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Aggregate Supply definition

Aggregate supply measures the sum total of goods and services produced within an economy, a sector, or a market. It indicates the amount of goods that are produced at various price levels during a specified period of time. Aggregate supply is typically measured over the course of a year. Aggregate Supply (AS) can be divided up into Short Run and Long Run Aggregate Supply. These are denoted by the acronyms SRAS and LRAS respectively.

The Short Run Aggregate Supply references the relationship between the current price level and real GDP. It reflects the production that an economy is capable of over the short term when price levels vary. This measure assumes inflexible capital levels, owing to regulated prices, wage contracts, and rental agreements. By contrast, Long Run Aggregate Supply references the theoretical productive capacity of an economy if there was a net unemployment rate of 0. This indicates that the country’s economy is operating at maximum productivity.

Long Run Aggregate Supply extrapolates that it is neither aggregate demand nor current price levels that determine aggregate supply. It is the factors of production such as technology, labour, and capital. There are notable differences between the Short Run and Long Run Aggregate Supply measures. Aggregate demand affects each of these measures in different ways. Over the short run, capital is inflexible. This means that any modification to aggregate demand will impact production levels over the short-term. Naturally, production is unlikely to change very much.

How to Assess Long Run Aggregate Supply (LRAS)

Conversely, Long Run Aggregate Supply assumes that changes in aggregate demand will have a transient effect on total production in the economy. Only a select group of factors can impact economic output over the long term. These include technology, labour, and capital. All other factors are operating at maximum efficiency with Long Run Aggregate Supply. With both SRAS and LRAS, various factors come into play. Over the short term, changes are unpredictable, but over the long term, it is possible to forecast changes.

Short Run Aggregate Supply is impacted by factors such as supply shocks, or modifications in aggregate demand. Long Run Aggregate Supply curves can also shift when a sector of the economy undergoes changes. When factors of production are modified, productivity can be affected. This includes elements such as wages, raw materials, and scarcity. Other factors that change aggregate supply including inflationary pressures, modifications to producer taxes, increased production costs, or subsidies. Supply output can be increased by improving the quality of the labour force, or enhancing its efficiency.

Aggregate Supply in Action

Assume that company ABC manufactures 10,000 units of output per quarter. If these incur a total expense of $10 million, and the cost of a vital component constitutes 20% of that expense and that happens to double in price, due to scarcity, aggregate supply can change. If the company can now only manufacture 8000 units of output per quarter and spends $10 million on production, this reduction in output reflects a drop in aggregate supply. In this case, aggregate demand could exceed aggregate supply/production. What invariably happens in the situation is that prices rise and demand drops to a lower level where the demand and supply curves intersect to satisfy the market.

Aggregate supply can be calculated over the short term as follows: Y= Y*+ a(P-Pe).

TABLE

Y = production of the economy

Y*= natural level of production in economy

a = the coefficient > zero

P = price level

Pe = expected price level with consumers

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