Aggregate Supply (AS)

We now shift our attention to the supply side of the macroeconomy. Aggregate supply explains the production and pricing side of the economy and the behavior of the businesses as a whole. This is something contrary to the Keynesian model (which is based on demand side of macroeconomy) where the price level was assumed to be constant and output was demand determined. This implies that aggregate supply is perfectly price elastic up to the full employment level of output. However, to have a more realistic bent of analysis, we relax the assumption of constant price level and allow aggregate supply to vary with changes in the price level. Moreover the behavior of the aggregate supply is not as straightforward as the behavior of aggregate demand because we must distinguish between aggregate supply in the short run and aggregate supply in the long run. In the short run, the interaction between aggregate demand and aggregate supply determines the level of the output, employment, and capacity utilization as well as the price level (the source of inflation). In the long run, a decade or more say, aggregate supply is considered as the major factor behind economic development and well-being of a nation. Let us begin with aggregate supply in the short run.