Short-Run Aggregate Supply (SRAS): Study Guide (Macroeconomics 3.3)

What the SRAS curve shows

In Topic 3.1 you met the aggregate demand (AD) curve: the total real output that households, firms, the government and the rest of the world want to buy at each price level. Aggregate supply is the other side of the model.

The short-run aggregate supply (SRAS) curve shows the total quantity of goods and services (real output, or real GDP) that all the firms in an economy are willing to produce at each price level, in the short run.

Two words in that definition matter:

• Price level, not price. The vertical axis is an index of the average price of all final goods and services, such as the GDP deflator. It is not the price of one product.
• Short run. In macroeconomics the short run is the period in which some input prices, especially nominal wages, are fixed. It is not a set number of months. Topic 3.4 explains the long run, when all prices and wages have fully adjusted.

So the axes of any aggregate supply graph are price level (vertical) and real GDP or real output (horizontal). Never label them “price” and “quantity”. That is the market model of Unit 1, and it is a common way to lose a graphing point.

Why the SRAS curve slopes upward: sticky wages and prices

A sticky price is one that is slow to change, even when market conditions change. In the short run many input prices are sticky:

• Nominal wages are often set by contracts that last one or two years, or are changed only once a year.
• Some other input prices, such as rent on a lease or the price in a supply contract, are fixed for a period.
• Some firms change their own output prices only now and then, because changing prices has costs (printing new price lists, upsetting regular customers).

Now suppose the price level rises, so firms can sell their output for more. Their wage bill and many other costs stay the same for a while. Each unit they sell earns a bigger gap between price and cost, so producing more becomes profitable. Firms hire more workers, add shifts and use their machines more intensively. Real output rises.

Another way to say this: a higher price level with an unchanged nominal wage means a lower real wage. Labour has become cheaper in real terms, so firms hire more of it.

The reverse also holds. If the price level falls while wages stay fixed, profit per unit shrinks, labour becomes more expensive in real terms, and firms cut output and jobs.

That is the whole explanation of the upward slope. Do not explain it with the law of supply for a single good, and do not use the wealth, interest-rate or exchange-rate effects. Those explain the slope of AD.

Our fictional economy: Valdoria

Valdoria is the fictional country used across the Marlbridge macroeconomics pages. Its currency is the valda (VD). The table shows Valdoria’s SRAS schedule this year, with employment. Valdoria’s labour force is 25.0 million and stays fixed. All data are fictional.

Price level (index)	Real GDP supplied (VD billion)	Employed (million)	Unemployed (million)	Unemployment rate
96	760	23.25	1.75	7.0%
100	800	23.50	1.50	6.0%
104	840	23.75	1.25	5.0%
108	880	24.00	1.00	4.0%
112	920	24.25	0.75	3.0%

Each rise of 4 points in the price level adds VD 40 billion of real output and 0.25 million jobs.

Worked example 1: moving along SRAS

Question. Valdoria’s price level rises from 100 to 108, and nothing else changes, so the economy moves from a to b on its SRAS curve. Nominal wages are fixed by contract at VD 24 an hour. (a) Calculate the inflation rate. (b) Describe and calculate the changes in real output, employment and the unemployment rate. (c) Explain why firms produce more. (d) What does this suggest about inflation and unemployment in the short run?

(a) Inflation rate = (108 − 100) ÷ 100 × 100 = 8.0%.

(b) Real output rises from VD 800 billion to VD 880 billion, an increase of VD 80 billion (80 ÷ 800 × 100 = 10.0%). To produce more, firms need more workers, so employment rises from 23.50 million to 24.00 million, 0.50 million more jobs. The labour force is fixed at 25.0 million, so the number unemployed falls from 1.50 million to 1.00 million. The unemployment rate falls from 6.0% to 4.0%.

(c) The nominal wage stays at VD 24 an hour while the price level rises 8%. In base-period money the real wage falls to 24 ÷ 1.08 = VD 22.22 an hour, about 7.4% lower. Each worker now costs firms less relative to what they can sell output for, so hiring more workers and producing more is profitable.

