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Aggregate Supply
Aggregate supply is the aggregate of all the
supply in the economy. Hence, the aggregate
supply (from now on, AS) curve is the sum of
all the industry supply curves. It shows the
relationship between the price level and real
output (and real national income).
When we looked at firm and industry
cost curves (see the 'Costs and revenues'
topic and the relevant 'Market structure'
topic) it was important to distinguish between
the short and long run. We have to do this
again here, in particular, the prices of all factor
inputs (including wage rates) are assumed to
be constant in the short run.
It makes sense, therefore, that in the
short run the AS curve will be upward sloping,
just like the industry supply curves. The
obvious reason is that all the industry supply
curves that are added together are upward
sloping too. There is a more technical
explanation, though.
If real output is to increase in the
short run, firms cannot attract new labour by
increasing the wage rate. The only way to
make more output is to get the current
workforce to work harder (overtime, perhaps).
In the real world, overtime pays double the
wage rate, or maybe time and a half. So the
costs to the firms and industries are likely to
raise as real output rises. These increased
costs will tend to be passed onto the
consumer through higher prices. In a
roundabout way, the increase in real output
has resulted in a rise in the price level.
Shifts in the short run AS curve
The short run AS curve shifts for
similar reasons as firms, or an industry's
supply curve might shift. Anything that causes
the costs of the industries within the economy
to change (regardless of changes in the price
level) will shift the AS curve. The factors must
have nothing to do with changes in the
general price level, remember. Otherwise, we
would be dealing with a movement
along the AS curve and not a shift in the
curve.

In the diagram you can see that the
short run AS curve (or SRAS curve) has shifted
upwards (or to the left) from SRAS
1
to SRAS
2
.
There are two different ways that this can be
interpreted.
You could argue that, for a given level
of real output, Y
1
, the price level has risen due
to a rise in the costs of various industries (like
an increase in wage rates, other input prices
or even the tax imposed by the government)
from P
1
to P
2
.
Another way of looking at it is that
real output falls for a given price level due to
the increases in industries' costs. The firms
may be unable to push the cost increases onto
the consumer (for whatever reason) so real
output cannot remain at Y
1
, and so it falls to
Y
2
. The economy cannot make as much real
output at the given price level if their costs
rise.
Just like with AD curves, the SRAS
curves can also shift to the right. Obviously,
this would happen if there were an increase in
costs for firms in the economy as a whole.
Given that we are assuming that
factor input price should remain constant in
the short run, the reasons given for the shifts
in the SRAS curve do not make much sense.
In the real world, industries and economies
are often on the receiving end of supply side
shocks. There is nothing they can do about
them and they affect the costs of the
industries or economies. The quadrupling of
the price of oil in the 70s is a good example.
The industries of the UK could do nothing
about it, but it increased the costs of nearly all
firms in all industries at the time, causing the
SRAS curve to shift to the left.
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Different economists have different
views about the long run AS curve (LRAS
curve). You have probably come across the
differences between Monetarist (or classical)
economists and Keynesian economists in your
studies. The two sets of economists have
different views about the shape of the LRAS
curve.
The classical (or monetarist) view
Classical economists believe strongly in the
concepts of supply and demand in all markets.
Whilst they are prepared to believe that
markets might not be in equilibrium in the
short run, they believe that all markets clear
(i.e. supply equals demand) in the long run.
They also believe that if all markets are
working efficiently and all resources are being
used, then the economy must be at a
point on their production possibility
frontier (PPF). In other words, the economy
is making as much as it can, given its
resources.

Classical economists think that the LRAS curve
is vertical. There is absolutely no spare
capacity in the economy. The maximum real
output is already being produced. In these
circumstances, if there is an increase in AD (a
shift from AD
1
to AD
2
) for whatever reasons
then all that will happen is the price level will
rise (from P
1
to P
2
). Demand increases, but
there is no more output to buy, so the price of
the various goods and services is bid up.
Note that the economy is in equilibrium where
the AD curve cuts the AS curve (in this case,
the LRAS curve). This occurs at point A
initially, and then at point B after the shift in
the AD curves from AD
1
to AD
2
.
The Keynesian view
John Maynard Keynes (1883 - 1946) is
probably the most famous economist of the
twentieth century. Until the depression of the
1930s, all economists were effectively
classical. Unemployment rose to astronomical
levels during the depression (a very
bad recession!). The classical economists,
with their belief in supply and demand up their
sleeves, said that the labour market would
'clear'. Unemployment was caused by excess
supply of labour due to the wage rate (the
price) being too high. Before long, the wage
rate would fall as workers realised that the
only way to get work was to take a lower
wage. Of course, when this didn't happen after
a number of years, they could not explain
why.
Keynes was an economist who was always
looking for answers to problems. He didn't
care that every other economist in the world
said that wages would fall and, with them,
unemployment. As far as he was concerned, it
wasn't happening, so the theory was wrong.
He argued that an economy could find itself in
a situation where unemployment was high and
stuck at the high rate. In other words, the
economy could find itself in an equilibrium
(i.e. a state of rest) that was not the full
employment equilibrium.

