Aggregate Supply
Aggregate supply refers to the total quantity of goods and services produced and offered in the market by firms operating within a specific economic sector or an entire economic system, relative to the general price level. It is represented on a Cartesian plane with the production quantity (y) on the horizontal axis and price level (p) on the vertical axis. The aggregate supply curve (also known as the AS curve) is upward-sloping because firms are willing to increase production as selling prices rise.
Aggregate supply represents the sum of the production quantities of all individual firms. The construction of the aggregate supply curve is based on microeconomic firm theory, which posits that each firm determines its production level to maximize profit. While most economists agree on the methods used to construct the aggregate supply curve, they diverge when discussing its shape and the impact of economic policies on production levels. This debate often centers on differing views of the aggregate supply curve held by Keynesian and neoclassical economists.
Aggregate Supply in Keynesian Theory
According to Keynesian theory, the aggregate supply curve is horizontal. In Keynes' framework, the economic system does not operate at full resource capacity. In the short run, part of the production capacity remains unused, and actual production (Y) is below its potential level (Y < Yp). Thus, any increase in demand can be met by increasing supply. Under such circumstances, demand drives supply (the principle of effective demand). Starting from an underemployment equilibrium, expansionary economic policies lead to increased production without affecting prices. Prices and wages are rigid (known as price rigidity), preventing them from adjusting to changes in demand and supply, which allows the economy to remain in an underemployment equilibrium.
The Keynesian perspective is only applicable in the short term when prices and wages can be considered rigid (unchanging). Over time, however, changes in the general price level (e.g., inflation) become more apparent, making it incompatible with long-term equilibrium.
Aggregate Supply in Neoclassical Theory
According to neoclassical theory, market forces naturally guide the economic system toward full resource utilization without external intervention by policymakers. Actual production (Y) aligns with its potential level (Y = Yp). Prices and wages are perfectly flexible (price flexibility), allowing them to quickly adjust to changes in demand or supply. Under these conditions, the aggregate supply curve is vertical, and supply drives demand (Say’s Law). When productive capacity is fully utilized, any increase in demand results in higher prices without affecting actual production. Expansionary economic policies are ineffective in this case, as they merely increase prices without boosting real output.
The neoclassical perspective is only applicable in long-term economic equilibrium. In the short term, economic systems often experience underemployment (e.g., unemployment).
Short- and Long-Run Aggregate Supply
These two perspectives can be reconciled by examining the convex shape of the aggregate supply curve. The initial portion of the curve corresponds to short-term conditions, where it is horizontal and price levels remain stable. Productive capacity is underutilized, so expansionary demand policies have a tangible impact on production.
The final portion of the supply curve aligns with the neoclassical long-term view. As the economy approaches full employment (Yp), the aggregate supply curve becomes nearly vertical. Once full productive capacity is reached, the production system cannot accommodate further demand increases, leading to higher prices for goods and production factors.
Aggregate Supply in New Classical Macroeconomics. According to new classical macroeconomics, economic agents make decisions based on rational expectations. Under these conditions, agents can anticipate economic trends and price changes, resulting in a vertical aggregate supply curve even in the short run. With rational expectations, the market remains in equilibrium in both the short and long term.
