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Aggregate supply

From Academic Kids

In economics, aggregate supply is the total supply of goods and services by a national economy during a specific time period. There are at least two different versions of this concept in Keynesian economics.

1. Sometimes the "Z curve" in the "Keynesian cross" diagram is referred to as "aggregate supply." This curve often represents the total amount of production that corresponds to the total amount of income in a country during a specific time period. Because the sum of all income received corresponds to the sum of all production, this is drawn as a 45 degree line. In this diagram, the desired total spending line crosses this Z curve, determining the equilibrium level of production, income, and spending.

2. In neo-Keynesian theory seen in many textbooks, an "aggregate supply and demand" diagram is drawn that looks like a typical Marshallian supply and demand diagram. The aggregate supply (AS) curve is usually drawn as upward-sloping in the short run, since the quantity of aggregate production supplied (Qs) rises as the average price level (P) rises.

There are two main reasons why Qs might rise as P rises, i.e., why the AS curve is upward sloping:

A. In neoclassical-influenced textbooks, it is necessary to raise prices to motivate profit-seeking firms to increase output. This is because of diminishing returns and thus rising marginal costs that arise because one or more of the inputs or factors of production does not change in the short run and is assumed to be fully employed at all times. Usually this is fixed capital equipment. The AS curve is drawn given some nominal variable, such as the nominal wage rate.

In the short run, the nominal wage rate is taken as fixed. Thus, rising P implies higher profits that justify expansion of output. In the neoclassical long run, on the other hand, the nominal wage rate varies with economic conditions. (High unemployment leads to falling nominal wages -- and vice-versa.) This is used to justify a vertical aggregate supply curve in the long run.

B. An alternative model starts with the notion that any economy involves a large number of heterogeneous types of inputs, including both fixed capital equipment and labor. Both main types of inputs can be unemployed. The upward-sloping AS curve arises because (1) some nominal input prices are fixed in the short run (as in the neoclassical theory) and (2) as output rises, more and more production processes encounter bottlenecks.

At low levels of demand, there are large numbers of production processes that do not use their fixed capital equipment fully. Thus, production can be increased without much in the way of diminishing returns and the average price level need not rise much (if at all) to justify increased production. The AS curve is flat.

On the other hand, when demand is high, few production processes have unemployed fixed inputs. Thus, bottlenecks are general. Any increase in demand and production induces increases in prices. Thus, the AS curve is steep or vertical.

This implies an AS curve which has the shape of a rounded backwards "L".

See also

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