Last Modified: May 28, 2026
Table of Contents
SERIES 7 | SERIES 63 | SERIES 65 | FINANCIAL REGULATION COURSES
Aggregate supply is the total quantity of final goods and services that producers throughout an economy are willing and able to supply at each possible overall price level during a given period.
The supply-side counterpart to aggregate demand in the fundamental AD-AS model of macroeconomics that policymakers at the Federal Reserve, the Congressional Budget Office, and the Treasury Department use to analyse economic conditions, formulate monetary and fiscal responses, and project the trajectory of output, employment, and inflation.
The distinction between short-run aggregate supply, which slopes upward because wages and certain prices are sticky and slow to adjust, and long-run aggregate supply, which is vertical at potential output because all prices including wages are fully flexible in the long run, is among the most consequential in all of macroeconomics.
It determines whether an economy can self-correct from recessions and inflationary gaps on its own or requires policy intervention, and it explains the most destructive economic condition in modern history: stagflation.
the simultaneous occurrence of rising inflation and falling output that devastated the United States economy across the 1970s when oil price shocks shifted aggregate supply sharply to the left.
This entry examines short-run and long-run aggregate supply in full technical depth, explains the causes of wage and price stickiness, analyses every factor that shifts each curve, traces the history of supply-side shocks from OPEC to COVID-19, examines the classical versus Keynesian debate about long-run self-correction, and connects the entire framework directly to the market analysis and policy interpretation skills tested on the SIE, Series 7, and Series 65 examinations.
Aggregate supply represents the economy-wide relationship between the overall price level and the total real output that all producers collectively choose to supply.
It is not the supply curve of any individual firm or industry but rather the summation of all production decisions across the entire economy expressed as a function of the general price level.
The concept operates across two fundamentally different time horizons, each governed by different assumptions about the flexibility of wages and prices — the distinction that gives aggregate supply its analytically rich and policy-relevant character.
The short-run aggregate supply curve is upward sloping, reflecting the behaviour of producers when wages and certain input costs are temporarily fixed or slow to adjust. The long-run aggregate supply curve is vertical, reflecting the economy's potential output capacity when all wages and prices have fully adjusted to whatever conditions prevail.
The short-run aggregate supply curve, universally abbreviated as SRAS, plots the total quantity of real output that producers are willing and able to supply at each price level during a period in which some input costs — most importantly wages — are fixed or slow to adjust. The curve slopes upward from left to right, meaning that at higher overall price levels, producers are willing to supply more real output, and at lower price levels, producers supply less.
The upward slope of the short-run aggregate supply curve is explained by the stickiness of wages and certain other input costs in the short run. When the overall price level for final goods and services rises, the prices that firms receive for their output increase, but wages and many input costs — constrained by existing contracts, social norms, and the mechanics of the labour market — do not immediately rise by the same proportion. Firms therefore find that their profit margins expand when the price level rises without a corresponding increase in their input costs, and they respond by increasing production. Conversely, when the overall price level falls but wages remain temporarily fixed, profit margins compress, and firms reduce output. The short-run aggregate supply curve is therefore upward sloping precisely because of the temporary gap between flexible output prices and sticky input costs.
The stickiness of wages is the most important source of nominal rigidity in modern economies and the reason the short-run aggregate supply curve does not behave like the long-run supply curve. Understanding why wages are sticky is essential for understanding the entire aggregate supply framework.
Wage contracts are the primary mechanism of wage stickiness. Most workers in formal employment have explicit or implicit wage agreements that fix their compensation for periods ranging from months to years — union collective bargaining agreements typically run for three years, and even non-union employment relationships generally involve implicit expectations of wage stability that employers violate at the cost of worker morale, productivity, and retention. When the economy contracts and the price level falls, employers cannot immediately cut wages to the new lower equilibrium level consistent with lower prices without disrupting their employment relationships, and workers who have accepted positions at existing wage levels resist downward revision.
Efficiency wages provide another mechanism. Economic theory and empirical research support the proposition that higher wages — above the market-clearing level — motivate greater worker productivity, reduce costly worker turnover, and attract higher quality candidates. Employers therefore resist cutting wages even during downturns because doing so would reduce productivity and increase turnover costs, making efficiency-wage-based employment relationships naturally resistant to downward wage adjustment.
