11.3 Shifts in Aggregate Supply

Factors Affecting Aggregate Supply

Productivity Growth and Aggregate Supply

Productivity growth means the economy can produce more output with the same amount of inputs. When that happens, per-unit production costs fall, and the aggregate supply curve shifts to the right.

This matters because productivity growth is the main driver of increases in potential GDP, which represents the maximum sustainable output the economy can produce at full employment. As productivity improves, the production possibilities frontier (PPF) expands outward.

Sources of productivity growth include:

• Technological advancements like automation or improved software that let firms produce more per worker
• Investment in physical capital (machinery, infrastructure) and human capital (education, job training)
• Better resource allocation through specialization and more efficient production methods
• Increased resource availability, such as discovering new energy sources or expanding arable land

The key takeaway: productivity growth shifts AS right, increases potential GDP, and puts downward pressure on the price level. It's one of the few factors that benefits the economy on every front.

Input Prices and Economic Impacts

Changes in input prices directly affect firms' production costs, which shifts the aggregate supply curve.

Rising input prices → AS shifts left. When the cost of labor, raw materials, or energy goes up, firms face higher per-unit costs. They produce less at every price level. For example, if oil prices spike from $60 to $120 per barrel, transportation and manufacturing costs rise across the economy. This can trigger cost-push inflation, where prices rise not because of strong demand but because production has become more expensive.

Falling input prices → AS shifts right. When commodity prices drop or firms find cheaper sources of labor, per-unit costs decrease and aggregate supply increases. Falling natural gas prices, for instance, reduce costs for manufacturers and utilities, expanding output.

The duration of the price change matters:

• Short-term fluctuations (like seasonal changes in agricultural prices) cause temporary AS shifts
• Persistent changes (like a long-term rise in global oil prices or structural wage increases) have lasting effects on growth and inflation

Supply Shocks in Macroeconomics

Supply shocks are sudden, unexpected events that cause a significant shift in aggregate supply. Unlike gradual changes in input prices or productivity, these hit the economy quickly and are hard to predict.

Positive supply shocks shift AS to the right. Think of a major technological breakthrough (like the internet revolution in the 1990s) or the discovery of large new resource deposits. These increase output and put downward pressure on prices.

Negative supply shocks shift AS to the left. Natural disasters (hurricanes, earthquakes), geopolitical crises (wars, trade embargoes), and pandemics (COVID-19) all reduce the economy's ability to produce. Output falls and prices rise.

Supply shocks affect three key macroeconomic variables:

• Output/GDP: Positive shocks boost growth; negative shocks reduce it
• Inflation: Positive shocks push prices down (more supply relative to demand); negative shocks push prices up (less supply relative to demand)
• Unemployment: Positive shocks increase labor demand and reduce unemployment; negative shocks do the opposite

Policymakers typically respond to supply shocks using monetary policy (adjusting interest rates) or fiscal policy (changing government spending or taxes). However, supply shocks create a difficult tradeoff: fighting the inflation from a negative shock with tighter monetary policy can make the output decline and unemployment even worse.

Long-Run and Short-Run Aggregate Supply

The aggregate supply model distinguishes between two time frames, and they behave very differently.

Long-run aggregate supply (LRAS) is a vertical line at the economy's full-employment output level. It's vertical because in the long run, changes in the price level don't affect how much the economy can produce. What shifts LRAS are the fundamental capacity factors: technology, the size of the labor force, and the capital stock. These are the same factors that drive productivity growth discussed above.

Short-run aggregate supply (SRAS) is upward-sloping. In the short run, higher price levels can temporarily increase output because some input costs (especially wages) are sticky and don't adjust immediately. When the price level rises but wages stay fixed, firms earn higher profits per unit and ramp up production.

SRAS shifts when input costs change, when firms' expectations about future prices change, or when supply shocks occur.