Inflation Caused by Continually Decreasing Short run Aggregate Supply is

Why do businesses cut down their production when the price level increases? How do wages being sticky affect businesses' production in the short run? Can a shift in the short run overall production cause inflation? And what causes the shift in short-run aggregate supply?

You will be able to answer all these questions once you read our explanation of the short-run aggregate supply.

Short-Run Aggregate Supply Definition

To understand short-run aggregate supply definition you need to understand that an economy is characterized by its long-run production and its short-run production.

The behavior of aggregate supply is what most clearly differentiates the economy in the short run from the economy's behavior in the long term. Because the general level of prices does not affect the capacity of the economy to create goods and services over the long run, the aggregate supply curve, in the long run, is vertical.

On the other hand, the price level in an economy influences to a great extent the level of production that takes place in the short run. Over a year or two, a rise in the overall level of prices in the economy tends to lead to an increase in the number of goods and services that are supplied. In contrast, a fall in the level of prices tends to lead to a decrease in the number of goods and services supplied.

Short-run aggregate supply refers to the overall production in an economy during the short run.

Why do changes in the overall price level affect production in the short run? Many economists have argued that the short-run aggregate supply changes with the price level due to sticky wages. As wages are sticky, employers can't change the wage in response to a change in the price of their product; rather, they choose to produce less than they would.

Determinants of Short-Run Aggregate Supply

Determinants of the short-run aggregate supply include price level and sticky wages.

The short-run aggregate supply has a positive relationship with the price level. An increase in the total aggregate price level is related to the rise in the total quantity of aggregate output supplied. A decrease in the aggregate price level is related to a reduction in the total quantity of aggregate output supplied, all other things being equal.

To understand how the price level determines the quantity supplied, consider the profit per unit a producer makes.

Profit per unit of output = Price per unit of output − Production cost per output unit.

This formula above means that the profit a producer receives depends on whether or not the producer's price for a unit of production is more than or lower than the cost that the producer incurs to make that unit of output.

One of the main costs a producer faces during the short run is its wages to employees during the short run. Wages work by having a contract that determines the amount an employee will be paid during a specific period. Even in situations with no formal contracts, there are often informal agreements between management and employees.

As a result, wages are considered not to be flexible. This makes it difficult for businesses to adjust pay under changes in the economy. Employers don't usually lower wages to not lose their workers, although the economy might be experiencing a recession.

This is mentioned because for economic theory to maintain market balance, all aspects of the economy need to rise and fall with the market circumstances. Any amount of unflexible values will slow the market's ability to self-correct. However, the market fluctuations in the short run can devastate livelihoods, so sticky wages are a necessary element.

As a result, the economy is characterized by sticky wages. Sticky wages are nominal wages that are slow to fall even in high unemployment and slow to rise even in the face of labor shortages. This is because both formal and informal agreements influence nominal wages.

As wages are sticky during an increase in the price level, the Price paid per output, the business's profit gets wider. Sticky wages mean the cost will not change while the prices increase. This allows the firm to increase its profit, incentivizing it to produce more.

On the other hand, as the prices decrease while the cost remains the same (sticky wages), businesses will have to produce less as their profit shrinks. They might respond to this by hiring fewer workers or laying off some. Which overall reduces the level of production.

Short Run Aggregate Supply Curve

The short-run aggregate supply curve is an upward sloping curve that depicts the number of goods and services produced at each price level in the economy. Increasing the price level causes a movement along the SRAS curve, leading to higher output and higher employment. As employment rises, there is a short-term trade-off between unemployment and inflation.

Figure 1. Short Run Aggregate Supply Curve, StudySmarter Originals

Figure 1 shows the short-run aggregate supply curve. We've established that a price change will also cause the quantity supplied to change due to sticky wages.

It's important to note that there are perfectly and imperfectly competitive markets, and for both these markets, the aggregate supply in the short run is upward sloping. This is because many costs are fixed in nominal terms. In completely competitive markets, producers have no say in the prices they charge for their goods, but in imperfectly competitive markets, producers have some say in the prices they set.

Let's consider perfectly competitive markets. Imagine if, for some unknown cause, there is a decrease in the level of aggregate prices. This would decrease the price that the average producer of a final commodity or service would get. In the near term, a significant share of production expenses remains constant; hence, the production cost per unit of output does not decrease in proportion to output price. As a result, the profit made from each production unit falls, which causes perfectly competitive producers to cut down on the amount of product they provide in the short run.

