This is the aggregate supply and aggregate demand model. In this tutorial, we will be focusing on aggregate supply, represented by the red line, but it is helpful to see how the whole model will eventually come together.
Notice that in microeconomics, the x-axis generally represents quantity, as in the quantity of one specific item, but here it represents overall quantity or all output in an economy, which is real GDP.
The y-axis represents the overall price level, not just the price of a specific item.
Now, real GDP, which is the x-axis, is actually real gross domestic product, or RGDP. This is the sum of the final value of goods and services produced over a specific time interval, within a country's borders. It is calculated across time periods using a constant price level--which is where the "real" aspect enters the equation.
It means we are adjusting for inflation and evaluating whether we have been more or less productive, as evidenced by our gross domestic product.
The price level on the y-axis is an aggregate index value that provides an indication of the increase in prices from one period to another. It is used to evaluate inflation across periods.
Aggregate supply involves the relationship between the two axes, price level and the total amount of real GDP that producers are willing to produce.
This relationship changes over time, so it is important to distinguish between the short run and the long run.
In the short run, you will see that there is a relationship between prices and GDP. As prices go up, producers will want and be able to produce more to take advantage of higher prices.
In the long run, however, there is not a relationship between the price level and real GDP. No matter how high prices are, there is a fixed amount that can actually be produced sustainably.
Let's discuss each supply curve in further detail.
For these reasons, the short-run aggregate supply is an upward sloping curve.
Again, this is a positive relationship between the overall price level and the total amount that producers can produce by real GDP.
In the short run, if prices go up, businesses can take advantage of this and produce more. They will not have to necessarily pay their workers more immediately because as prices go up, wages will not immediately adjust. In addition, businesses can use the inventories that they already have.
Therefore, this is why it is possible for aggregate supply to slope upwards in the short run.
The same is true with employers. If employers want to take advantage of higher prices in the short run, they can certainly do that. They can hire workers to work overtime, or they can draw down their inventories to try to produce more immediately. However, at some point, there is a limit to the amount of resources--land, labor, and capital--which leads us to the idea of long-run aggregate supply, which we will cover next.
Because there is a fixed amount that we can ultimately produce given our land, labor, and capital, the long run aggregate supply curve is a vertical curve.
So the LRAS curve represents our economy's full potential in terms of our production, given our current resources. When we have no cyclical unemployment at all, meaning we only have those standard types of unemployment like frictional and structural, this means that all of our land, labor, and capital are fully employed.
We have a low unemployment rate in the economy and resources are fully employed, we are on this long-run aggregate supply curve.
So, our production capacity is actually fixed unless something changes our ability to produce more. Certainly, as prices go up, producers would like to produce more--and as mentioned, in the short run, they can. However, at some point, it will simply revert to the long run unless something actually changes to increase our ability to produce more into the long run.
Ramping up production in the short run can only get us so far. We have a limited amount of resources like materials and workers. Therefore, in the long run, the amount of production that producers can sustain is fixed.
Sustainability, then, is the idea that consumption and production do not stress or exceed the threshold required for natural regeneration of depleted resources.
EXAMPLEFor example, if producers were using a lot of resources like timber, for instance, to produce more in the short run, that would be fine. However, if they are producing faster than those resources are being replaced, this rate of growth is unsustainable. They cannot sustain that into the long run.
So, how does our economy grows over time? We know that it does, but If we are saying our growth is limited to the vertical curve in the long run by using all of our land, labor, and capital, then how is it that we grow from year to year and from decade to decade?
Well, the long run aggregate supply curve can actually move. Over time, it is possible for the economy to grow. We must find more land, labor, or capital.
This is possible, given the following sources:
As you can see, if any of these things would happen, it would actually shift our long-run aggregate supply curve to the right, giving us the ability to produce more into the long run.
This equates to real GDP growth, which shows the measure of the percentage change in real GDP from one period to another, where the price level is held constant and the growth provides insight to the increase in the production of final goods and services over the interval evaluated.
Unfortunately, the long run aggregate supply curve can also shift to the left, which would happen if something reduces the amount of land, labor, and capital that we have.
EXAMPLEExamples of this include natural disasters or wars, unfortunately, which would be shown by a movement to the left of the long run aggregate supply curve.
Source: Adapted from Sophia instructor Kate Eskra.