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Lesson summary: Short-run aggregate supply

AP.MACRO:
MOD‑2 (EU)
,
MOD‑2.C (LO)
,
MOD‑2.C.1 (EK)
,
MOD‑2.C.2 (EK)
,
MOD‑2.C.3 (EK)
,
MOD‑2.D (LO)
,
MOD‑2.D.1 (EK)
In this lesson summary review and remind yourself of the key terms and graphs related to short-run aggregate supply. topics include sticky wage theory and menu cost theory, as well as the causes of short-run aggregate supply shocks.

Lesson Summary

Think of something that is stuck. It’s fixed in place and, if it’s moving, it’s doing so really slowly! When things don’t move or adjust quickly, economists will often refer to them as “sticky.” For instance, if market prices or wages don’t adjust quickly to changes in the economy, they are called sticky prices. And when faced with things like sticky wages and prices, an economy might not produce its full employment output.
The short-run aggregate supply curve (SRAS) lets us capture how all of the firms in an economy respond to price stickiness. When prices are sticky, the SRAS curve will slope upward. The SRAS curve shows that a higher price level leads to more output.
There are two important things to note about SRAS. For one, it represents a short-run relationship between price level and output supplied. Aggregate supply slopes up in the short-run because at least one price is inflexible. Second, SRAS also tells us there is a short-run tradeoff between inflation and unemployment. Because higher inflation leads to more output, higher inflation is also associated with lower unemployment in the short run.

Key Terms

Key termDefinition
short-run aggregate supply (SRAS)a graphical model that shows the positive relationship between the aggregate price level and amount of aggregate output supplied in an economy
short-runin macroeconomics, a period in which the price of at least one factor of production cannot change; for example, if wages are stuck at a certain level, we would still be in the short-run.
sticky prices or wages(also called nominal price rigidity) the idea that some prices and wages are not fully flexible and cannot completely respond to changes such as inflation or deflation
menu coststhe idea that firms might not change their prices when there is a change in the price level because it is costly to do so; menu costs have been proposed as one of the reasons that prices are “sticky” in an economy.
determinants of SRASanything that will shift the SRAS curve, also called an aggregate supply shock; if the prices of any of the factors of production change, or firms expect those prices to change, then the SRAS curve will shift.
expectationswhat firms believe will happen to the prices of the factors of production

Key Takeaways

The SRAS curve is upward sloping

The SRAS curve shows the positive relationship between the price level and output. Wait a minute, does that mean that firms respond to inflation by producing more output? Surprisingly, it does!
SRAS might look a lot like a supply curve in a product market, but some key differences make SRAS different than "supply." In the market model, supply slopes up because of the profit motive of individual firms. If a firm gets a higher price, they will make a higher profit by selling more, so quantity supplied increases when price increases. The SRAS curve slopes up for two reasons: sticky input prices (like wages) and sticky output prices (also called “menu costs”).

Sticky wages and sticky prices

Why would producers see inflation and think, “let’s all make more stuff”? After all, during inflation, shouldn’t producers be scared to produce more?
Let’s start with the first reason producers might continue despite inflation: sticky input prices. Economists used to believe that all prices were flexible. That means that if conditions change, like a recession happens, prices will quickly adapt to that change. For example, if there is a recession, high unemployment will quickly drive down wages. Lower wages make firms more willing to hire more workers. More workers mean more output, so flexible prices (like wages) mean that recessions should mostly fix themselves. Or so the thinking was at the time!
The Great Depression made us question the idea that all prices are flexible. After all, if prices adjust so well, why wasn’t the depression going away? Economists had to rethink what they thought they knew about how well prices adjust. Price adjustment might work well in the long run, but the short run is a different story altogether. This developed into an idea called “short-run nominal price rigidity,” which is just an economist’s way of saying “prices don’t adjust quickly.”
Today, most economists believe that prices are sticky (at least in the short run). After all, wages are usually set for long time periods because of labor contracts. Businesses might lock themselves into long-term purchase agreements for other resources too. If there is unanticipated inflation, firms benefit from those long-term contracts because they are paying wages (and other resource prices) using dollars that aren’t worth as much, so the real wages they are paying decrease.
The idea behind “menu costs” is that output prices are sticky too. Suppose you own a restaurant called Sticky’s Tacoland. One of your many costs of being in business is printing paper menus. When inflation occurs, you could respond by raising prices. But to do that, you would have to incur the cost of printing new menus that reflect the higher prices. So maybe you don’t raise your prices. Now, your taco prices seem relatively cheaper, and you sell more tacos. The aggregate effect of this is that you, and every other firm that kept their prices sticky, will sell more stuff when inflation goes up. Good decision not to raise your prices!

What causes shifts in SRAS?

When the price level changes and firms produce more in response to that, we move along the SRAS curve. But, any change that makes production different at every possible price level will shift the SRAS curve. Events like these are called “shocks” because they aren’t anticipated.
For example, imagine the price of labor unexpectedly gets more expensive. In response to that shock, the SRAS curve decreases (shifts to the left). Interestingly, this happens if firms expect that this will happen too. If you see it coming, you adjust your expectations accordingly! If factors of production get cheaper, or producers think they will get cheaper, then SRAS increases.
You can easily remember all of the shocks that shift SRAS by thinking of SPITE:
Subsidies for businesses
Productivity
Input prices
Taxes on businesses
Expectations about inflation

The short-run tradeoff between inflation and unemployment

The SRAS curve tells us that firms will respond to inflation by producing more. If you want to produce more, you will need to hire more workers, so the unemployment rate decreases. In this way, the SRAS captures the tradeoff between inflation and unemployment.
When the price level increases, producers are willing to make more and hire more workers because sticky wages make them a better bargain. On the other hand, when the price level decreases, producers are willing to make less because sticky wages make workers not as good of a deal and producers sell less.

Key graphs

The Short-Run Aggregate Supply Curve (SRAS)

Figure 1: An increase in SRAS
The SRAS curve shows that as the price level increases and you move along the SRAS, the amount of real GDP that will be produced in an economy increases.
An increase in the SRAS is shown as a shift to the right.
Remember the importance of labeling this model: price level (P, L) is on the vertical axis, and real GDP (or r, G, D, P) is on the horizontal axis. SRAS shows that the short-run relationship between price level and aggregate output is positive, so this should always be an upward sloping curve.

Common misperceptions

  • Don’t forget what shifts SRAS. Anything that makes production more expensive or more difficult, or any belief by firms that this will happen, will cause the SRAS to shift to the left. On the other hand, anything that makes production cheaper or easier to produce will cause the SRAS curve to shift to the right.
  • When learning economics for the first time, some learners think that the different models in macro have nothing to do with each other, but this is not the case. Often one model is closely related to another model. (Spoiler Alert: We will see the short-run relationship between the inflation and unemployment that captured by the SRAS curve come up again! Much later in the course, you will learn about a new model (called the Phillips Curve) that also shows this inverse relationship in the short run. For now, though, you just need to know that this relationship exists, and we can see it in the SRAS curve.)

Discussion Questions

  • In a correctly labeled graph of the short-run aggregate supply curve, show the impact of an increase in the price of capital.
  • Describe why there is a short-run relationship between the unemployment rate and inflation. Can you think of a reason why this might not hold up in the long run?
  • Describe sticky wage theory to someone who has never heard of it before. How would you describe it?

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