Let's consider the case of a producer in an imperfect market. Should there be an increase in the demand for the product that this manufacturer makes, they will be able to sell more of it at any given price. Because there is a greater demand for the company's goods or services, it is quite likely that the company will decide to raise both its pricing and its production to achieve a higher profit per unit of output.

The short-run aggregate supply curve illustrates the positive relationship between the aggregate price level and the quantity of aggregate output producers are willing to supply. Many production costs, most notably nominal wages, can be fixed.

Causes of Shift in Short-Run Aggregate Supply

A price change causes a movement along with the short-run aggregate supply. External factors are causes of shift in short-run aggregate supply. Some of the factors that would shift the SRAS curve include changes in commodity prices, nominal wages, productivity, and future expectations about inflation.

Figure 2. Leftward shift in SRAS, StudySmarter Originals

Figure 2 shows an aggregate demand and aggregate supply model; this features three curves, aggregate demand (AD), short-run aggregate supply (SRAS), and long-run aggregate supply (LRAS). Figure 2 displays a leftward shift in the SRAS curve (from SRAS₁ to SRAS₂). This shift causes quantity to decrease (from Y₁ to Y₂) and price to increase (from P₁ to P₂)

In general, a shift to the right of the SRAS curve lowers the overall prices and raises the output produced. In contrast, a leftward shift in the SRAS increases prices and lowers the quantity produced. This is determined in the AD-AS model, where the equilibrium occurs between aggregate demand, short-run aggregate supply, and long-run aggregate supply.

For more information on equilibrium in the AD-AS model, check out our explanation.

What type of market fluctuations can cause a shift in the short-run aggregate supply? Check out this list below:

• Changes in commodity prices. The raw materials a firm uses to develop the final goods impact the quantity supplied. When commodity prices increase, it becomes more expensive for businesses to produce. This shifts the SRAS to the left, resulting in higher prices and lower quantity produced. On the other hand, reducing commodity prices makes production cheaper, shifting SRAS to the right.

• Changes in nominal wages. Likewise, the commodity prices and nominal wage increase the production cost, shifting the SRAS to the left. On the other hand, a decrease in nominal wage lowers production costs and shifts SRAS to the right.

• Productivity. A rise in productivity gives the firm the ability to produce more while maintaining low or constant costs. As a result, a surge in productivity would allow firms to make more, shifting the SRAS to the right. On the other hand, a decrease in productivity would shift the SRAS to the left, resulting in higher prices and less output produced.

• Expectations about future inflation. When people expect an increase in inflation, they will demand higher wages to prevent inflation from reducing their purchasing power. This will increase the cost firms face, shifting the SRAS to the left.

Short-Run Aggregate Supply Examples

Let's consider the supply chain problems and inflation in the United States as short-run aggregate supply examples. Although this is not the entire story behind inflation numbers in the United States, we can use short-run aggregate supply to explain a considerable part of inflation.

Due to COVID-19, several supply chain problems arose, as foreign suppliers were in lockdown or didn't wholly resume their production. However, these foreign suppliers were making some of the key raw materials used in producing goods in the United States. As the supply for this raw material is limited, this caused their price to increase. An increase in the price of raw materials meant that the cost for many firms increased as well. As a result, the short-run aggregate supply shifted to the left, resulting in higher prices.

Short-run aggregate supply is a key economic indicator that can track the balance of price levels and the quantity of goods and services supplied. The SRAS curve has a positive slope, increasing in quantity as price increases. Factors that can disrupt normal production can cause a shift in the SRAS, such as inflation expectations. If the supply moves along the SRAS, this will result in a trade-off between unemployment and inflation, one going down, the other up. Short-run aggregate supply is an important metric for firms and policymakers to track the overall health and direction of the market.

Short-Run Aggregate Supply (SRAS) - Key takeaways

• The SRAS curve shows the relationship between the price level and the quantity of goods supplied on an aggregate level.
• Due to sticky wages and prices, the SRAS curve is an upward sloping curve.
• Factors that cause a change in the production cost cause the SRAS to shift.
• Increasing the price level causes a movement along the SRAS curve, leading to higher output and higher employment. As employment rises, there is a short-term trade-off between unemployment and inflation.

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Source: https://www.studysmarter.us/explanations/macroeconomics/aggregate-supply-and-demand/short-run-aggregate-supply/

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