2.3 Aggregate supply GapFill

Alongside aggregate demand, aggregate supply is a central macroeconomic concept. The interaction of aggregate demand and aggregate supply allows us to map changes to the price level and output in the economy. When movement along the aggregate supply curve occurs, it is due to changes in prices influencing  the supply of moneyexternalitiesaggregate demandthe production process. When shifts in the aggregate supply curve occur, it is due to changes in  aggregate demandexternalitiesthe production processthe supply of money.

We can identify two different types of aggregate supply. The first is influenced by changes in the cost of production and aggregate demand, and is known as  classicalKeynesianshort-runlong-run aggregate supply. The second is influenced by the four factors of production: labour, land, capital and enterprise. This is known as  short-runlong-runKeynesianfiscal aggregate supply.

With regard to the second type of aggregate supply, different interpretations exist as to how it functions. The first interpretation assumes that a reduction in output will lead to a decrease in the price level, which will in turn stimulate aggregate demand and return the economy to an equilibrium level of maximum output. This is known as the  monetaryfiscalclassicalKeynesian interpretation. The second interpretation contends that a reduction in output will not necessarily lead to a reduction in the price level. With intervention, this reduction in output can be reversed, but the price level will continue to remain the same due to spare capacity in the economy. Only once the economy has returned to its maximum output will prices again begin to rise. This is known as the  monetaryclassicalKeynesianfiscal interpretation.

It is important you are familiar with how these two interpretations are represented differently in diagrams. The first interpretation assumes that the level of output will not reduce in the long term, and so represents aggregate supply as a  falling curvestraight vertical linestraight horizontal linerising curve in which only changes to the price level occur. The second interpretation does allow for the possibility that aggregate supply could reduce in the long term, and so represents aggregate supply as a  shift leftstraight horizontal lineshift rightstraight vertical line until reaching the equilibrium level. Both interpretations represent aggregate supply in the same manner after reaching the equilibrium level.