Difficulty: Intermediate | Prerequisites: Part 1 of these notes (Aggregate Expenditure and Aggregate Demand). You need to understand the AD curve, the spending multiplier, and what shifts AD before this material will click.
This is the supply side of the AD-AS model. Where Part 1 covered what drives total spending, this part covers what determines the economy's ability and willingness to produce. Once you combine AD with both forms of aggregate supply (short-run and long-run), you can explain how the economy reaches equilibrium, what happens when it is knocked off balance, and how it self-corrects over time. This is the framework your course uses to analyse recessions, inflations, and the effects of policy.
The long-run aggregate supply (LRAS) curve is vertical at potential GDP because, over time, all prices and wages adjust and real output depends only on the economy's productive capacity. The short-run aggregate supply (SRAS) curve slopes upward because input costs (especially wages) are sticky, so firms produce more when prices rise. When the economy is above or below potential GDP, wages and input prices gradually adjust, shifting SRAS until output returns to the long-run level.
Long-run aggregate supply (LRAS) curve
A vertical line at the economy's potential GDP, showing that in the long run, real output is determined by productive capacity (technology, labour force, capital stock), not the price level.
Think of it as: the economy's speed limit. No matter what prices do, you cannot sustainably produce more than your resources allow.
Short-run aggregate supply (SRAS) curve
An upward-sloping curve showing that, in the short run, higher price levels lead firms to produce more output (and vice versa), because input costs lag behind.
In simple terms, this means firms see rising prices as higher revenue while their costs have not caught up yet, so they ramp up production.
Potential GDP (full-employment output)
The level of real GDP the economy produces when all resources are fully employed at normal utilisation rates. Determined by technology, the size of the labour force, and the capital stock.
Think of it as: the output level where unemployment is at its natural rate and there is no unusual strain on resources.
Sticky prices / sticky wages
The tendency for input prices, particularly wages, to be slow to adjust to changes in the overall price level. Caused by contracts, menu costs, and institutional rigidities.
In simple terms, this means wages and supply contracts lock in prices for weeks or months, so they do not move instantly when inflation changes.
Menu costs
The costs firms incur when changing their prices (updating catalogues, reprogramming systems, printing new menus). These costs make firms reluctant to change prices frequently, contributing to price stickiness.
Recessionary gap
A situation where actual GDP is below potential GDP. The economy has excess unused resources (unemployed workers, idle factories) and surplus capacity.
Think of it as: the economy underperforming, with slack in the system.
Expansionary (inflationary) gap
A situation where actual GDP exceeds potential GDP. Resources are over-utilised, labour markets are tight, and shortages emerge.
Think of it as: the economy running hotter than it can sustain, which drives prices up.
Long-run macroeconomic equilibrium
The point where AD, SRAS, and LRAS all intersect. Real GDP equals potential GDP, the price level is stable, and there is no tendency for wages or prices to change.
Demand shock
An unexpected event that shifts the AD curve (e.g. a sudden increase in government spending, a collapse in consumer confidence, or a change in foreign demand).
The LRAS curve is a vertical line at potential GDP on the AD-AS diagram.
Vertical because, in the long run, all prices and wages fully adjust. A higher price level raises both output prices and input costs proportionally, leaving real output unchanged.
The position of LRAS is determined by the economy's productive capacity: technology, the size and skills of the labour force, and the capital stock.
Shifts in LRAS happen when any of these fundamentals change (e.g. technological progress shifts LRAS rightward, meaning potential GDP grows).
The SRAS curve slopes upward: as the price level rises, the quantity of real GDP supplied increases in the short run.
The reason is sticky input costs. Wages and many other input prices (energy contracts, raw materials) are fixed by contracts for periods of weeks, months, or years.
When inflation pushes up the prices of final goods, firms see their revenues rise while their costs have not yet adjusted. This temporarily boosts profitability, so firms increase production.
The reverse also holds: when the price level falls, revenue drops but costs remain fixed, squeezing profits and reducing output.
Wage contracts (monthly, annual) are the primary source of stickiness. Workers cannot instantly renegotiate their pay when the price level changes.
Energy and raw-material contracts may also lock in prices for fixed periods.
Menu costs (the expense of updating prices) add a further layer of friction.
Over time, contracts expire and are renegotiated at new price levels. As wages and input costs catch up, the temporary profit boost (or squeeze) disappears, and SRAS shifts.
The two most important inputs for economy-wide SRAS are labour wages and energy prices.
When input prices fall, production costs decrease and SRAS shifts rightward (more output at each price level).
When input prices rise, costs increase and SRAS shifts leftward (less output at each price level).
Other inputs exist but are less significant at the macroeconomic level. For exam purposes, focus on labour and energy.
Long-run equilibrium is the single point where all three curves intersect.
At this point, real GDP equals potential GDP, the price level is stable, and there are no recessionary or inflationary gaps.
The economy is at full employment: unemployment is at its natural rate.
Graphically, the vertical LRAS sits at potential GDP, and the downward-sloping AD and upward-sloping SRAS cross each other exactly on the LRAS line.
Occurs when actual GDP < potential GDP.
Consequences: excess unused resources, higher unemployment, surplus capacity.
Self-correction mechanism:
Excess supply in labour and resource markets pushes wages and input prices downward.
Falling input costs increase firm profitability, shifting SRAS rightward.
As SRAS shifts right, real GDP gradually rises back toward potential GDP.
The price level falls (or rises less) during this adjustment.
This process can be slow, which is one reason governments sometimes intervene with fiscal or monetary policy rather than waiting for self-correction.
Occurs when actual GDP > potential GDP.
