The Aggregate Supply Ranges

Idea

Aggregate supply is treated in two forms. The short-run aggregate supply (SRAS) is upward-sloping; the long-run aggregate supply (LRAS) is drawn with three ranges that capture how much spare capacity the economy has. Together they determine how an increase in aggregate demand divides between higher output and a higher general price level.

Mechanism

The SRAS slopes upward because of stickiness. Under the sticky-wage account, nominal wages are slow to adjust — fixed by existing contracts and social norms against frequent cuts — so when the general price level rises, real wages and real production costs fall, firms hire more and output rises. Under the sticky-price account, menu costs keep firms from re-pricing immediately, so a change in the price level changes the quantity sold.

The LRAS has three ranges, each corresponding to a position on the economy’s production possibility curve:

Keynesian (horizontal) range — much spare capacity and demand-deficient unemployment; resources are widely available, so a rise in AD raises real national output with no rise in the general price level. This is a point deep inside the PPC.
Intermediate range — production nears full capacity; as AD rises, the cost of the increasingly scarce resources is bid up, so both output and the general price level rise. This is a point close to the PPC.
Classical (vertical) range — full employment of resources; firms must compete for a fixed resource pool, so a rise in AD raises only the general price level, not output, and the economy risks overheating. This is a point on the PPC itself.

Diagram

The long-run aggregate supply curve and its three ranges: the horizontal Keynesian range (spare capacity), the upward-sloping intermediate range (nearing capacity), and the vertical classical range at full-employment output Yf.

Considerations

The two curves shift on different determinants:

LRAS shifts with the economy’s productive capacity — the quantity of resources (a larger labour force, newly discovered land, more private capital, better public infrastructure) and their quality (human capital, technology, entrepreneurship). Any rise in capacity shifts LRAS rightward; a fall in economy-wide cost of production lowers the Keynesian (horizontal) portion.
SRAS shifts with cost of production — a rise in wages not matched by productivity shifts SRAS leftward and can cause cost-push inflation — and with supply shocks, such as a bumper harvest (rightward) or a disease outbreak (leftward).

Potential growth shown on the AD–AS diagram: an increase in the quantity or quality of resources shifts LRAS rightward from LRAS0 to LRAS1, raising full-employment output from Yf0 to Yf1 against an unchanged AD.