Macroeconomics guide, Unit 3, step 7 of 23Previous step Next step

Step 7: Aggregate Supply

By the EconTutorials team. 11-minute read with 6 practice questions.

SyllabusAP Macro 3.3–3.4 · Cambridge 4.3 · IB 3.2

In 30 seconds

Aggregate supply (AS) is the total real output firms are willing to produce at each price level. It has two versions: short run and long run.
Short-run aggregate supply (SRAS) slopes upward because wages and prices are sticky, or because firms misread price changes. Long-run aggregate supply (LRAS) is vertical at potential output, because once all prices and wages adjust, nothing real has changed.
SRAS shifts with production costs and expected inflation. LRAS shifts only when real productive capacity changes: labour, capital, resources, technology and institutions.
Key exam idea: in the long run, output is set by supply and the price level by demand. An adverse supply shock causes stagflation, and no demand-side policy can fix both problems at once.

Video lesson coming soonA short animated lesson for this step will appear here.

What aggregate supply means

Imagine you run a bakery and agreed your staff’s wages in January for the whole year. In March, prices across the economy rise 5%, so you charge 5% more for bread while your wage bill stays the same. Every loaf is more profitable, so you hire an extra worker and bake more. A year later, wages also rise 5%. Revenue and costs have risen together, so the extra profit, and the reason to bake more, has gone.

In short: in the short run, higher prices can raise output; in the long run, once costs catch up, they do not.

Key termAggregate supply (AS): the total real output that all firms in the economy are willing and able to produce at each price level.

Unlike a market supply curve, on an AS curve all prices rise together, so nothing becomes more profitable than anything else. The explanation depends on the time horizon.

The macroeconomic short run is the period when some input prices, especially money wages, have not yet adjusted to a change in the price level.
The macroeconomic long run is the period after all prices, including wages, have fully adjusted. Output returns to potential output ($ Y_p $), the level produced when unemployment is at its natural rate.

Common mistakeCarrying over the microeconomic definition of the short run (“at least one factor is fixed”). In macroeconomics, the short run means at least one price has not adjusted. A macro long run can arrive in eighteen months.

Why SRAS slopes upward

There are three theories. They work differently, but each relies on something that fails to adjust straight away.

Sticky wages. Wages are set in contracts, often once a year. If the price level rises unexpectedly while wages stay fixed, firms sell output for more but pay the same wage bill. The real wage falls, profit per unit rises, and firms hire more and produce more. This is the oldest explanation and the one Keynes stressed.
Sticky prices. Firms do not change their prices all the time, because of menu costs and not wanting to annoy customers. When the general price level rises, firms that are slow to reprice find their goods relatively cheap, so their sales and output rise.
Misperceptions (associated with Robert Lucas). A wheat farmer sees the price of wheat rising and cannot tell at once whether wheat has become more valuable or whether all prices are rising. Mistaking general inflation for a rise in her own relative price, she produces more. This theory implies that only unexpected inflation raises output.

All three imperfections fade with time. Contracts are renegotiated, prices are reset and mistakes are corrected. When that happens, the reason for the upward slope disappears.

Why LRAS is vertical

In the long run, what an economy can produce depends on how much labour, capital and natural resources it has, and on its technology. It does not depend on the price level.

Suppose every price doubles overnight: output prices, wages, rents, everything. A firm’s revenue and costs both double, so real profit is unchanged. A worker’s wage and living costs both double, so her real wage is unchanged. Nothing real has changed, so output stays at potential.

Key termMonetary neutrality: the idea that in the long run, changes in the money supply and the price level affect only nominal variables, leaving real output, employment and real wages unchanged.

On the diagram (price level against real GDP), SRAS slopes up and LRAS is vertical at $ Y_p $.

Exam tipLearn this sentence: in the long run, output is determined by supply and the price level is determined by demand. Demand-side policy can move the economy along SRAS in the short run, but it cannot move LRAS. A rightward AD shift on a vertical LRAS raises only the price level.

What shifts SRAS and what shifts LRAS

The two curves are shifted by different things. Mixing them up is a quick way to lose marks.

