Difficulty: Intermediate Prerequisites: Part 1 of these notes (aggregate demand), natural rate of unemployment, factors of production (labour, capital, natural resources, technology).
Source: Mankiw, Principles of Macroeconomics, 8th Edition, Chapter 20
Tags: aggregate supply, LRAS, SRAS, long-run aggregate supply, short-run aggregate supply, natural rate of output, sticky-wage theory, sticky-price theory, misperceptions theory, menu costs, expected price level
The supply side of the AD-AS model has two curves, not one, and understanding why they behave differently is the core insight of this section. In the long run, output is pinned to the economy's productive capacity and the price level does not matter (LRAS is vertical). In the short run, various market imperfections mean that output responds to price-level changes (SRAS slopes upward). The gap between short-run and long-run behaviour is what makes recessions, booms, and policy interventions possible. If you are comfortable with the AD curve from Part 1, this section completes the model.
Long-run aggregate supply is vertical at the natural rate of output because real GDP depends on real factors (labour, capital, resources, technology), not the price level. Short-run aggregate supply slopes upward because of temporary imperfections: sticky wages, sticky prices, or misperceptions about relative prices. Everything that shifts LRAS also shifts SRAS, and changes in the expected price level shift SRAS as well.
Aggregate supply (AS) curve
The curve showing the total quantity of goods and services firms produce and sell at each price level. In simple terms, it is the economy-wide supply curve, and it behaves very differently depending on the time horizon.
Long-run aggregate supply (LRAS) curve
A vertical line at the natural rate of output. It shows that in the long run, the total quantity supplied does not depend on the price level. Think of it as the economy's speed limit: determined by how much labour, capital, resources, and technology are available.
Natural rate of output (Y_N)
The amount of output the economy produces when unemployment is at its natural rate (i.e. when cyclical unemployment is zero). Also called potential output or full-employment output. In simple terms, it is the GDP the economy settles at when nothing unusual is happening.
Short-run aggregate supply (SRAS) curve
An upward-sloping curve showing that over a period of one to two years, a higher price level is associated with a higher quantity of goods and services supplied. Think of it as: firms produce more when prices rise, at least for a while, because costs have not caught up.
Sticky-wage theory
The theory that nominal wages adjust sluggishly in the short run (due to labour contracts and social norms), so when the actual price level exceeds the expected price level, production becomes more profitable and firms expand output. In simple terms, if prices rise but wages stay put, firms make more profit per unit and hire more.
Sticky-price theory
The theory that some firms are slow to adjust their output prices because of menu costs (the costs of changing prices, such as reprinting catalogues or updating systems). When the overall price level rises, firms that have not yet adjusted have relatively low prices, face higher demand, and increase output.
Menu costs
The costs of adjusting prices, including printing new menus, updating price tags, reprogramming systems, and the time involved. In simple terms, changing prices costs money and effort, so firms do not do it instantly.
Misperceptions theory
The theory that firms sometimes confuse a rise in the general price level with a rise in the relative price of their own product. When they see their price rising, they may believe demand for their product has increased specifically, so they produce more.
Expected price level (P_E)
The price level that workers, firms, and other agents expect to prevail. All three SRAS theories rely on the gap between the actual price level (P) and the expected price level (P_E). When P = P_E, there is no reason for output to deviate from the natural rate.
In the long run, real GDP (Y) is determined by the economy's stocks of labour (L), physical capital (K), human capital (H), natural resources (N), and the level of technology (A).
An increase in the price level does not change any of these real factors.
Therefore, the price level has no effect on real GDP in the long run. This is the classical dichotomy at work.
LRAS is a vertical line at Y_N on the AD-AS diagram.
Any event that changes the determinants of Y_N shifts the LRAS curve:
Changes in labour (L) or the natural rate of unemployment:
Immigration or emigration
Government policies such as minimum wage laws and unemployment insurance (which affect the natural rate of unemployment)
Changes in physical capital (K) or human capital (H):
More factories, equipment, or infrastructure (K)
More education, training, or college degrees (H)
Changes in natural resources (N):
Discovery of new mineral deposits (shifts LRAS right)
Reduction in imported oil supply (shifts LRAS left)
Changing weather patterns affecting agriculture
Changes in technology (A):
Productivity improvements from technological progress (shifts LRAS right)
Over decades, two things happen simultaneously:
Technological progress shifts LRAS steadily to the right, increasing output.
Growth in the money supply shifts AD steadily to the right, increasing demand.
The result is ongoing growth in real GDP and ongoing inflation. Both curves shift right over time, but AD typically shifts faster than LRAS, so the price level trends upward.
Over a period of one to two years, a higher price level leads to a higher quantity of goods and services supplied. Three theories explain why, and they all share the same core logic: output deviates from the natural rate when the actual price level deviates from the price level people expected.
1. Sticky-wage theory:
Nominal wages are set in advance based on the expected price level (P_E), often locked in by labour contracts or social norms.
If the actual price level (P) rises above P_E, firms' revenue increases but their labour costs do not.
Production becomes more profitable, so firms expand output and employment.
Higher P leads to higher Y, giving SRAS its upward slope.
2. Sticky-price theory:
Many firms set their output prices in advance based on P_E, because changing prices involves menu costs.
If the money supply increases unexpectedly and the overall price level rises, firms without significant menu costs raise prices immediately, but firms with high menu costs keep their old (now relatively low) prices.
Firms with relatively low prices see higher demand and increase output.
Higher P is associated with higher Y, giving SRAS its upward slope.
3. Misperceptions theory:
Firms may confuse a rise in the overall price level (P) with a rise in the relative price of their own product.
