By Arnold S. Kling
What Is Aggregate Supply?
Aggregate supply is the relationship between the overall price level in the economy and the amount of output that will be supplied. As output goes up, prices will be higher.
We draw attention to factors that shift the aggregate supply curve. An adverse supply shock, such as a bad harvest, will cause supply to contract, raising prices and lowering output. A favorable supply shock, such as a productivity-enhancing innovation, will lower prices and raise output.
Aggregate demand and aggregate supply can be depicted on a diagram relating price and output in a way that is analogous to microeconomic supply and demand curves. But the mechanisms behind the relationships are subtle.
Aggregate demand goes down as the price level rises not because people are thinking “the price of GDP has gone up, so I want to purchase less of it.” Instead, a higher price level means that a given quantity of money can facilitate fewer transactions and business and consumer loans. We say that an increase in the price level reduces the real money supply, which is defined as the ratio of the quantity of money to an overall price index. A lower real money supply raises the interest rate on loans, leading to a reduction in investment and consumer spending, and hence lower aggregate demand.
The reason that aggregate supply rises with the price level is also not straightforward. In fact, if all prices and costs went up by the same amount, then the desired level of output would not change. But many economists believe that wages adjust slowly to prices, at least in the short run. So higher prices of output will reduce the real wage, which is defined as the ratio of average wages to average prices. This in turn will reduce the cost to firms of increasing output, and hence output will rise.
One theory of the aggregate supply curve is that it has three segments. When the economy is deep in a recession, with high unemployment, an increase in aggregate demand will result in little or no increase in price. Instead, unemployed resources will be put to work to fill the demand. When the economy is growing but not yet at full employment, an increase in aggregate demand will raise both output and prices. When the economy is at full employment, supply cannot increase further, so an increase in aggregate demand will primarily raise prices.
The importance of aggregate supply was “discovered” in the 1970s. A cutback in oil supply orchestrated by Saudi Arabia late in 1973 caused the United States to experience both rising unemployment and rising inflation. According to the Phillips Curve, higher unemployment should have produced lower inflation. To explain the anomaly, economists came to describe the situation as an adverse supply shock.
The Phillips Curve is like the aggregate supply curve in that it depicts the relationship between prices and output. But the Phillips Curve looks at the rate of change in prices (inflation) as the price axis and it looks as the unemployment rate (which varies inversely with output) as the quantity axis. The experience of the 1970s can also be characterized as a shift in the Phillips Curve.
Another instance of a supply shock was the COVID-19 pandemic that hit the United States in the Spring of 2020. Many businesses curtailed activities, in some cases because of government-ordered closures. It became difficult to supply goods that were made with foreign components, because some factories were shut down in China and elsewhere. The need for telework and to care for children home from school probably cut into productivity.
The pandemic also reduced aggregate demand, as people chose to cut back on travel, entertainment, and eating in restaurants. Thus, it could be described as a combination of an adverse demand shock and an adverse supply shock.
Phillips Curve. Concise Encyclopedia of Economics.
Aggregate Demand. Economics Topics Detail.