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aggregate supply: The amount of total goods and services supplied at a given price level.
Aggregate supply consists of all the goods and services produced by all the firms in an economy. There is a difference in the decision of how much firms produce in the long and short run.
- Long-run aggregate supply curve (LRAS)
- The amount produced based on the amount of capital and labor available is called the natural rate of output. Movements away from the natural rate are called short-run economic fluctuations.
- In the long run, if there is a change in the demand for a firm’s good, the firm will change the price of its good or change the wage paid to its employees without changing the amount it produces (the "natural" amount). Every firm in the economy does the same thing.
- Therefore, in the long run, firms do not choose the amount they are going to produce based on the overall price level; the price level will adjust to the amount that they decide to produce. Therefore the long-run aggregate supply curve is vertical.
- Short-run aggregate supply curve (SRAS)
- In the short run, individual firms do take into consideration the overall price level when they make their decision on how much to produce.
- This result is based on the assumption that a firm cannot change its price or wage paid to employees in the short run. (Refer to a textbook such as N. Gregory Mankiw’s Principles of Economics 4th edition chapter 33 for an in depth discussion on why the short-run aggregate supply curve is upward sloping.)
- For example, assume a firm starts to see the general price level rise, but it cannot raise its own prices because it is stuck (assume the firm printed its prices in a catalog and cannot change the price until it prints a new catalog). In order to take advantage of the higher price level, it decides to produce more. A firm without sticky prices will just raise the price of its good when it sees the general price level rise, causing firms with sticky prices to produce even more.
- So, as the overall price level rises, more goods are supplied in the short run. Reversing the logic you will see that as the price level falls, fewer goods will be supplied.
There are things other than the price level that can affect the aggregate supply curve. Changes in the cost of producing goods will shift the aggregate supply curve.