Menu costs and information lags contribute to stickiness in goods prices as well as wages. Changing prices involves real costs — printing new catalogues, reprogramming point-of-sale systems, renegotiating supplier contracts — and firms therefore adjust prices less frequently and more slowly than a pure market-clearing model would predict. This contributes to the general price stickiness that underlies the upward slope of the short-run aggregate supply curve.
The long-run aggregate supply curve, universally abbreviated as LRAS, is vertical — a straight line rising directly from a point on the horizontal real GDP axis at the economy's potential output level. Unlike the short-run aggregate supply curve, the long-run curve is not affected by the overall price level at all. At any price level, the economy's long-run output is the same — its potential GDP.
Potential GDP, also called potential output, full-employment GDP, or trend GDP, represents the maximum level of real output the economy can sustain over the long run while maintaining price stability — the output consistent with all productive resources being fully and efficiently employed, with unemployment at its natural rate rather than above or below it. The natural rate of unemployment is not zero — it incorporates frictional unemployment from workers in transition between jobs and structural unemployment from workers whose skills are mismatched with available positions — but it excludes cyclical unemployment, which arises specifically from insufficient aggregate demand during recessions.
The vertical position of the long-run aggregate supply curve is explained by the full flexibility of all wages and prices in the long run. When the overall price level changes in the long run — after all contracts have expired and all prices including wages have fully adjusted — the real wages received by workers, the real costs paid by firms, and the real returns available to capital are unchanged. Because relative prices and real factor rewards are unaffected by a proportional change in all nominal prices, producers have no incentive to change their output decisions. The economy therefore always returns to its potential output level in the long run regardless of where the price level settles, making the long-run aggregate supply curve vertical.
A critical distinction exists between movements along the short-run aggregate supply curve — caused by changes in the overall price level, which change how much producers are willing to supply given fixed input costs — and shifts of the entire curve, caused by changes in underlying production conditions that alter the quantity supplied at every price level simultaneously.
Changes in the prices of major productive inputs shift the short-run aggregate supply curve. When input prices rise — whether from energy price increases, raw material cost escalation, or rising import prices driven by currency depreciation — production costs increase at every level of output, compressing profit margins and causing producers to reduce supply at every price level, shifting the short-run aggregate supply curve to the left. When input prices fall — from declining energy costs, cheaper imported materials, or technological improvements reducing input requirements — production costs fall, margins expand, and producers increase supply at every price level, shifting the curve to the right.
Wages are the single largest input cost in most economies, representing approximately two thirds of total production costs in the United States. When wages rise for reasons unrelated to price level changes — through tighter labour markets, minimum wage legislation, union negotiated increases, or changes in labour market regulation — the short-run aggregate supply curve shifts to the left. When wages fall or grow more slowly than productivity — as occurred following the productivity acceleration of the 1990s technology revolution — the short-run aggregate supply curve shifts to the right.
Changes in productivity — the amount of output produced per unit of input — shift both the short-run and long-run aggregate supply curves. When productivity improves through technological advancement, process innovation, or capital deepening, firms can produce more output at any given input cost, reducing their per-unit costs and shifting the short-run aggregate supply curve to the right. Because sustained productivity improvements also increase the economy's potential output capacity — the maximum sustainable level of real GDP — they shift the long-run aggregate supply curve rightward as well, representing genuine long-run economic growth rather than merely a cyclical fluctuation.
Changes in the regulatory environment affecting business costs shift the short-run aggregate supply curve. Regulations that increase compliance costs — environmental standards, workplace safety requirements, financial reporting obligations — raise the effective cost of production and shift the short-run aggregate supply curve to the left. Deregulation that reduces compliance costs, subsidies that lower effective input costs, or tax policy changes that reduce effective business tax burdens shift the curve to the right.
Supply shocks are sudden and typically unexpected changes in production costs or productive capacity that cause large, rapid shifts in the short-run aggregate supply curve. Supply shocks can be either negative — shifting the curve to the left and producing the combination of higher inflation and lower output known as stagflation — or positive, shifting the curve to the right and producing the exceptionally favourable combination of lower inflation and higher output.
