Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Getting to Grips with Short-Run Aggregate Supply


In the short run, aggregate supply doesn’t need to equal the natural level of output. Output can be temporarily above or below the natural level of output , because prices are sticky in the short run and take some time to adjust to changes in aggregate demand (AD). (You can read more about in ‘Deciding on output in the long run’, earlier in this chapter.)


Producing more in the short run

Firms are able to produce more than in the short run by hiring more people or using the people and machines they already have more intensively. Even at some unemployment exists, so increasing output beyond this causes unemployment to fall temporarily below the natural rate. These additional workers increase L in the production function and allow firms to produce more output.

In Figure 8-5, you can see that the short-run aggregate supply (SRAS) curve is upward sloping, which means that as the average price level in the economy rises (due to an increase in AD), firms produce more output in the short run.

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Figure 8-5: Short-run aggregate supply.

In the long run, though, output has to return to its natural level, . To see how this works in practice, consider the increase in aggregate demand shown in Figure 8-6.

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Figure 8-6: Aggregate demand increase in the short and long run.

Aggregate demand has increased from AD₁ to AD₂. If prices had been fully flexible, this would’ve left output unchanged at and caused the price level to increase to P₃ (point C). In the short run, however, prices are sticky and the increase in AD causes output to increase from to Y₁ (a movement along the SRAS curve from point A to point B). You can also see that, even though prices are sticky in the short run, they aren’t completely fixed: the short-run price level increases from P₁ to P₂.

Moving to the long run, prices in the economy are able to adjust more fully to the increase in AD and the economy moves from point B to point C. This shifts the SRAS curve gradually from SRAS₁ to SRAS₂. When the economy is at point C, it has responded fully to the increase in AD, which has resulted only in an increase in the price level and not in real output.

Notice that in the movement from A to B, output increases above its natural level. This leads to a fall in unemployment to below the natural rate of unemployment. As the price level adjusts fully (from B to C), output falls back to , which means unemployment also returns to its natural rate.