AD-AS Model - Aggregate Supply Curve

Aggregate Supply Curve

The aggregate supply curve may reflect either labor market disequilibrium or labor market equilibrium. In either case, it shows how much output is supplied by firms at various potential price levels. The aggregate supply curve (AS curve) describes for each given price level, the quantity of output the firms plan to supply.

The Keynesian aggregate supply curve shows that the AS curve is significantly horizontal implying that the firm will supply whatever amount of goods is demanded at a particular price level during an economic depression. The idea behind that is because there is unemployment, firms can readily obtain as much labour as they want at that current wage and production can increase without any additional costs (e.g. machines are idle which can simply be turned on). Firms' average costs of production therefore are assumed not to change as their output level changes. This provides a rationale for Keynesians' support for government intervention. The total output of an economy can decline without the price level declining; this fact, in conjunction with the Keynesian belief of wages being inflexible downwards, clarifies the need for government stimulus. Since wages cannot readily adjust low enough for aggregate supply to shift outward and improve total output, the government must intervene to accomplish this result. However, the Keynesian aggregate supply curve also contains a normally upward-sloping region where aggregate supply responds accordingly to changes in price level. The upward slope is due to the law of diminishing returns as firms increase output, which states that it will become marginally more expensive to accomplish the same level of improvement in productive capacity as firms grow. It is also due to the scarcity of natural resources, the rarity of which causes increased production to also become more expensive. The vertical section of the Keynesian curve corresponds to the physical limit of the economy, where it is impossible to increase output.

The Classical aggregate supply curve comprises a short-run aggregate supply curve and a vertical long-run aggregate supply curve. The short-run curve visualizes the total planned output of goods and services in the economy at a particular price level. The "short-run" is defined as the period during which only final good prices adjust and factor, or input, costs do not. The "long-run" is the period after which factor prices are able to adjust accordingly. The short-run aggregate supply curve has an upward slope for the same reasons the Keynesian AS curve has one: the law of diminishing returns and the scarcity of resources. The long-run aggregate supply curve is vertical because factor prices will have adjusted. Factor prices increase if producing at a point beyond full employment output, shifting the short-run aggregate supply inwards so equilibrium occurs somewhere along full employment output. Monetarists have argued that demand-side expansionary policies favoured by Keynesian economists are solely inflationary. As the aggregate demand curve is shifted outward, the general price level increases. This increased price level causes households, or the owners of the factors of production to demand higher prices for their goods and services. The consequence of this is increased production costs for firms, causing short-run aggregate demand to shift back inwards. The theoretical ultimate result is inflation.