Consequences: over-utilisation of resources, shortages, tight labour markets.
Self-correction mechanism:
Tight markets push wages and input prices upward.
Rising input costs reduce profitability, shifting SRAS leftward.
As SRAS shifts left, real GDP falls back toward potential GDP.
The price level rises further during this adjustment, which is why this gap is called inflationary.
A positive AD shock (e.g. increased government spending or a surge in consumer confidence) shifts AD rightward:
Short-run effect: higher output and higher prices (expansionary gap).
Long-run adjustment: rising wages shift SRAS left until output returns to potential GDP, but at a higher price level.
A negative AD shock (e.g. a fall in investment or a decline in exports) shifts AD leftward:
Short-run effect: lower output and lower prices (recessionary gap).
Long-run adjustment: falling wages shift SRAS right until output returns to potential GDP, at a lower price level.
The key insight: demand shocks change output temporarily but change the price level permanently (in the context of this model).
The SRAS mechanism explains why oil price shocks matter so much. When oil prices spike (as in the 1970s energy crises), energy input costs rise sharply, SRAS shifts left, and the economy experiences both falling output and rising prices, a combination called stagflation.
The self-correction from a recessionary gap is the theoretical basis for the argument that "the economy will heal itself." In practice, this adjustment can take years because wages are slow to fall, which is why policymakers often prefer active intervention through fiscal stimulus or monetary easing.
Students often think the SRAS curve slopes upward for the same reason a single firm's supply curve does. It does not. A single firm's supply curve involves relative prices; SRAS involves the overall price level rising while input costs are temporarily stuck.
A frequent mistake is saying the LRAS shifts when the price level changes. It does not. LRAS shifts only when the economy's productive capacity changes (more capital, better technology, larger labour force).
Students confuse which direction SRAS shifts in each gap scenario. Remember: in a recessionary gap, excess resources push input costs down, shifting SRAS right. In an inflationary gap, tight markets push input costs up, shifting SRAS left. The adjustment always moves output back toward potential GDP.
Some students assume the economy snaps back to long-run equilibrium instantly. It does not. The self-correction process depends on how quickly wages and contracts renegotiate, which can take months or years.
⚠️ Expect a question giving you a scenario and asking whether it affects SRAS, LRAS, AD, or some combination. Know which curve each factor shifts.
⚠️ The self-correction mechanism for both recessionary and inflationary gaps is heavily tested. You need to trace the full chain: gap identified, wages adjust, SRAS shifts, economy returns to potential GDP, price level changes.
⚠️ Know why SRAS slopes upward (sticky wages and input costs) and why LRAS is vertical (all prices fully adjust in the long run). These are distinct explanations and exams test whether you can keep them separate.
⚠️ Be prepared for a graph-based question asking you to show the short-run and long-run effects of an AD shock, including labelling the initial equilibrium, the short-run equilibrium, and the new long-run equilibrium.
True or False: The LRAS curve is vertical because wages are sticky. (False. LRAS is vertical because, in the long run, all prices and wages fully adjust, so only productive capacity determines output.)
Fill in the blank: The SRAS curve slopes upward because ______ costs lag behind changes in the price level. (input / wage)
True or False: In a recessionary gap, wages tend to rise, shifting SRAS leftward. (False. In a recessionary gap, excess resources push wages down, shifting SRAS rightward.)
Fill in the blank: Long-run equilibrium is where AD, SRAS, and ______ all intersect. (LRAS)
True or False: A positive demand shock permanently raises real GDP above potential in the AD-AS model. (False. It raises output temporarily; self-correction returns GDP to potential, but the price level stays higher.)
Q: Why is the SRAS curve upward sloping while the LRAS curve is vertical?
A: In the short run, input costs (especially wages) are sticky due to contracts, so when the price level rises, firms see higher revenue but roughly the same costs, making production more profitable and increasing output. In the long run, all contracts renegotiate, wages and input costs fully adjust to the new price level, and the temporary profit boost disappears, so output returns to potential GDP regardless of the price level.
Q: The economy is in long-run equilibrium when oil prices suddenly spike. Which curve shifts, in which direction, and what happens in the short run?
A: SRAS shifts leftward (higher energy input costs). In the short run, real GDP falls below potential (recessionary gap) and the price level rises. This combination of falling output and rising prices is sometimes called stagflation.
Q: Describe the self-correction mechanism for an inflationary gap.
A: When actual GDP exceeds potential GDP, labour and resource markets are tight. Wages and input prices rise as contracts are renegotiated. Rising costs reduce firm profitability, shifting SRAS leftward. Output falls back toward potential GDP, and the price level rises further.
Q: The government increases spending significantly. Trace the short-run and long-run effects on the AD-AS diagram.
A: The spending increase shifts AD rightward. In the short run, the economy moves to a new equilibrium with higher real GDP and a higher price level (expansionary gap). Over time, tight markets drive wages up, SRAS shifts left, and the economy returns to potential GDP at an even higher price level.
Q: What are the two primary inputs that shift the SRAS curve?
A: Labour wages and energy prices. When these rise, SRAS shifts left; when they fall, SRAS shifts right.
This material completes the AD-AS model introduced in Part 1 (Aggregate Expenditure and Aggregate Demand). Together, both parts give you the full framework for analysing recessions, inflations, and policy responses.
The self-correction mechanism connects to debates about fiscal and monetary policy: if the economy self-corrects, what is the case for government intervention? That question drives the policy chapters that follow.
The concept of potential GDP ties back to economic growth (what makes potential GDP grow over time?) and to the labour market (what determines the natural rate of unemployment?).
Related Terms / Search Tags
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