budging.

2. Upward-sloping (growing pressure): Now we’re moving. Resources tighten, wages start to rise, prices inch up.

3. Vertical (full stretch): At YF. Everyone’s busy. Any extra demand just causes inflation.

Gaps and Wobbles: Inflationary & Deflationary Gaps

If actual GDP exceeds full employment GDP, we get an inflationary gap. That’s when demand is so hot it overheats the economy - prices rise fast.

So, an inflationary gap (or positive output gap) exists if actual real GDP exceeds the full employment level of output: (YE > YF).

The economy maintains full employment, despite higher levels of aggregate demand in the economy. This leads to higher average price levels (inflation).

If actual GDP is below full employment, that’s a deflationary gap - also known as a recession. Demand is weak, output is low, and yes, unemployment is back.

So, a deflationary gap (or recessionary gap or negative output gap) exists when the equilibrium real national output (YE) is below the full employment level of output (YF) and yes! actual growth is below potential growth.

Deflationary gaps are caused by lower levels of aggregate demand (AD). This might be caused by any combination of a fall in:

• Consumer spending

• Investment expenditure

• Net export earnings.

These gaps explain why governments and central banks obsess (yes, they really do) over tiny changes in inflation or output - it’s not about perfection, it’s about not falling off a cliff.

Shifting the Long Run: How to Grow the Economy

So, how do we push out the productive potential of an economy?

Here are your four long-run friends:

1. More and better resources: A more skilled workforce, better machines.

2. Technology: AI, robotics, and yes, even new agricultural tech.

3. Efficiency: Producing more with less.

4. Institutional improvements: Good governance, education systems, legal frameworks.

South Korea is a great example: a post-war economy turned high-tech powerhouse, thanks to huge investments in education, infrastructure, and tech.

Final Thought

Aggregate supply might not have the drama of market failure or the glamour of GDP stats, but it’s the backbone of long-term growth. Get this right, and your economy’s ready for the future. Get it wrong, and you’re stuck baking cupcakes with one oven and 500 orders.

Stay well