Factors that shift short-run aggregate supply

Overview

Depreciation of the domestic currency affect short-run aggregate supply, effect of an increase in indirect taxes on producers and government subsidy to producers affect short-run aggregate supply.

What you need to know

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Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What kind of change shifts the short-run aggregate supply curve, and in which direction does a cost increase move it?

   Model answer

   Anything that changes firms' costs of production at each level of output shifts the curve. A rise in costs means that any given real output will only be supplied at a higher price level, so the short-run aggregate supply curve shifts upwards and to the left. A fall in costs shifts it downwards and to the right, allowing more real output to be supplied at any given general price level.

2. 2

   Analyse the effect of a national pay settlement well above productivity growth on short-run aggregate supply.

   Model answer

   Labour is the largest cost for most firms, so a pay rise that outstrips productivity growth raises the cost of producing each unit of output. Firms need a higher price to supply any given quantity, so on a diagram with the general price level on the vertical axis and real national output on the horizontal axis the short-run aggregate supply curve shifts left. With aggregate demand unchanged, the new equilibrium has a higher general price level and lower real national output.

3. 3

   Money wages rise by 5 per cent while labour productivity rises by 2 per cent. Calculate the approximate change in unit labour costs and state the effect on short-run aggregate supply.

   Model answer

   Unit labour cost is the wage bill divided by output, so it changes by 1.05 / 1.02 = 1.0294, a rise of about 2.9 per cent. Costs per unit of output have risen, so the short-run aggregate supply curve shifts upwards and to the left. Had productivity risen by the full 5 per cent, unit labour costs would have been unchanged and the curve would not have moved.

4. 4

   Analyse the effect on short-run aggregate supply of a sharp rise in world oil prices in an oil-importing economy.

   Model answer

   Energy is an input into almost every product, directly through fuel and power and indirectly through transport and petrochemicals, so a rise in the oil price raises production and distribution costs across the economy. Firms require a higher price to supply any given quantity of output, so with the general price level on the vertical axis and real national output on the horizontal axis the short-run aggregate supply curve shifts to the left. At the new equilibrium the general price level is higher and real national output is lower, the combination usually described as cost-push inflation with falling output.

5. 5

   The price of oil rises from 60 dollars to 90 dollars a barrel, and energy accounts for 6 per cent of a typical firm's costs. Calculate the percentage rise in the oil price and the approximate direct effect on that firm's total costs.

   Model answer

   The oil price rises by (90 - 60) / 60 = 30 / 60 = 0.50, or 50 per cent. If energy is 6 per cent of costs and its price rises 50 per cent, the direct effect on total costs is 0.06 × 50 = 3 per cent. The total effect will be larger once suppliers pass on their own higher energy and transport costs, which is why an energy shock spreads through the whole price level.

6. 6

   How does a depreciation of the domestic currency affect short-run aggregate supply?

   Model answer

   A weaker currency raises the domestic-currency price of imported raw materials, components, energy and machinery. Firms that rely on imported inputs face higher costs at every level of output, so the short-run aggregate supply curve shifts upwards and to the left, raising the general price level and reducing real national output at the new equilibrium with demand unchanged. This works against the boost that the same depreciation gives to aggregate demand through net exports, so the effect on output depends on which is stronger.

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