Short Run Aggregate Supply
Short run aggregate supply is the relationship between the quantity of goods and services that firms are willing to produce and the overall price level, holding the prices of inputs, especially wages, constant. It is the supply side of the aggregate demand and aggregate supply model, and it explains how output responds to changes in demand in the short run. In the short run, an increase in the price level raises output, because firms' costs do not rise immediately, while in the long run, costs adjust and the relationship becomes vertical.
The upward slope
The short-run aggregate supply curve slopes upward, indicating that a higher price level is associated with a higher level of output. The reason is that some prices and costs are sticky or slow to adjust. If the price level rises while nominal wages and other input prices remain fixed, firms' profit margins widen, and they increase production and employment. The higher output is a response to the higher relative price of output compared with costs.
Several mechanisms can generate the upward slope. Sticky wages, arising from long-term contracts, from norms, or from the reluctance of firms to cut pay, mean that nominal wages do not adjust immediately to changes in prices. Sticky prices, arising from the costs of changing prices, mean that some firms do not adjust their prices immediately. Misperceptions about relative prices, in which firms confuse general price increases with increases in the relative price of their own product, can also produce an increase in output.
Determinants of position
The position of the short-run aggregate supply curve depends on the costs of production and on expectations. A rise in nominal wages, in the prices of raw materials, or in other input costs shifts the curve upward, meaning that less output is supplied at any given price level. A fall in these costs shifts it downward. Changes in taxes and subsidies on production, and in the productivity of inputs, also shift the curve.
Expectations about the price level matter. If firms and workers expect higher prices, they will set higher wages and prices in advance, shifting the aggregate supply curve upward. If they expect lower prices, the curve shifts downward. The interplay between expectations and actual prices determines the position of the curve and the extent to which changes in demand affect output rather than prices.
The long run
In the long run, the short-run aggregate supply curve gives way to a vertical long-run curve at potential output. Over time, wages and other costs adjust to changes in the price level, and the initial effect on output is eroded. Firms revise their expectations, wages are renegotiated, and the economy returns to the level of output consistent with full employment and stable inflation.
The transition from the short run to the long run explains the adjustment of the economy to shocks. An increase in demand raises output and prices in the short run, but as costs adjust, output returns to potential and prices end higher. The speed of adjustment depends on the flexibility of wages and prices and on the anchoring of expectations, and it determines how long the short-run effects persist.
Policy implications
The short-run aggregate supply curve is central to the analysis of stabilisation policy. Because output can deviate from potential in the short run, demand management can influence output and employment, and the size of the effect depends on the slope of the supply curve and on the adjustment of costs. When the curve is relatively flat, additional demand raises output with little increase in prices; when it is steep, additional demand mainly raises prices.
Supply shocks shift the curve and present a difficult choice for policy. An adverse supply shock, such as a rise in oil prices, raises costs, shifting the curve upward, which raises prices and reduces output simultaneously. Policy cannot address both inflation and unemployment at the same time, and it must choose which to prioritise, or rely on the adjustment of the economy over time to restore the previous level of output at a higher price level.
Sticky wages and prices
The stickiness of wages and prices is central to the upward slope of the short-run aggregate supply curve. Nominal wages are often set by contracts that cover a year or more, and they reflect expectations formed when the contracts were negotiated. If prices rise unexpectedly, wages do not adjust immediately, and real wages fall, so firms increase employment and output. The stickiness of wages therefore provides a mechanism through which demand changes affect output.
The stickiness of prices provides an additional mechanism. Firms may delay price changes because of the costs of doing so, known as menu costs, and because of the risk of alienating customers. When prices are sticky, an increase in demand raises output rather than prices in the short run, because firms satisfy the additional demand at existing prices. The combination of wage and price stickiness produces the upward-sloping supply curve and the short-run response of output to demand.
Coordination and expectations
The response of output to demand also depends on expectations and on the coordination of price setting. If firms expect higher prices and set them in advance, the aggregate supply curve shifts upward, and the effect of a demand increase on output is smaller. If expectations are well anchored and firms do not revise their prices, the effect on output is larger. The interaction between expectations and supply is central to the analysis of the transmission of policy.
Coordination failures can amplify the effects of demand changes. If each firm is reluctant to be the first to raise prices, output may rise more than the sum of individual decisions would suggest, and the adjustment may be slow. If, by contrast, firms adjust in coordination, prices may rise more quickly and the effect on output may be smaller. The analysis of these interactions draws on models of price setting with strategic complementarity.
The slope and its variability
The slope of the short-run aggregate supply curve varies across economies and over time. It is flatter where wages and prices are more sticky, and steeper where they are more flexible. It is also flatter at low levels of output, where there is spare capacity, and steeper near potential output, where capacity constraints bite and additional demand mainly raises prices.
The variability of the slope has implications for policy. When the curve is flat, demand management is effective at raising output with little inflation, and the case for stimulus is strong. When the curve is steep, additional demand mainly raises inflation, and the case for stimulus is weaker. The assessment of the slope, and of the position of the economy relative to potential, informs the calibration of policy, and it requires judgment about the level of slack and the degree of price flexibility.
Supply shocks and policy trade-offs
An adverse supply shock, such as a rise in the price of energy or of other inputs, shifts the short-run aggregate supply curve upward, raising prices and reducing output in the short run. The economy faces a combination of higher inflation and higher unemployment, and policy cannot address both at once. The choice is between accommodating the inflation, which supports output but allows inflation to rise, and offsetting it, which stabilises inflation but deepens the fall in output.
The appropriate response depends on the nature of the shock and on the credibility of the monetary framework. If the shock is temporary, the central bank may look through it, keeping policy unchanged and allowing the economy to adjust as the shock fades. If the shock threatens to raise inflation expectations and to become entrenched, a response may be needed. The trade-off between inflation and output in the face of supply shocks is one of the central challenges of stabilisation policy.