Aggregate Supply measures the volume of goods and services produced within the economy at a given aggregate price level. Normally there is a positive relationship between aggregate supply and the general price level. Rising prices are a signal for businesses to expand production to meet a higher level of aggregate demand.

Short Run Aggregate Supply Curve

Aggregate supply is determined by the supply side performance of the economy. It reflects the productive capacity of the economy and the costs of production in each sector.

Shifts in the AS curve can be caused by the following factors:

·        changes in size & quality of the labour force available for production

·        changes in size & quality of capital stock through investment

·        technological progress and the impact of innovation

·        changes in factor productivity of both labour and capital

·        changes in unit wage costs (wage costs per unit of output)

·        changes in producer taxes and subsidies

·        changes in inflation expectations - a rise in inflation expectations is likely to boost wage levels and cause AS to shift inwards

In the diagram above - the shift from AS₁ to AS₂ shows an increase in aggregate supply at each price level might have been caused by improvements in technology and productivity or the effects of an increase in the active labour force.  Supply side policies are a very important government tool for increases national income.

An inward shift in AS (from AS₁ to AS₃) causes a fall in supply at each price level. This might have been caused by higher unit wage costs, a fall in capital investment spending (capital scrapping) or a decline in the labour force.

Long Run Aggregate Supply

Long run aggregate supply is determined by the productive resources available to meet demand and by the productivity of factor inputs (labour, land and capital).

In the short run, producers respond to higher demand (and prices) by bringing more inputs into the production process and increasing the utilisation of their existing inputs. Supply does respond to change in price in the short run.

In the long run we assume that supply is independent of the price level, the productive potential of an economy (measured by LRAS) is driven by improvements in productivity and by an expansion of the available factor inputs (more firms, a bigger capital stock, an expanding active labour force etc). As a result we draw the long run aggregate supply curve as vertical.

Improvements in productivity and efficiency cause the long-run aggregate supply curve to shift out over the years. This is shown in the diagram below