Chapter 9 · Aggregate demand and aggregate supply
Shift of the short-run aggregate supply curve
Use an SRAS diagram to explain changes in production costs and productivity. Compare the effects on real GDP and the price level.
The economic idea
Short-run aggregate supply is the total real output firms are willing and able to produce at different average price levels while at least one input price is fixed.
A change in the price level causes movement along SRAS. The curve shifts when non-price production conditions change, including nominal wages, energy and raw-material prices, indirect taxes, subsidies, productivity, regulation or the exchange rate’s effect on imported inputs.
An increase in SRAS means firms can produce more at every price level, so the curve shifts right or downward. A decrease in SRAS means production is less profitable at every price level, so the curve shifts left or upward.
An adverse supply shock can create stagflation: a higher price level together with lower real output and rising unemployment. This combination makes demand management difficult because correcting one problem may worsen the other.
Reading an increase in short-run aggregate supply
“Price level” measures the economy-wide price level and “Real GDP” measures real GDP.
“SRAS₁” is the original production schedule and “SRAS₂” is the new schedule. “AD” remains the expenditure schedule.
“E₁” gives the original price level “P₁” and output “Q₁”. “E₂” gives the new price level “P₂” and output “Q₂” when a distinct shift is visible.
Starting point: E₁
“E₁” is where “AD” intersects “SRAS₁”. It establishes the short-run equilibrium price level “P₁” and real output “Q₁” because planned expenditure equals the output firms are willing to produce.
The change: SRAS₁ to SRAS₂
“SRAS₂” lies to the right/below “SRAS₁”, so short-run aggregate supply has increased. The economy moves from “E₁” to “E₂”: the price level falls from “P₁” to “P₂”, while real output rises from “Q₁” to “Q₂”.
Adjustment along AD
The change in production conditions creates a mismatch with planned expenditure at the old equilibrium. The economy moves along the unchanged “AD” toward “E₂”; aggregate demand itself has not shifted.
Does a cost improvement also mean capacity has grown?
Cheaper imported fuel can lower firms’ costs without increasing the quantity or quality of productive resources. Better technology may lower costs and also increase productive capacity, but a shift of SRAS alone does not prove both effects.
State the cost or productivity change supplied by the question. Explain why firms change output at each price level, then read the movement along AD. Add an LRAS shift only when the question supports a change in potential output.
From a production-cost shock to the new equilibrium
A non-price production determinant changes firms’ costs or productivity, moving the schedule from “SRAS₁” to “SRAS₂”.
At the old price level, firms are willing to produce more than before.
Price-level and output adjustment creates movement along the unchanged “AD”.
The process ends at “E₂”. “SRAS₂” lies to the right/below “SRAS₁”, so short-run aggregate supply has increased. The economy moves from “E₁” to “E₂”: the price level falls from “P₁” to “P₂”, while real output rises from “Q₁” to “Q₂”.
Common mistakes to avoid
- The change from “SRAS₁” to “SRAS₂” is not movement along supply. It is a new production schedule at every price level.
- The economy moves along “AD”; aggregate demand does not shift merely because the price level changes.
- A favourable supply shift is not the same as an increase in demand: it normally lowers the price level while raising output.
- Stagflation describes rising inflation with weak or falling output; it is not simply a high price level.
How to draw this diagram
- Title the diagram “Shift of the short-run aggregate supply curve”. Label the horizontal axis “Real GDP” and the vertical axis “Price level”.
- Draw AD first and label it clearly.
- Draw SRAS₁ next and label it clearly.
- Draw SRAS₂ next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Project important intersections to the axes with dashed guide lines and label the outcomes.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- The diagram does not reveal whether the supply change is temporary or permanent.
- A temporary cost shock may reverse, while productivity or infrastructure changes may also affect LRAS.
- Wage bargaining, exchange rates and expectations can amplify or dampen the initial movement.
- Demand-management policy faces a trade-off when output and the price level move in undesirable opposite directions.
- The model aggregates sectors even though a supply shock may affect industries very unevenly.