Defining aggregate supply

Aggregate Supply (AS) measures the volume of goods and services produced within the economy at a given overall price level. There is a positive relationship between AS and the general price level. Rising prices are a signal for businesses to expand production to meet a higher level of AD. An increase in demand should lead to an expansion of aggregate supply in the economy.

Short-run aggregate supply curve. Aggregate supply is determined by the supply side performance of the economy. It reflects the productive capacity of the economy and the costs of production in each sector.

Shifts in the AS curve can be caused by the following factors:

Changes in size & quality of the labour force available for production. Changes in size & quality of capital stock through investment. Technological progress and the impact of innovation. Changes in factor productivity of both labour and capital. Changes in unit wage costs (wage costs per unit of output). Changes in producer taxes and subsidies. Changes in inflation expectations - a rise in inflation expectations is likely to boost wage levels and cause AS to shift inwards.

The long run aggregate supply curve as vertical. In the diagram above - the shift from AS1 to AS2 shows an increase in aggregate supply at each price level might have been caused by improvements in technology and productivity or the effects of an increase in the active labour force. An inward shift in AS (from AS1 to AS3) causes a fall in supply at each price level. This might have been caused by higher unit wage costs, a fall in capital investment spending (capital scrapping) or a decline in the labour force.