Question

The short run aggregate supply curve was constructed assuming that as the price of outputs increases, the price of inputs stays the same. How would an increase in the prices of important inputs, like energy, affect aggregate supply?

Short answer

An increase in the prices of important inputs, like energy, can negatively impact the short run aggregate supply curve by causing it to shift to the left. This occurs as firms are willing to produce fewer goods and services at any given price level due to increased production costs. In turn, this can lead to higher inflation and lower real GDP, potentially resulting in a recession in the overall economy.

Step-by-step solution

1. Understanding Aggregate Supply Curve

The aggregate supply curve is a graphical representation of the relationship between the overall price level in the economy and the total output (real GDP) that firms are willing to produce. In the short run, the aggregate supply curve is upward sloping, which means that as the price of outputs increases, the quantity of output that firms are willing to produce also increases.

2. Short Run Aggregate Supply Curve Assumptions

The upward slope of the short run aggregate supply curve is based on the assumption that only the price of outputs changes while the price of inputs remains fixed. This allows firms to increase their output and profits as the price level rises.

3. Increase in the prices of important inputs

An increase in the prices of important inputs such as energy can affect the aggregate supply curve. If the cost of energy increases, it implies that the cost of production for firms also increases. This could lead to a reduction in their profit margins since a larger share of the revenue generated from the sale of their products will go towards covering the increased production costs.

4. Effect on the Aggregate Supply Curve

When the prices of important inputs like energy increase, it is likely to cause the short run aggregate supply curve to shift to the left. This means that at any given price level, firms are now willing to produce fewer goods and services as their production costs have increased.

5. Overall Impact on the Economy

An increase in the prices of important inputs, like energy, can result in a decrease in aggregate supply. This affects the overall economy and can lead to a higher overall price level (inflation) and lower real GDP, as firms produce less due to increased production costs. Moreover, if the decrease in aggregate supply is significant, it could lead to a recession in the economy. In conclusion, an increase in the prices of important inputs, like energy, can have a detrimental effect on the aggregate supply curve and the overall economy. It can lead to a leftward shift in the short run aggregate supply curve, resulting in higher inflation and lower output.