The 1973 to 1974 OPEC oil embargo is the defining historical example of a severe negative supply shock. When Arab members of the Organisation of Petroleum Exporting Countries embargoed petroleum exports in October 1973, crude oil prices quadrupled from approximately three dollars per barrel in late 1972 to over twelve dollars by early 1974 — and then rose further to above thirty dollars following the Iranian Revolution of 1979. Because oil is an input in the production of virtually every good and service in a modern economy, this price increase cascaded through the entire production cost structure of the United States economy, shifting the short-run aggregate supply curve sharply to the left. The result was stagflation — United States CPI inflation surged to eleven percent in 1974 while GDP contracted, and unemployment rose from four point eight percent in the second half of 1973 to nearly eight percent by 1975. US inflation ultimately peaked at thirteen point five percent in 1980, and the Federal Reserve under Chairman Paul Volcker was forced to raise the federal funds rate to an unprecedented nineteen percent in early 1981 to break the inflationary spiral — producing a severe recession that pushed unemployment to ten point eight percent by 1982.
The COVID-19 pandemic produced a negative supply shock of a different character but comparable significance. Factory shutdowns, port congestion, and logistical disruption severely constrained the supply of goods worldwide, shifting the short-run aggregate supply curve to the left precisely as massive fiscal stimulus and unprecedented monetary accommodation shifted aggregate demand sharply to the right. The combination produced the inflation surge of 2021 to 2022 — with US CPI reaching nine point one percent in June 2022 — that combined supply shock cost-push pressures with demand-pull inflation from excess aggregate demand, complicating the Federal Reserve's policy response because reducing aggregate demand through rate increases could not directly address the supply-side component of the inflation.
The long-run aggregate supply curve shifts only when the economy's underlying productive capacity changes — when potential GDP itself increases or decreases. This is a fundamentally different category of change from short-run aggregate supply shifts, which reflect temporary cost pressures without changing the economy's fundamental capacity.
Changes in the quantity and quality of productive resources shift the long-run aggregate supply curve. Growth in the labour force through population increase, immigration, or higher labour force participation increases the economy's potential output capacity, shifting the long-run curve rightward. Investment in physical capital — machinery, equipment, infrastructure, and structures — increases the capital stock available to the economy, expanding potential output. Investment in human capital through education, training, and healthcare improves the quality and productivity of the labour force, shifting potential output higher.
Technological advancement — both specific innovations that improve particular production processes and general-purpose technologies that enhance productivity across broad sectors of the economy — is the primary long-run driver of rightward shifts in the long-run aggregate supply curve and is therefore the primary source of sustained long-run economic growth. The information technology revolution of the 1990s produced a sustained acceleration in United States productivity growth that shifted both the short-run and long-run aggregate supply curves rightward for an extended period, contributing to the unusually long expansion of the 1990s with its combination of strong output growth and declining inflation.
One of the most important and contested questions in macroeconomics is whether the economy will automatically return to its potential output following a disruption to aggregate demand, or whether it requires policy intervention to do so. The answer depends critically on how quickly wages and prices adjust — the same question that determines the slope of the short-run aggregate supply curve.
The classical view holds that wages and prices are sufficiently flexible that the economy self-corrects quickly and reliably. Following a decline in aggregate demand that produces a recessionary gap — output below potential — wages will fall as workers compete for scarce jobs, reducing input costs and shifting the short-run aggregate supply curve to the right. This process continues until the short-run aggregate supply curve has shifted far enough to intersect the aggregate demand curve at the potential output level, restoring full employment without any government intervention. In this view, active fiscal or monetary policy is unnecessary and potentially destabilising.
The Keynesian view holds that wages and prices are sufficiently sticky — particularly in a downward direction — that the self-correction process is too slow, too uncertain, and too socially costly to rely upon in practice. Workers and their unions strenuously resist wage cuts, and firms may be reluctant to cut prices even at lower demand levels. The result is that the economy can remain trapped below potential output with high unemployment for extended periods without policy intervention — as it did during the Great Depression, when the self-correcting mechanism failed entirely to restore full employment over more than a decade. In the Keynesian view, government fiscal stimulus or Federal Reserve monetary easing is necessary to shift aggregate demand rightward and restore output and employment in a reasonable timeframe.
