Aggregate Supply

In 1973-74, Arab oil exporters embargoed shipments to the U.S. Oil prices quadrupled. The result was not a standard recession -- it was stagflation: inflation and unemployment rising at the same time. The Phillips curve, which had suggested a stable trade-off between the two, appeared to break down. The aggregate supply framework explains why: a leftward shift of SRAS moves the economy to a point of lower output and higher prices simultaneously.

Understanding aggregate supply means understanding two different time frames. In the short run, sticky wages and prices mean that demand shocks translate partly into output and partly into prices. In the long run, full price flexibility means output is pinned at potential and demand only affects the price level. Most real-world policy debates are about how quickly this adjustment happens.

Short-run aggregate supply (SRAS) slopes upward because input prices -- especially wages -- adjust slowly. When the price level rises unexpectedly, output prices rise but input costs are temporarily fixed, so profit margins widen and firms expand production. This gives the short-run positive relationship between prices and output.

Long-run aggregate supply (LRAS) is vertical at potential output. Once wages and expectations fully adjust to the new price level, real profit margins return to normal, and output returns to its potential level regardless of where prices sit. The position of LRAS -- how much potential output the economy has -- depends on technology, labor supply, human capital, and the capital stock.