(d) Moving up the SRAS curve, the higher price level (8% inflation) comes with lower unemployment. Moving down it, as from a price level of 100 to 96, output falls to VD 760 billion and unemployment rises to 7.0%. So in the short run there is a trade-off: higher inflation goes with lower unemployment, and lower inflation with higher unemployment.

Check. The trade-off only works because the labour force is held constant. If the labour force grew at the same time, the unemployment rate could change for another reason. You will draw this trade-off as the short-run Phillips curve in Topic 5.2.

What shifts the SRAS curve

A change in the price level never shifts SRAS; it moves the economy along it, as in Worked example 1. The curve shifts when something changes the cost of producing any given level of output.

• Decrease in SRAS (shift left, or up): at every price level firms supply less, because producing each unit costs more.
• Increase in SRAS (shift right, or down): at every price level firms supply more, because producing each unit costs less.

The main determinants:

Determinant	Example that decreases SRAS (left)	Example that increases SRAS (right)
Nominal wages	Workers win a general pay rise	Nominal wages fall
Prices of other inputs	Energy or raw material prices rise	Energy or raw material prices fall
Inflationary expectations	People expect higher inflation	People expect lower inflation
Productivity	Output per worker falls	New methods raise output per worker
Government actions on costs	Higher taxes on businesses, costly regulations	Subsidies to producers, lower business taxes
Supply shocks	Floods or drought destroy crops	An unusually good harvest

Inflationary expectations need a sentence of their own. If workers expect prices to rise 6% next year, they will push for a nominal pay rise of at least 6% to protect their real wage. Firms that expect their own prices to rise are more willing to agree. Higher wage costs at every level of output mean less output at every price level: SRAS shifts left. Expected inflation therefore matters even before any actual inflation has happened.

Be careful with factors that change spending, such as consumer confidence, household income taxes or interest rates on household loans. These shift AD, not SRAS.

Worked example 2: a rise in expected inflation

Question. Valdorian unions and firms come to expect higher inflation. New wage agreements raise production costs so that firms supply VD 40 billion less at every price level. (a) Write the new SRAS schedule. (b) How much real output is supplied at a price level of 104, before and after? (c) What price level would firms now need to supply VD 840 billion? (d) Describe the shift in two ways.

(a) Subtract 40 from each output in the table:

Price level	96	100	104	108	112
SRAS₁ (VD billion)	760	800	840	880	920
SRAS₂ (VD billion)	720	760	800	840	880

(b) At a price level of 104, real output supplied falls from VD 840 billion to VD 800 billion.

(c) On SRAS₂, VD 840 billion is supplied at a price level of 108, 4 points higher than before.

(d) The curve has shifted left (less output at each price level) or, equally, up (a higher price level needed for each level of output). Either description is correct; both say that SRAS has decreased.

Check. Nothing in this example changed the price level by itself. Comparing the same price level (104) on two curves shows a shift; comparing two price levels on one curve would show a movement.

Common misconceptions

• Labelling the axes “Price” and “Quantity”. Aggregate supply uses price level and real GDP (or real output).
• “SRAS slopes up because of the law of supply.” The law of supply is about one good. SRAS slopes up because wages and some prices are sticky in the short run.
• “A higher price level shifts SRAS right.” A change in the price level is a movement along the curve. Only changes in production costs shift it.
• “Higher expected inflation shifts SRAS right, because firms expect higher prices.” Expected inflation raises wage demands and costs, so SRAS shifts left.
• “Sticky wages never change.” They are slow to change. Over time contracts are renegotiated, which is why the long run is different (Topic 3.4).
• Treating a household tax cut or higher consumer confidence as an SRAS shift. These change spending, so they shift AD.
• “Up and left are different shifts.” For a decrease, left and up describe the same new curve.
• Forgetting the labour force assumption. The link from more output to lower unemployment assumes the labour force is constant.

Where this leads

Topic 3.4 adds the long-run aggregate supply curve, which is vertical because in the long run wages and prices fully adjust: start with the long-run aggregate supply study guide. In Topic 3.5 you will put AD and SRAS together to find short-run equilibrium, and in Topic 3.6 you will shift SRAS to show supply shocks and cost-push inflation. If you need to revise AD and the multipliers first, go back to Topic 3.2.

Now try the practice questions, then use the revision notes and the checklist to consolidate.