Aggregate supply and the business cycle
Why aggregate supply is vertical in the long run but slopes upwards in the short run, and how shifts in demand and supply cause recessions and stagflation.
FinanceThe economy behind your investmentsAbout 5 min: 3 reading, 2 practiceUpdated
General education, not financial advice.
- Explain why long-run aggregate supply is vertical
- Give the three theories of an upward-sloping short-run aggregate-supply curve
- Trace a shift in aggregate demand and a shift in aggregate supply from short run to long run
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The economy behind your investments: lesson 7 of 16
- The economy behind your investments
- Financial markets and intermediaries 5 min
- The market for loanable funds 5 min
- Banks and the money supply 5 min
- The quantity theory of money 5 min
- The aggregate-demand curve 5 min
- Monetary policy and aggregate demand 5 min
- Aggregate supply and the business cycle 5 min
- Fiscal policy and the multiplier 5 min
- The Phillips curve 5 min
- Expectations and the cost of lower inflation 5 min
- Rules or discretion 6 min
- Deficits and the case for balance 7 min
- Exchange rates and purchasing-power parity 5 min
- Exports, imports and capital flows 5 min
- The market for foreign-currency exchange 5 min
- Policies and shocks in an open economy 5 min
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Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 20
What it is
In the long run, aggregate supply is vertical. Output depends on labour, capital, natural resources and technology, not on the price level (monetary neutrality). The long-run curve sits at the natural rate of output: what the economy produces when unemployment is at its natural rate. Anything that changes those inputs, such as more capital or better technology, shifts it.
In the short run, aggregate supply slopes upwards. A higher price level raises the quantity of output supplied, for a time. Mankiw gives three theories, which share one idea: output rises above its natural level when the price level is higher than people expected.
- Sticky wages (the one Mankiw emphasises). Nominal wages are set in advance by contracts and customs. If prices turn out higher than expected, firms' revenues rise but wages don't yet, so production is more profitable and firms hire and produce more.
- Sticky prices. Because of menu costs, some firms are slow to change prices. If prices in general fall, those firms' prices are too high, their sales fall, and they cut production.
- Misperceptions. When the overall price level falls, some suppliers mistake it for a fall in the relative price of what they sell, and produce less.
All three are temporary: in time wages, prices and expectations adjust, and output returns to its natural rate.
Quick check
Tap an answer to check it.
Why is the long-run aggregate-supply curve vertical?
- Prices change; output doesn't depend on them
Show answer
In the long run, output depends on labour, capital, resources and technology, not the price level. Monetary neutrality holds in the long run.
Why it matters
Mankiw's four steps for analysing fluctuations: decide which curve shifts, which way, work out the short-run effect on output and prices, then trace the move to the long-run equilibrium.
A fall in aggregate demand (for example, a wave of pessimism):
- Short run: output falls and the price level falls: a recession, with rising unemployment.
- Long run: as expectations, wages and prices adjust downwards, short-run supply shifts right and output returns to its natural rate at a lower price level.
- Policymakers can shorten the slump by raising aggregate demand.
Mankiw's examples of big demand shifts: the Great Depression of the 1930s (a large fall in demand) and World War II (a large rise from government spending). He also discusses the 2008–2009 recession, triggered by falling house prices and a financial crisis.
A fall in aggregate supply (for example, a jump in oil prices or bad weather):
- Short run: output falls and prices rise: stagflation.
- Long run: if wages adjust, output returns to normal. Or policymakers can accommodate the shock by raising aggregate demand, which restores output faster but makes the higher prices permanent.
Mankiw notes that the oil-price rises of the 1970s caused stagflation in the US, and that oil-price falls in the mid-1980s helped output grow while inflation fell.
Keynes. In 1936, John Maynard Keynes's General Theory argued that recessions and depressions can come from too little aggregate demand, and that governments should act to raise it.
Worked example
Trace each shock: short run, then long run (if policy does nothing).
- Households lose confidence (demand falls): in the short run, output falls and prices fall; in the long run, output returns to its natural rate.
- Big rise in government spending (demand rises): in the short run, output rises and prices rise; in the long run, output returns to its natural rate.
- Oil price shock (supply falls): in the short run, output falls and prices rise; in the long run, output returns to its natural rate.
