Lecture 12 - Aggregate Demand and Aggregate Supply (Part II)

1. The Short-Run Aggregate Supply Curve

Conceptual Overview

In macroeconomics we distinguish between:

  • Short-run aggregate supply (SRAS)
  • Long-run aggregate supply (LRAS)

The key difference concerns price flexibility and expectations.

Definition

Short-Run Aggregate Supply (SRAS)
The relationship between the price level and the quantity of output supplied when nominal rigidities or imperfect information prevent full adjustment of wages and prices.

In the short run:

  • wages adjust slowly
  • many prices are sticky
  • agents may have imperfect information

As a result, changes in the price level affect output and employment.

The Positive Short-Run Relationship

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_7_set1(ADAS_P2)/Slide3.png

This diagram illustrates the upward sloping SRAS curve.

When the price level falls from to :

  • firms reduce production
  • output falls from to

This creates a positive relationship between prices and output in the short run.

The key insight is that firms make decisions based partly on expectations about prices, and when reality differs from those expectations, production adjusts.

Economic Intuition

If firms suddenly receive lower prices than expected, their revenues fall relative to costs. Production becomes less profitable, so they cut output and employment.
Conversely, if prices rise more than expected, production becomes temporarily more profitable and firms expand output.

2. Why the SRAS Curve Slopes Upward

Three main theories explain the upward slope of SRAS:

  1. Sticky-wage theory
  2. Sticky-price theory
  3. Misperceptions theory

Each explanation relies on a temporary mismatch between expected and actual price levels.

3. Sticky-Wage Theory

Mechanism

Nominal wages often adjust slowly because:

  • labour contracts fix wages for periods of time
  • renegotiation is costly
  • firms prefer wage stability for morale and planning

Workers and firms typically negotiate wages based on expected inflation or expected prices.

Definition

Sticky Wages
Nominal wages that adjust slowly to changing economic conditions, often due to contracts, institutions, or bargaining frictions.

Implications for Output

Suppose wages were negotiated based on an expected price level .

Case 1: Actual prices are lower than expected

Then:

  • Real wage = increases
  • Labour becomes more expensive for firms
  • Firms reduce hiring and production

Result:

Case 2: Actual prices are higher than expected

Then:

  • Real wages fall
  • Labour becomes cheaper
  • Firms increase hiring and production

Result:

Theoretical Interpretation

Firms base labour demand on the real wage .
If wages are fixed in nominal terms but prices move unexpectedly, real wages change automatically.
This creates temporary distortions in labour demand and output.

4. Sticky-Price Theory

Price Adjustment Costs

Many firms do not continuously update prices.

Reasons include:

  • menu costs
  • coordination problems
  • customer relationships
  • uncertainty about demand
Definition

Menu Costs
The costs associated with changing prices, including administrative costs, customer reaction, and strategic considerations.

Because firms set prices in advance, unexpected changes in the overall price level affect real outcomes.

Output Implications

If the general price level differs from expectations:

When

  • Firms that set prices in advance receive lower revenues than expected
  • Production becomes less profitable
  • Firms reduce output

When

  • Firms receive higher revenues
  • Production becomes more profitable
  • Output increases
Economic Intuition

Firms base their production decisions on expected selling prices.
If the overall price level rises unexpectedly, firms perceive their goods as relatively more valuable, so they produce more.

5. Misperceptions Theory

Imperfect Information

Producers often observe the price of their own product faster than they observe the overall price level.

This can lead to confusion between:

  • relative price changes
  • general inflation

Mechanism

Suppose the general price level falls.

A firm might interpret this as:

  • a decline in demand for its product

Rather than recognising it as a macro-wide price decline.

The firm therefore:

  • cuts production
  • reduces employment
Theoretical Interpretation

Firms react to relative price signals.
If they misinterpret a general price change as a relative price change, they respond incorrectly by altering production.

6. A Unified SRAS Equation

All three theories can be summarised by a single macroeconomic relationship:

Where:

  • = actual output
  • = natural level of output
  • = actual price level
  • = expected price level
  • = responsiveness of output to unexpected price changes

Interpretation

If:

  • output rises above the natural rate

  • output falls below the natural rate
Definition

Natural Rate of Output
The level of output determined by labour, capital, natural resources, and technology, corresponding to the Long-Run Aggregate Supply (LRAS).

Economic Intuition

Unexpected inflation temporarily stimulates production because firms perceive conditions as more favourable than expected.
Unexpected deflation temporarily reduces production because firms perceive conditions as worse.

7. Long-Run Equilibrium

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_7_set1(ADAS_P2)/Slide10.png

The economy reaches long-run equilibrium where:

  • AD intersects LRAS
  • output equals the natural level

At this point:

This equality ensures that:

  • no systematic surprises occur
  • production decisions align with expectations

The SRAS curve therefore also passes through this equilibrium point.

Theoretical Interpretation

In the long run, expectations adjust through adaptive or rational learning.
Workers renegotiate wages and firms adjust prices.
As a result, the economy converges to potential output, eliminating temporary deviations.

8. Shifts in the SRAS Curve

SRAS shifts whenever production costs or expectations change.

Structural Factors

The SRAS curve shifts with the same structural factors that affect LRAS:

  • labour supply
  • capital stock
  • natural resources
  • technological progress

These change the productive capacity of the economy.

Expectations

SRAS also shifts when expected price levels change.

Example:

If expected prices rise:

  • workers demand higher nominal wages
  • firms face higher production costs

This shifts SRAS leftward.

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_7_set1(ADAS_P2)/Slide12.png

The diagram illustrates how changes in expectations shift the SRAS curve.

If expected prices increase:

  • production costs rise
  • firms reduce output at each price level
  • SRAS shifts left.
Economic Intuition

Expectations influence wage negotiations and price-setting behaviour.
If workers anticipate inflation, they demand higher wages, increasing firms’ costs and reducing supply.

9. Linking AD-AS to Business Cycles

The AD-AS framework provides a foundation for analysing business cycles.

Definition

Business Cycles
Short-run fluctuations of economic activity around its long-run trend.

In the AD-AS model:

  • Demand shocks shift AD
  • Supply shocks shift SRAS
  • Expectation adjustments move the economy back to LRAS
Exam Insight

A common exam question asks you to explain why the SRAS curve slopes upward.
A full-marks answer should:

  • mention sticky wages
  • mention sticky prices
  • mention misperceptions
  • explain the difference between expected and actual prices
  • reference the equation .

10. Key Takeaways

Summary
  • The SRAS curve is upward sloping because wages, prices, and expectations adjust slowly.
  • Three key theories explain this relationship:
    • sticky wages
    • sticky prices
    • misperceptions.
  • Output deviates from the natural rate when actual prices differ from expected prices.
  • In the long run, expectations adjust and the economy returns to LRAS equilibrium.
  • Changes in expectations or production costs shift the SRAS curve.
  • The AD-AS framework provides a powerful tool for analysing business cycles and macroeconomic fluctuations.

Bibliography

Mankiw, N.G. and Taylor, M.P. (2023) Macroeconomics. 6th edn. Andover: Cengage Learning.

Jensen, M.K. (2026) Aggregate Demand and Aggregate Supply II (Lecture Slides). ECON1002 Introduction to Macroeconomics, University of Nottingham.