CFA Level 1
Aggregate Output and Economic growth (Part 4)
The Aggregate Supply curve
We can analyse the aggregate supply curve in three time frames the very short run, short run and long run.
In the very short run, in response to Demand firms can change the output without changing the price by making small changes to factors of production like labour and hours for which plant and machinery are used. Therefore in the very short run the supply curve (VSRAS) is perfectly elastic (horizontal line). (Supply is said to be perfectly elastic when it changes even when there is no change in the price.)
In the short run, cost of factors of production will change in response to change in production. In the short run however some input prices do not change with the increase in output. However output prices increase with price level and this causes the firm to further increase output to earn greater profits. Therefore in the short run the supply curve (SRAS) is elastic and upward sloping as more quantity is supplied at higher prices. (Supply is said to be elastic when it adjusts in relation to prices. As a rule more quantity is supplied at higher prices than at lower prices.)
In the long run, all input prices vary in relation to the price level. Therefore in the long run the price level has no effect on the supply and the supply curve (LRAS) is perfectly inelastic in the long run (vertical line) as supply remains the same whatever the price.(Supply is said to be perfectly inelastic when it does not change with the price.)
Diagram depicting the aggregate supply curve:
credit: Schweser CFA notes
Reasons for shift in the aggregate demand curve:
The demand curve shifts when the quantity demanded increases or decreases at every price point. If the quantity demanded increases at every price level the curve shifts upward and to the right. If the quantity demanded decreases at every price level the curve shifts downward and to the left. See the diagram below;
credit: Schweser CFA notes
Some of the reasons for shift in the demand curve are listed below;
1. As wealth with individuals’ increases, saving decreases and spending increases thus increasing demand at all price levels.
2. When income increases it creates a sense of job stability thus leading to less saving and more spending thus increasing demand at all price levels.
3. When an economy follows an expansionary monetary policy there is more money supply. As a result banks have more money to lend which pushes down the interest rates. Low interest rates lead to increase in borrowing by consumers for spending. This increases demand at all price levels.
4. When an economy follows expansionary fiscal policy, i.e. it decreases its fiscal surplus by reducing taxes or increasing government spending, it increases demand as reduction in taxes cause disposable incomes to increase and increase in government spending increases demand at all price levels.
5. A depreciating currency will increase exports and decrease imports thus increasing domestic demand at all price levels.
6. When economies globally do well it increases their import demand which in turn increases your export demand and quantity demanded increases.
For solved examples please refer to the CFA Institute Books, Schweser CFA notes and Schweser Secret Sauce CFA level 1. The problems can be easily solved using the CFA Institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.