If P rises above P_E, a firm sees its own price rising and may believe demand for its product specifically has increased.
The firm increases production and employment.
An increase in P can cause an increase in Y, giving SRAS its upward slope.
Over time, sticky wages become flexible (contracts are renegotiated).
Sticky prices adjust (firms eventually absorb the menu costs and reprice).
Misperceptions are corrected (firms realise all prices rose, not just theirs).
In the long run, P_E adjusts to equal P, and the AS curve is vertical.
Everything that shifts LRAS also shifts SRAS. Changes in L, K, H, N, or A affect short-run supply just as they affect long-run supply.
Changes in the expected price level (P_E) also shift SRAS:
If P_E rises, workers and firms set higher wages.
At each actual price level, production is less profitable.
Output falls at every P, so SRAS shifts left.
If P_E falls, the reverse: SRAS shifts right.
SRAS equation (conceptual):
Y = Y_N + a(P - P_E)
Where a is a positive constant. When P > P_E, output exceeds the natural rate. When P < P_E, output falls below it. When P = P_E, output equals Y_N (the economy is on LRAS).
LRAS diagram: A vertical line at Y_N. The price level does not affect where this line sits.
SRAS diagram: An upward-sloping curve. Shifts left when P_E rises or when any LRAS-shifting factor reduces productive capacity; shifts right when P_E falls or productive capacity increases.
Sticky wages are easy to observe: most employees have contracts specifying a fixed nominal wage for at least a year. If inflation turns out higher than expected, employers benefit because the real cost of labour falls, which is precisely the sticky-wage theory's logic. Menu costs are visible in industries like restaurants, where reprinting menus is a literal cost, and in e-commerce, where repricing thousands of items requires time and systems work.
Students often think LRAS slopes upward like SRAS. It does not. LRAS is vertical because in the long run all prices (including wages) adjust fully, and output depends only on real factors.
Students sometimes believe only one of the three SRAS theories is "correct." All three are considered valid; they highlight different imperfections that likely coexist in the real economy.
Students mix up what shifts SRAS vs. what shifts LRAS. Remember: everything that shifts LRAS shifts SRAS too, but changes in P_E shift only SRAS, not LRAS.
Students sometimes think a change in the actual price level shifts SRAS. It does not. A change in P causes movement along SRAS. Only a change in P_E or in the real determinants of output shifts SRAS.
⚠️ Be prepared to explain why LRAS is vertical in one or two sentences. The answer is classical dichotomy: real GDP depends on real factors, not the price level.
⚠️ You may be asked to compare the three theories of SRAS. Know the market imperfection each one identifies (sticky wages, sticky prices, misperceptions) and how each leads to the same conclusion: higher P causes higher Y in the short run.
⚠️ The relationship Y = Y_N + a(P - P_E) is a compact way to express all three theories. If the exam gives you a scenario where P_E changes, you should be able to say which direction SRAS shifts and why.
⚠️ Know what shifts LRAS vs. SRAS. A common exam question gives a scenario (e.g. "a new technology is invented" or "workers expect higher inflation") and asks which curve shifts.
True or False: LRAS is vertical because firms produce more when prices are higher.
Fill in the blank: The natural rate of output is the level of GDP produced when unemployment is at its ________ rate.
True or False: An increase in the expected price level shifts SRAS to the right.
Fill in the blank: In the sticky-wage theory, if P > P_E, firms find production more ________ and expand output.
True or False: A new technology that raises productivity shifts both LRAS and SRAS to the right.
Answers: 1. False (LRAS is vertical because real GDP depends on real factors, not the price level). 2. Natural. 3. False (it shifts SRAS to the left). 4. Profitable. 5. True.
Q: Why is the long-run aggregate supply curve vertical?
A: In the long run, real GDP is determined by the economy's stocks of labour, capital, natural resources, and the level of technology. A change in the price level does not affect any of these real factors, so it does not affect real GDP. Output stays at the natural rate regardless of the price level.
Q: Explain the sticky-wage theory of short-run aggregate supply.
A: Nominal wages are set in advance based on the expected price level. If the actual price level rises above expectations, firms' revenues increase while their labour costs remain fixed. This makes production more profitable, so firms hire more workers and produce more output. The result is a positive relationship between the price level and output in the short run.
Q: What is the difference between a shift of SRAS and a movement along SRAS?
A: A movement along SRAS is caused by a change in the actual price level: as P rises, firms supply more. A shift of SRAS occurs when something other than P changes, such as a change in the expected price level, or a change in the economy's productive capacity (labour, capital, resources, technology).
Q: If workers and firms come to expect a higher price level, what happens to the SRAS curve?
A: SRAS shifts to the left. Workers and firms negotiate higher nominal wages in anticipation of higher prices. At each actual price level, production is now less profitable (costs have risen), so the quantity supplied is lower.
The three SRAS theories connect to the microeconomic concept of market imperfections and price rigidity. The sticky-price theory ties directly to the idea of menu costs from microeconomics. The long-run vertical LRAS links back to classical economics and the quantity theory of money (Chapter 17). Understanding how SRAS shifts over time is essential for the next section of these notes (Part 3), which covers how the economy moves from short-run to long-run equilibrium after a shock.
aggregate supply, LRAS, SRAS, long-run aggregate supply, short-run aggregate supply, natural rate of output, potential output, full-employment output, Y_N, sticky wages, sticky prices, menu costs, misperceptions theory, expected price level, P_E, factors of production, labour, capital, human capital, natural resources, technology, classical dichotomy, Mankiw Chapter 20