What are the determinants of short-run aggregate supply?

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Steve Earley, King’s College, Madrid

The Monetary Policy Committee of the Bank of England is directed by the government to maintain ‘price stability’.

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This is defined as keeping inflation in the UK at the rate of 2% per annum.• C

Since 2003 this target has been based on the Consumer Prices Index (CPI) measure of inflation.

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The MonetaryPolicy Committee

But the CPI inflation rate has consistently outstripped the 2% target in every month since November 2009.

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Over this same period the Bank of England’s base rate has remained unchanged at the historically low level of 0.5%.

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This is a seeming contradiction – surely inflation above 2% should imply an increase in the rate of interest?

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This article will show how an understanding of the determination of short-run aggregate supply can provide a reasoned explanation for this apparent paradox.

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To appreciate the factors that impact aggregate supply in the short-run it will be worthwhile to contrast this concept with the logic that underpins the long-run.

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The long-run is seen as the length of time it takes for the resources of an economy to be changed in some way.

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This may be due to adjustments in the quantities of land, labour, capital and entrepreneurial talent available, or to quality improvements to one or all of these factors of production.

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The long-run 1

Equally the long-run may be identifiable when there has been a change in the way in which resources are organised within the economic system: various privatisations and deregulations have been aimed at reinvigorating the way industry can utilise resources to produce output.

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Thus the long-run should be viewed as the period of time it takes for amendments to productive capacity to take place, and can be associated with a movement of the production possibility curve (PPC) to the right.

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The left-hand panel shows an outward shift of the PPC.• CThis could be due for instance to net immigration, or where privatisations have reaped the hoped for improvements, such that the production limits of the economy are boosted from OA goods and OC services to OB goods and OD services.

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Correspondingly the long-run aggregate supply (LRAS) curve, as shown in the right hand diagram, also moves to the right.

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The long-run 2

LRAS1 now becomes LRAS2 echoing this increased productive potential.• C

The vertical nature of both LRAS curves reflects the respective limits that the original and new resource levels impose on output in the different time periods – OY1 for LRAS1 and OY2 for LRAS2.

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In direct contrast, aggregate supply in the short-run is based on the presumption that no changes can be made to productive capacity during this time.

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But this does not mean that supply is incapable of responding to economic stimuli in the short-run.

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A rise in aggregate demand (AD) for example, would, by putting upward pressure on prices, encourage businesses to make more use of existing resources through, say, additional overtime for workers or by returning to production capital that was previously considered to be no longer economically viable.

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The short-run 1

The figure below shows a rise in aggregate demand from AD1 to AD2.

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This initiates an increase in the general price level from OP1 to OP2.

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These higher prices enhance profitability from production and induce firms to increase output from OY1 to OY2, by using existing factors of production more extensively.

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The short-run 2

In this way, changes to the average price level act as an important determinant of aggregate supply in the short-run.

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In the figure below the resulting ascending movement along the curve is referred to as an extension of aggregate supply.

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(A descending movement as the general price level falls is called a contraction).

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It is the increase in aggregate demand that causes the rise in the general level of prices within the economy – aggregate supply simply responds to the stimulus offered.

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A rise in the price level encourages businesses to increase output, as shown by a short-run aggregate supply (SRAS) curve which is upward sloping from left to right.

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The short-run 3

A change in the average price level is not the only factor that can impact on aggregate supply decisions in the short-run.

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Whilst alterations to the quantity, quality and organisation of resources are not possible it is still conceivable that the costs of the factors of production could change in this time period.

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If, for instance, unit labour costs rose – wage rates increased or productivity levels fell – then UK firms would immediately face higher costs of production.

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Changes to SRAS 1

This would reduce the amount of profits available.• C

The business community would respond by cutting output levels.

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The movement of SRAS1 to SRAS2 shown in the Figure below causes the economy to move to a new equilibrium level of real GDP at OY3 with a new higher average price level of OP2.

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In this scenario the inflation which is experienced within the economic system is caused by the change in aggregate supply.

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Changes to SRAS 2

Any change in the costs of resources within an economy will impact upon aggregate supply in the short-run.

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Changes which impact negatively on profit levels will see the SRAS curve move to the left – a decrease in SRAS – while changes which improve profitability will witness a move to the right – an increase.

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Causes of changes to aggregate supply in the short-run include: C

A rise (or fall) in commodity prices on world markets.• C

The introduction by the government of new regulations aimed at improving, say, safety procedures in the workplace.

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Changes to SRAS 3

Higher taxation on, for instance, greenhouse gas emissions to help a country meet its environmental targets.

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An appreciation (or depreciation) of the exchange rate which will alter the price of imported components and raw materials.

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The introduction (or removal) of a tariff by a country on imported commodities.

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So how can this analysis lend support to the Monetary Policy Committee’s inaction in terms of interest rate policy given that the inflation target has been breached consistently for over three and a half years?

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Figure 3 showed that the rise in the average price level was caused by an increase in aggregate demand.

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It would be highly rational in this case to consider a rise in the rate of interest as an appropriate policy to deal with the inflationary issue.

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The Bank of England,inflation and SRAS 1

By raising the rate of interest the MPC would dampen both consumer and investment expenditure in the economy.

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Doing this would help to extinguish the AD cause of the inflation being encountered.

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But Figure 4 showed that a rise in the average price level is now always derived from demand-side factors.

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When an economy is experiencing decreases in short-run aggregate supply the impact on the price level will be upward.

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In this scenario any change to interest rates will be ineffectual, indeed ill-advised, as the cause of the inflation is independent of aggregate demand.

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The Bank of England,inflation and SRAS 2

The MPC can therefore justify maintaining interest rates at their historic low if it can display that it has been a series of short-run aggregate supply factors that are the source of the above-target inflationary pressures.

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“The impact of depreciation of sterling earlier this year.”• C

“Higher domestic energy and import prices.”• C

“Increases in VAT, energy and import prices.”• C

The Bank of England,inflation and SRAS 3

According to various Inflation Reports from the Bank of England, higher than target inflation rates have been seen as being the consequence of:

The analysis presented highlights the impact that aggregate supply issues can have on the average price level in the short-run.

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It should be appreciated that the seemingly paradoxical policy response of the MPC to above target inflation in recent years is in fact a highly rational approach founded on firm economic logic.

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The Bank of England,inflation and SRAS 4