In each case, the short-run move in output is temporary; only the long-run aggregate-supply curve sets output in the long run.
Text description
Long-run aggregate supply is vertical at the natural rate of output. The economy starts at A, where AD crosses short-run AS on the long-run line. A fall in aggregate demand shifts AD left: in the short run the economy moves to B, with lower output and a slightly lower price level, a recession. Over time, as expected prices and wages fall, short-run AS shifts right, and the economy moves to C: output back at its natural rate, with a lower price level.
Text description
Long-run aggregate supply is vertical at the natural rate of output, and the economy starts at A. A fall in aggregate supply, such as a sharp rise in oil prices, shifts short-run AS to the left. The economy moves to B: output falls below its natural rate while the price level rises. Falling output with rising prices is called stagflation.
Common mistake
Thinking a fall in aggregate demand leaves output permanently lower. In the model, expectations and wages adjust, and output returns to its natural rate. The question for policy is how long that takes, and whether policy should speed it up.
Key terms
- long-run aggregate-supply curve
- vertical at the natural rate of output
- natural rate of output
- the production of goods and services an economy achieves in the long run, when unemployment is at its natural rate
- short-run aggregate-supply curve
- upward-sloping: a higher price level raises output for a time
- sticky-wage theory
- nominal wages adjust slowly, so unexpected price rises raise output
- sticky-price theory
- some prices adjust slowly because of menu costs
- misperceptions theory
- suppliers mistake changes in the overall price level for changes in relative prices
- stagflation
- falling output with rising prices
- accommodation
- raising aggregate demand in response to a fall in supply
Practise the key terms
Tap a card to turn it over. 8 cards.
| Front | Back |
|---|---|
| long-run aggregate-supply curve | vertical at the natural rate of output |
| natural rate of output | the production of goods and services an economy achieves in the long run, when unemployment is at its natural rate |
| short-run aggregate-supply curve | upward-sloping: a higher price level raises output for a time |
| sticky-wage theory | nominal wages adjust slowly, so unexpected price rises raise output |
| sticky-price theory | some prices adjust slowly because of menu costs |
| misperceptions theory | suppliers mistake changes in the overall price level for changes in relative prices |
| stagflation | falling output with rising prices |
| accommodation | raising aggregate demand in response to a fall in supply |
Practice
Sort it
Which group does this belong to?
A sharp rise in world oil prices
A rise in production costsShow answer
Shifts short-run aggregate supply. A rise in production costs
A fall in consumer confidence
Consumption fallsShow answer
Shifts aggregate demand. Consumption falls
Workers and firms expect higher prices and raise wages
Higher expected prices shift it leftShow answer
Shifts short-run aggregate supply. Higher expected prices shift it left
A new war raises military spending
Government purchases riseShow answer
Shifts aggregate demand. Government purchases rise
Quick quiz
Tap an answer to check it.
What is stagflation?
- That would follow a rise in supply
Show answer
Falling output together with rising prices. A fall in aggregate supply causes it.
What does accommodating a supply shock do?
- It raises demand, so prices rise further
Show answer
Restores output sooner, but keeps the price level permanently higher. Policymakers raise aggregate demand to offset the fall in supply.
What do the three short-run supply theories have in common?
- They depend on expectations of the price level
Show answer
Output rises above its natural level when prices are higher than expected. Wages, prices or perceptions are slow to adjust.
In short
- Long-run aggregate supply is vertical at the natural rate of output.
- Short-run supply slopes up: sticky wages, sticky prices, misperceptions.
- Fall in demand: recession now, recovery as expectations adjust.
- Fall in supply: stagflation; accommodation trades lower output for higher prices.
Mastery check
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Check yourself
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Name the three theories of the short-run aggregate-supply curve.
Show answer
Sticky wages, sticky prices and misperceptions.
What did Keynes argue in 1936?
Show answer
That recessions and depressions can result from too little aggregate demand.
In the long run, what happens to output after a fall in aggregate demand?
Show answer
It returns to its natural rate, at a lower price level.
Further reading
- N. Gregory Mankiw, Principles of Macroeconomics, 6th ed. (South-Western Cengage, 2012), chapter 20.
- On this site: The aggregate-demand curve.
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