The Short-Run Supply Schedule
and Supply Curve

At any given time, the production-possibili- ties curve for an economy is given. The economy may produce less than the maximum indicated by its production-possibilities frontier, but it cannot produce more. Given this fact, let us make up an aggregate-supply schedule for the economy, as- suming that the full-employment production limit is $400 billion. Column 1 in Table 5-1 simply shows different assumed levels of aggregate de- mand; column 2 shows the amount that will be produced in response to each level of demand. As long as the economy is below its capacity limit, rising demand calls forth more output, dollar for dollar. But after full capacity is reached, more demand cannot increase output further. The re- suit will be inflation, but this doesn’t show in Table 5-1, because the aggregate supply schedule there is in real (constant price) terms. Above $400 billion of aggregate demand, total real output is unchanged at $400 billion, although money g.n.p. rises with inflation.

It is useful to represent this aggregate sup- ply schedule graphically as an aggregate “supply curve” for the economy. This curve will show how much will be produced (supplied) in response to different levels of aggregate demand.2 In Fig. 5-1, we show on the horizontal axis the amount supplied—that is, real g.n.p. (iii initial prices). On the vertical axis we show ag- gre gate demand—total spending by all those who buy goods and services in the economy in this period. (We investigate in detail the forces deter- mining aggregate demand in Chapters 6 and 7.) Equal distances show equal amounts on both axes.

At one extreme, if there is no demand, nothing will be produced in our profit-motivated economy. At the other extreme, OQ3 shows the maximum real output possible for the economy in this period. Output OQ3 corresponds to $400 billion in Table 5-1. More generally, it corresponds to a point on the nation’s production-possibilities frontier, since OQ2 is the maximum output feasi- ble for the economy this year. No matter how much people spend and try to buy, more than this cannot be produced. Below OQa, as people spend more or less, businesses will increase or decrease output in response to this demand.

FIG. 5-1 Curve OA suggests that as aggregate demand
rises, output will be increased proportionately without
any price increase (inflation) up to full-employment out-
put 0Q3. If demand increases further, however, the re-
sult will be purely rising prices since output cannot be
expanded further in the short run.

For example, if aggregate demand is zero, output will be zero. If aggregate demand is OD1, businessmen will produce real g.n.p. OQi. At OQi, the economy would be operating far inside its production-possibilities frontier. If aggregate deFIG. 5-1 Curve OA suggests that as aggregate demand rises, output will be increased proportionately without any price increase (inflation) up to full-employment out- put OQ3. If demand increases further, however, the re- sult will be purely rising prices since output cannot be expanded further in the short run. mand rises to OD2, output will rise to OQ2. Thus, if we can imagine the output levels called forth by all possible levels of aggregate demand from zero to OD3, we would have the line OA, rising at a 45-degree angle from the zero point in Fig. 5-1. It rises at a 45-degree angle because for each level of OD, real output on the horizontal axis is an identi- cal amount. We call this line OA the economy’s aggregate supply curve; it shows how much the economy would produce at each different level of aggregate demand.

But once the economy reaches its full em- ployment g.n.p. (here OQ3), it cannot increase output further, no matter how high aggregate demand rises. Thus, the aggregate supply curve OA becomes perpendicular at that point; Fig. 5-1 extends it up to become OAB. Further increases in demand, say aggregate demand of OD4, will simply bid up prices rather than calling forth more out- put. Intuitively, it is easy to see that if aggregate demand rises into this range, inflation will be the result. Figure 5-1 suggests that the total mone1z g.n.p. will now be OD4, of which OD3 is real output corresponding to OQ3, while the rest is simply higher prices. Actually, we shall see later  that demand OD4 might generate a cumulative rise in prices rather than an equilibrium g.n.p. of OD4, but we postpone this problem temporarily.

It is important to recognize that by the same reasoning as above, we are assuming that if ag- gregate demand falls, the results are just the reverse of those that occur when demand rises. Given the aggregate supply curve OAB, when ag- gregate demand falls from OD4 to OD3 the result is purely lower prices. But when demand falls from OD3 to OD2 or to OD1, the result is purely reduced real g.n.p., not falling prices. That is, we assume temporarily that below full-employment out put, rising or falling aggregate demand will alter only real g.n.p., while after full-employment has been reached changes in demand will affect only the price level. We shall see later that this is not strictly true, but it is a useful temporary assumption.

Thus, at any given time, in this simplest model the level of aggregate demand determines the aggregate output of this economy. Given sup- ply curve QAB, if demand is less than OD3, real g.n.p. is less than potential full-employment g.n.p., and productive resources are wasted. If aggregate demand is more than OD3, there will be full em- ployment but there will be inflation in addition. Only if aggregate demand is just OD3 will the economy operate precisely at full employment without inflation.

Aggregate demand and aggregate supply are key concepts to remember through all of eco- nomics. Much of the next eight chapters center around the determinants of these big, key vari- ables. Changes in their relationship to each other provide the framework for analyzing booms and depressions, inflation and unemployment, eco- nomic growth and stagnation. Remember them, and the simple little model we have just de- veloped. For it underlies all the more complex, detailed analysis that follows.