The relationship between actual real output and potential output defines two important concepts that appear prominently in macroeconomic analysis and examinations.
A recessionary gap exists when actual output falls below potential output — when the AD-SRAS equilibrium occurs to the left of the long-run aggregate supply curve. Unemployment is above its natural rate. In the classical view the economy will self-correct over time as falling wages shift the short-run aggregate supply curve rightward. In the Keynesian view, expansionary policy is required.
An inflationary gap exists when actual output exceeds potential output — when the AD-SRAS equilibrium occurs to the right of the long-run aggregate supply curve. Labour markets are tighter than sustainable, wages begin rising, and the short-run aggregate supply curve shifts to the left, reducing output and raising the price level toward the long-run equilibrium. The Federal Reserve typically responds to inflationary gaps by tightening monetary policy to shift aggregate demand leftward, reducing the inflationary pressure before it becomes entrenched in wage and price expectations.
Long-run macroeconomic equilibrium occurs when all three curves — aggregate demand, short-run aggregate supply, and long-run aggregate supply — intersect at the same point. At this intersection, actual output equals potential output, unemployment equals its natural rate, there is neither recessionary nor inflationary pressure, and no further adjustment to wages or prices is needed. This is the economy's sustainable steady state — the position to which classical economists believe markets will reliably return and from which Keynesian economists note the economy can be displaced for uncomfortably long periods by insufficient aggregate demand.
Supply-side economics is the school of policy thinking that focuses on shifting the long-run aggregate supply curve rightward as the primary mechanism for generating sustained economic growth and reducing inflationary pressure simultaneously. Supply-side policies include reducing marginal tax rates on income and capital to increase incentives for work, investment, and risk-taking; deregulating product and labour markets to reduce compliance costs and increase business flexibility; investing in public infrastructure and education that enhance the productivity of private capital and labour; and promoting international trade that exposes domestic producers to competitive pressure and allows specialisation according to comparative advantage.
The tax reforms of 1981 under the Economic Recovery Tax Act and the Tax Cuts and Jobs Act of 2017 were each justified in part on supply-side grounds — the argument that lower marginal tax rates would increase labour supply, business investment, and productive capacity, shifting both the short-run and long-run aggregate supply curves rightward and generating economic growth without inflationary pressure. The empirical evidence on the magnitude of supply-side effects from tax cuts remains actively debated.
Aggregate supply is tested on the SIE, Series 7, and Series 65 examinations in the context of macroeconomic analysis, business cycle dynamics, inflation theory, supply shocks, and the relationship between Federal Reserve policy and economic conditions. Candidates must understand the distinction between the upward-sloping short-run aggregate supply curve and the vertical long-run aggregate supply curve, the role of wage and price stickiness in generating the short-run slope, the factors that shift each curve, the concept of stagflation as the result of a negative supply shock shifting the short-run aggregate supply curve to the left, and the difference between recessionary and inflationary gaps.
The core points to retain are these: the short-run aggregate supply curve slopes upward because wages and other input costs are sticky in the short run, meaning that when the overall price level rises firms earn higher margins and increase output while falling price levels compress margins and reduce output; the long-run aggregate supply curve is vertical at potential GDP because all wages and prices are fully flexible in the long run and proportional price level changes leave real factor rewards unchanged, eliminating any incentive to change production decisions; the short-run aggregate supply curve shifts to the left when input prices especially wages rise, when regulation increases production costs, or when negative supply shocks such as oil price spikes reduce productive capacity, and shifts to the right when input costs fall, productivity improves, or positive supply shocks occur; the long-run aggregate supply curve shifts rightward only with genuine increases in productive capacity through labour force growth, capital accumulation, or technological advancement; stagflation — the simultaneous occurrence of rising inflation and falling output — results from a leftward shift of the short-run aggregate supply curve caused by a negative supply shock, as illustrated by the OPEC oil embargoes of 1973 to 1974 and 1979 which produced double-digit inflation alongside rising unemployment in the United States; long-run macroeconomic equilibrium occurs at the intersection of all three curves where actual output equals potential GDP; and the classical view holds that the economy self-corrects to potential output through flexible wages while the Keynesian view holds that wage stickiness prevents reliable self-correction and justifies active monetary and fiscal policy intervention.
