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Aggregate Demand and Supply

Effects of Changes in Aggregate Supply

Cost Push Inflation (Decrease in Aggregate Supply)

Cost push inflation is where the aggregate supply of an economy has decreased shown from the movement in the aggregate supply curve from AS1 to AS2. 

Sources of a decrease in aggregate supply could be from:

  • Lower productivity levels

  • Rise in anti-competitive behaviour (eg formation of cartels or price fixing)

  • Protectionist measures which will increasing the cost of inputs

  • Increase in wages (eg from a higher minimum wage or inefficient labour economic policies)

  • Inefficient investment in infrastructure causing bottlenecks and shortages

  • Higher levels of tax and complexity of taxation - which could increase cost of production and lower future investment

This position is not ideal in the economy as it results in:

  • Higher price levels - conflicts with objective of price stability

  • Lower economic growth - conflicts with objective of sustainable economic growth

  • Higher cyclical unemployment (from lower economic growth) - conflicts with the objective of full employment

In addition, Government policy options are also limited: 

  • RBA could increase cash rate to reduce inflationary pressure but this will lower real GDP further

  • Government could impose a larger deficit to increase economic growth but this will also stimulate further increases in price level

An appropriate Government policy response would be to increase aggregate supply through microeconomic reform and promoting productivity. (More details in productivity section)

Increase in Aggregate Supply

An increase in aggregate supply is ideal for the economy. 

Sources for an increase in aggregate supply could be from:

  • Lower wage costs (lower minimum wage or more flexible wage arrangements)

  • Increased market efficiency (from market reform such as privatisation)

  • Increased productivity

  • Increased and more efficient infrastructure

  • Simple and low taxation rates

An increase in aggregate supply from AS1 to AS2 is beneficial towards an economy as it:

  • Reduces price levels from P1 to P2 - meeting the objective of price stability

  • Increases economic growth - meeting the objective of sustainable economic growth

  • Lowers unemployment - meeting the objective of full employment

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