In the diagram above, the levels of real output
between 0 and Y
1
are ones where there is a
lot of excess capacity. There are many unused
resources (unemployed labour, for example)
and the economy is at a point well within its
PPF (see the topic called 'Market failure' for
details of the PPF). This was the situation in
the depression of the 30s. Keynes' solution
was simple. If there is excess supply, the
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solution is not to hope the wage (and other
prices) falls, causing the supply of labour to be
offered onto the market to fall. Why not close
the gap by increasing demand? Consumers
were too poor at the time to create this
increase in AD, so, Keynes argued, it was up
to the government to create this demand,
through investment in roads, railways,
hospitals, etc. Not only would this create jobs
for the unemployed, but it would also improve
the infrastructure of the economy.
Anyway, diagrammatically, you can see that,
up to point A, the AD curve can shift to the
right without the price level rising. A large
increase in real output with no rise in the price
level. Also note that at every point where an
AD curve cuts the LRAS curve is an equilibrium
point. Importantly (as Keynes said), these
equilibrium levels of real output can occur at
levels below the full employment level of real
output (like the equilibrium at point C, price
P
1
and real output Y
1
).
The section of the LRAS curve between points
A and B shows the levels of output where the
economy is coming out of recession. If AD
continues to rise (a shift to AD
2
, say), real
output will still rise, but the price level will also
rise. In this situation, some industries will still
be experiencing excess capacity, but others
will be finding that they are getting close to
full capacity. So some prices will not be rising,
but others will be. The price level, remember,
is a measure of the average price level across
the whole economy. So, in this situation, the
price level will rise.
The final section of the LRAS curve, above
point B, is vertical. Keynes agreed with the
classical economists that, once the economy
had reached the full employment level of real
output, any rise in AD will be inflationary. A
shift in AD from AD
3
to AD
4
will result in no
increase in real output, but the price level will
rise from P
3
to P
4
. This last bit of the
Keynesian LRAS curve is the same as the
whole of the classical LRAS curve.
Comparisons with the 45 degree diagram
analysis
For those of you who prefer the 45 degree
diagram analysis, look at the diagram below
and see how it compares with the AS/AD
diagram above.

The Y = AD line at 45 degrees to the
horizontal gives all the points where the
economy is in equilibrium, just like all the
points where the various AD curves cut the
LRAS curve are equilibrium points in the
previous diagram. Notice that each AD line in
this diagram denotes planned expenditure,
which is C + I + G + X M.
Note that AD
3
gives the full employment level
of real national income (Y
FE
), just as the AD
curve, AD
3
, does as is crosses the LRAS curve
at point B in the previous diagram.
The AD
4
lines are showing the same thing as
well. In the first diagram you see the price rise
to P
4
, and in the second diagram this rise in
the price level is illustrated by
the inflationary gap in green.
The AD
1
lines are also showing the same
thing. In the first diagram, this gives a level of
real output of Y
1
, which is below the full
employment level, and in the second diagram
it does the same. The deflationary gap in
blue illustrates the downward pressure on
prices of being in this recessionary position.
You can probably see why examiners prefer
the AS/AD approach. It shows both the
Keynesian position and the classical position
(when the LRAS curve is vertical), whereas the
45-degree diagram is just a Keynesian
diagram. Also, when AD shifts to a position
past AD
3
, real output remains at the full
employment level Y
FE
. This doesn't really
happen on the 45-degree diagram. The AS/AD
diagram also shows the price levels. The 45-
degree diagram hints at what is going on with
prices with its deflationary and inflationary
gap, but it is not specific.