After much emphasis on aggregate demand, this chapter builds the concepts of aggregate supply. AS models the behavior of the firms that produce the output. Based on managerial economics foundations, these firms set output and price in accordance with profit-maximization goals. We develop both short-run and long-run models of aggregate supply where the former focus on capital-constrained firms and the latter involve ways and means to increase the capacity to produce. Once developed, we look at the numerous determinants of AS and see how cost and productivity developments are equally important to AD in determining the resulting changes in changes in market output and prices. We find that while AD shocks cause output and prices to always move in the same direction, AS shocks help us to understand why at times, output and prices move in opposite directions. AS theory helps us also to see very different policy tools to influence the economy and why it is possible through AS policy to increase output without a corresponding increase in prices. We look into these policy options again in the next Note on Inflation and Unemployment.
Chapter: Aggregate Demand Topic No.