Curve	Shifts left when…	Shifts right when…
SRAS	Oil, commodity or imported input prices rise; wages rise faster than productivity; business taxes or regulation costs rise; supply chains are disrupted; expected inflation rises	Input prices fall; subsidies to producers increase
LRAS	Real capacity is permanently lost, such as oil reserves running out or capital destroyed in a war	The labour force grows or gets more skilled; the capital stock grows; new technology arrives; institutions improve (property rights, rule of law, open markets)

Note expected inflation: if workers expect 5% inflation, they ask for 5% higher wages, shifting SRAS left before any actual inflation happens. Expectations become self-fulfilling.

A temporary shock, like a one-year drought, shifts SRAS but not LRAS, so the economy recovers. A permanent loss of capacity shifts LRAS, so it does not.

Supply shocks and stagflation

An adverse supply shock is a sudden rise in production costs that shifts SRAS to the left. The price level rises and real output falls, so unemployment rises too. This combination is called stagflation. The classic example is 1973, when the oil price rose from roughly $3 to nearly $12 a barrel within months. US inflation rose above 11% in 1974 while unemployment climbed towards 9%.

Stagflation creates a genuine dilemma. Shifting AD left fights inflation but deepens the recession. Shifting AD right supports output but makes inflation worse. Because the shock moved supply and the policy tools move demand, no single policy can fix both.

Worked example

An economy has potential output of $2,000bn. AD is $ Y = 2{,}800 – 4P $ and SRAS is $ Y = 1{,}200 + 4P $, where Y is real GDP in $bn and P is the price level. An oil shock changes SRAS to $ Y = 1{,}040 + 4P $. Find the equilibrium before and after the shock, and the new output gap.

Step 1$ 2{,}800 – 4P = 1{,}200 + 4P \Rightarrow 1{,}600 = 8P \Rightarrow P = 200, \ Y = 1{,}200 + 4(200) = 2{,}000 $

Step 2$ 2{,}800 – 4P = 1{,}040 + 4P \Rightarrow 1{,}760 = 8P \Rightarrow P = 220, \ Y = 1{,}040 + 4(220) = 1{,}920 $

Step 3$ \text{Output gap} = \dfrac{1{,}920 – 2{,}000}{2{,}000} \times 100 = -4\% $

Before the shock the economy sat at potential. Afterwards the price level is 10% higher (from 200 to 220) while output has fallen by $80bn, leaving a negative output gap of 4%. Prices up and output down: stagflation. Check: $ 2{,}800 – 4(220) = 1{,}920 $.

Supply-side policy

Demand-side policy shifts AD. Supply-side policy tries to shift LRAS to the right by raising potential output. If it works, it gives the only outcome in macroeconomics with no trade-off: more output and a lower price level.

Market-based policies try to improve incentives and competition:

lower marginal tax rates on income and capital;
deregulation of product and labour markets;
privatisation and freer trade;
weaker trade union power and shorter benefit periods, aimed at lowering the natural rate of unemployment.

Interventionist policies supply what markets underprovide:

education and training to build human capital;
public infrastructure such as transport, energy and broadband;
subsidies for research and development;
retraining and relocation help for the structurally unemployed.

The evidence is mixed. The 1981 and 2017 US tax cuts both raised deficits without the promised jump in trend growth, and deregulation helped some industries but contributed to the 2008 crisis in finance. Supply-side policies work slowly, often beyond one election cycle, which is why governments often prefer demand-side policy.

Practise: 6 questions

Try each one on paper first, then check the worked answer.

EasyQ1. Why is the LRAS curve vertical? Show worked answer

In the long run all prices and wages have adjusted. If every price doubles, firms’ revenues and costs both double, so real profit is unchanged; workers’ wages and living costs both double, so the real wage is unchanged. Nothing real changes, so output stays at potential. Output depends only on real factors (labour, capital, resources, technology), not on the price level.

EasyQ2. What does a sharp rise in world oil prices do to SRAS, the price level and real output? Show worked answer

Oil is an input into almost everything, so costs rise at every price level. SRAS shifts left. The price level rises and real output falls: stagflation.

