What aggregate supply means

Aggregate supply is the total quantity of goods and services that firms are willing and able to supply at each price level in a given period.

• SRAS slopes upwards. In the short run, costs of production are fixed (wage contracts are signed, input prices are agreed). So a higher price level, with costs unchanged, means higher profit margins — firms expand output. A change in the price level is a movement along SRAS.
• A change in anything else — any cost of production — is a shift of SRAS.

The relationship between SRAS and LRAS. They answer different questions. SRAS asks: how much will firms produce given today's costs? LRAS asks: how much can the economy produce when all resources are fully and efficiently employed? LRAS is the macroeconomic equivalent of the PPF (1.1.4). It is determined only by the quantity and quality of the factors of production — not by the price level, and not by demand. That is why a rise in AD can never shift LRAS.

What shifts SRAS?

Anything that changes firms' costs of production. Edexcel names three:

• Changes in the costs of raw materials and energy. A spike in the world oil or gas price raises costs across every industry that uses transport, plastics or heating. SRAS shifts left → price level up, real output down = cost-push inflation and stagflation.
• Changes in exchange rates. A depreciation of sterling makes imported raw materials, components and energy dearer in pounds — costs rise, SRAS shifts left. (Note the tension: the same depreciation shifts AD right by boosting net trade. So a depreciation is inflationary from both directions.)
• Changes in tax rates. Higher indirect taxes (VAT, duties) or higher employers' National Insurance raise the cost of supplying each unit — SRAS shifts left. Cutting them shifts SRAS right.

Also worth citing: wage costs rising faster than productivity, and supply shocks (war, pandemic, a broken supply chain).

Your turn — the cost shock

The classical (free-market) LRAS

Classical economists draw LRAS as a vertical line at the full employment level of output (Yfe). The argument: in the long run, markets clear. Wages and prices are flexible, so any unemployment is temporary — real wages fall until the labour market clears. The economy therefore always returns to its productive capacity.

The devastating policy conclusion. If LRAS is vertical, demand-side policy cannot raise long-run output at all — it only raises the price level. Any short-run boost to output is temporary: workers eventually realise their real wages have fallen, demand higher pay, SRAS shifts back left, and output returns to Yfe at a higher price level. The only way to raise long-run growth is to shift LRAS right — with supply-side policy (2.6.3). This is the intellectual foundation of monetarism and of the 1980s free-market reforms.

The Keynesian LRAS

Keynes disagreed. Wages are "sticky downwards" — workers and unions resist nominal pay cuts, so labour markets do not automatically clear. An economy can therefore get stuck in a deep recession with mass unemployment for years. "In the long run we are all dead."

The Keynesian LRAS is drawn as a reverse-L with three sections:

• Horizontal (perfectly elastic) section — deep recession, huge spare capacity. Firms can raise output using idle labour and machines without any upward pressure on costs or prices. A rise in AD here raises real output with zero inflation. Demand-side policy is a free lunch.
• Upward-sloping section — as spare capacity is used up, bottlenecks appear: skilled labour becomes scarce, wages are bid up. AD rises now bring both higher output and higher prices.
• Vertical section — full capacity. Here Keynes and the classicals agree: further AD is purely inflationary.

The policy conclusion is the exact opposite. In a slump, the government should use expansionary fiscal policy: it raises output and employment at no inflationary cost. Waiting for the market to self-correct wastes years of output and inflicts hysteresis — long-term unemployment that permanently scars LRAS. The examiner's point: which model you use depends on where the economy currently is. In 2009, with huge spare capacity, the Keynesian case was strong. Near full capacity, the classical warning bites.

Match the claim to the school of thought

Tap a claim on the left, then the school it belongs to.

Classical LRAS

Keynesian LRAS

The determinants of long-run AS

LRAS shifts right when the quantity or quality of the factors of production rises — exactly the same causes that shift the PPF outwards (1.1.4).

• Technological advance — raises output per unit of input. The single biggest driver of long-run growth.
• Changes in relative productivity — output per worker per hour. The UK's chronically weak productivity growth since 2008 is the central explanation for its weak long-run growth and stagnant real wages. Net investment (capital deepening) is the main route to raising it.
• Changes in education and skills — raises the quality of human capital, cuts structural unemployment and raises occupational mobility.
• Changes in government regulations — deregulation can cut business costs and encourage entry and enterprise. (But evaluate: some regulation corrects market failure; scrapping it can be a false economy.)
• Demographic changes and migration — net inward migration of working-age people directly increases the labour supply and can fill skills gaps. An ageing population does the opposite, shrinking the labour force and raising the dependency ratio.
• Competition policy — more competitive markets force firms to cut X-inefficiency and innovate, raising productive potential.

The key distinction to hammer: the factors above shift LRAS (productive capacity). Falling oil prices, exchange rates and tax rates shift SRAS (costs). A tax cut lowers costs today (SRAS→) and may also raise incentives to work and invest over years (LRAS→) — but do not confuse the two channels.

Your turn — labour productivity

SRAS, LRAS or AD?

Costs → SRAS. Productive capacity → LRAS. Planned spending → AD.

SRAS or LRAS?

Which model should you use?

The big ideas to know

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