2.3.2 Short-Run Aggregate Supply

This study note for Edexcel economics covers Short-Run Aggregate Supply

1. Changes in Costs of Raw Materials and Energy

• Explanation:
  • Changes in the costs of raw materials and energy directly affect production costs for firms.
  • Higher costs increase the overall cost of production, shifting the SRAS curve to the left.
  • Lower costs decrease production costs, shifting the SRAS curve to the right.
• Impact on SRAS:
  • Increase in Costs:
    • Example: A rise in oil prices increases transportation and production costs across industries.
    • Result: Firms reduce output at existing price levels, shifting the SRAS curve leftward.
  • Decrease in Costs:
    • Example: A significant discovery of natural resources, such as shale gas, lowers energy costs.
    • Result: Firms can produce more at lower costs, shifting the SRAS curve rightward.
• Real-World Example:
  • 2008 Oil Price Shock: The spike in oil prices led to increased costs for energy-dependent industries, shifting the SRAS curve leftward and contributing to global economic slowdown.

2. Changes in Exchange Rates

• Explanation:
  • Exchange rates influence the cost of imported goods and services.
  • A stronger domestic currency makes imports cheaper, reducing production costs.
  • A weaker domestic currency makes imports more expensive, increasing production costs.
• Impact on SRAS:
  • Appreciation of Domestic Currency:
    • Example: If the US dollar appreciates against the euro, the cost of importing raw materials from Europe decreases.
    • Result: Lower production costs shift the SRAS curve to the right.
  • Depreciation of Domestic Currency:
    • Example: If the US dollar depreciates against the yen, the cost of importing components from Japan increases.
    • Result: Higher production costs shift the SRAS curve to the left.
• Real-World Example:
  • Post-Brexit Pound Depreciation: The depreciation of the British pound after the Brexit referendum increased import costs for UK firms, shifting the SRAS curve to the left.

3. Changes in Tax Rates

• Explanation:
  • Changes in tax rates on businesses affect their cost structures and profitability.
  • Higher tax rates increase costs, reducing supply.
  • Lower tax rates decrease costs, increasing supply.
• Impact on SRAS:
  • Increase in Tax Rates:
    • Example: An increase in corporate taxes raises the cost of doing business.
    • Result: Firms reduce output at existing price levels, shifting the SRAS curve leftward.
  • Decrease in Tax Rates:
    • Example: A reduction in payroll taxes lowers the cost of labor.
    • Result: Firms can afford to produce more, shifting the SRAS curve rightward.
• Real-World Example:
  • 2018 US Tax Cuts and Jobs Act: The reduction in corporate tax rates in the US lowered production costs for businesses, contributing to a rightward shift in the SRAS curve.

Key Economists and Contributions

• John Maynard Keynes:
  • Emphasized the role of aggregate demand in influencing economic output and employment.
  • His analysis of sticky wages and prices helps explain why the SRAS curve slopes upward.
• Milton Friedman:
  • Highlighted the importance of monetary policy and expectations in the economy.
  • His work on the natural rate of unemployment informs the long-term implications of shifts in SRAS.
• Edmund Phelps:
  • Developed the expectations-augmented Phillips curve, showing the relationship between inflation, unemployment, and expectations.
  • His work underscores the short-term trade-offs between inflation and output.

Glossary

• Exchange Rate: The value of one currency for the purpose of conversion to another.
• Corporate Tax: A tax imposed on the net income of a company.
• Depreciation (Currency): A decrease in the value of a currency relative to other currencies.
• Appreciation (Currency): An increase in the value of a currency relative to other currencies.
• Payroll Tax: A tax imposed on employers or employees, usually calculated as a percentage of the salaries that employers pay their staff. In this UK, this is called National Insurance.
• Production Costs: The costs incurred by a business in the process of producing goods or services.

Possible Essay-Style Questions

1. Analyze how a significant increase in global oil prices might affect the short-run aggregate supply curve of an oil-importing country. Use real-world examples to illustrate your points.
2. Discuss the impact of a country's currency depreciation on its short-run aggregate supply. Include in your answer the effects on both import costs and domestic production.
3. Evaluate the effects of a reduction in corporate tax rates on the short-run aggregate supply. How might this policy change influence economic output and employment?
4. Explain the relationship between changes in raw material costs and shifts in the short-run aggregate supply curve. Provide examples of industries that might be particularly affected.
5. Compare and contrast the impact of supply-side shocks versus demand-side shocks on the short-run aggregate supply curve. Use real-world examples to support your analysis.