MediumQ3. Does each of these shift SRAS, LRAS, both or neither? (a) a one-year drought; (b) a permanent increase in the capital stock; (c) a rise in the general price level; (d) a rise in expected inflation from 2% to 6%. Show worked answer

(a) SRAS only (left). Costs rise for a year, but the land, labour and capital remain, so potential output is unchanged.
(b) Both (right). Capacity rises permanently, and costs per unit of output fall.
(c) Neither. A change in the price level is a movement along SRAS, and LRAS is vertical.
(d) SRAS only (left). Workers demand higher wages, raising costs. Potential output does not depend on expectations.

MediumQ4. Explain the sticky-wage theory of the upward-sloping SRAS curve, and why it does not apply in the long run. Show worked answer

Money wages are fixed by contract for a period. If the price level rises unexpectedly, firms get more for their output but pay the same wages, so the real wage falls and profit per unit rises. Firms hire more and produce more, so output rises with the price level.
In the long run contracts are renegotiated. Once wages rise in line with prices, the real wage returns to its old level and the extra profit, and the extra output, disappear.

MediumQ5. A government cuts income tax rates and builds new broadband networks, hoping to shift LRAS right. If it succeeds, what happens to real output and the price level? Why might it take a long time? Show worked answer

A rightward LRAS shift raises potential output, so real output rises while the price level falls (for a given AD), with no trade-off.
It is slow because new infrastructure takes years to build, and changes in incentives to work and invest feed through gradually. The evidence that tax cuts boost trend growth is also weak, so the gains are uncertain.

ExamQ6. An economy has potential output of $1,500bn. AD is $ Y = 2{,}400 – 3P $ and SRAS is $ Y = 900 + 3P $. (a) Find the short-run equilibrium and the output gap. (b) An oil shock changes SRAS to $ Y = 600 + 3P $. Find the new equilibrium and the changes in P and Y. (c) Explain what will happen to nominal wages before the shock, and comment on the shock’s effect. [6 marks] Show worked answer

(a) $ 2{,}400 – 3P = 900 + 3P \Rightarrow 1{,}500 = 6P \Rightarrow P = 250 $; $ Y = 900 + 3(250) = 1{,}650 $. Check: $ 2{,}400 – 750 = 1{,}650 $. Output gap $ = \dfrac{1{,}650 – 1{,}500}{1{,}500} \times 100 = +10\% $: the economy is overheating. [2 marks]
(b) $ 2{,}400 – 3P = 600 + 3P \Rightarrow 1{,}800 = 6P \Rightarrow P = 300 $; $ Y = 600 + 3(300) = 1{,}500 $. Check: $ 2{,}400 – 900 = 1{,}500 $. The price level rises by 50 points (20%) and output falls by $150bn. [2 marks]
(c) Before the shock, output is above potential, so the labour market is tight and nominal wages would rise, shifting SRAS left until output returns to potential at a higher price level. The oil shock does the same thing abruptly: output falls to $1,500bn (gap now zero) but the price level jumps to 300. Prices up and output down is the signature of a supply shock. [2 marks]

Check yourself

1. Which of these is NOT a theory of why SRAS slopes upward?

The wealth effect explains why aggregate demand slopes downward (Step 5), not aggregate supply.

2. Which of these shifts LRAS to the right?

Only a lasting rise in productive capacity moves LRAS; cheaper inputs shift SRAS and government spending shifts AD.

3. Workers start to expect higher inflation and demand higher wages. What is the immediate effect?

Higher wage demands raise costs at every price level, even before any actual inflation happens.

Your score: 0 out of 3

The short version

Aggregate supply is total real output firms will produce at each price level. The macro short run means some prices, especially wages, have not yet adjusted.
SRAS slopes up because of sticky wages, sticky prices or misperceptions, and all three fade with time.
LRAS is vertical at potential output (monetary neutrality). In the long run, supply sets output and demand sets the price level.
SRAS shifts with costs and expected inflation; LRAS shifts only with real capacity (labour, capital, resources, technology, institutions).
An adverse supply shock causes stagflation. Supply-side policy can raise output and lower prices together, but it works slowly and unevenly.

This guide covers the core of Chapter 24 of Economics Made Simple. For the full chapter, including the SRAS and LRAS diagrams, the 1973 oil shock case study and 15 exam-style questions with a complete answer key, get the book.