Short-Run Aggregate Supply

Picture a firm that signed labor contracts last year at fixed wages. If the price level rises this year, the firm sells its output for more, but it is still paying the same old wage. That gap between higher revenue and unchanged costs makes expanding production temporarily more profitable, so firms hire overtime, run extra shifts, and raise output. This is the sticky wage story: nominal wages, along with many supplier contracts and input prices, adjust slowly because they're set in advance and renegotiated only occasionally. A rising price level outruns these fixed costs in the short run, and that mismatch, not some new desire for profit itself, is what bends SRAS upward. Firms always want more profit, at every price level. What changes along SRAS is the cost side lagging behind the price side.

Push the economy far past full employment and the story shifts. Factories run at capacity, equipment gets overworked, and firms compete for a shrinking pool of available workers. Now squeezing out more output takes ever-larger price increases, so SRAS gets steeper, bending toward vertical. This connects directly to the natural rate of unemployment: SRAS crosses long-run aggregate supply exactly where wages and prices have fully adjusted and the economy sits at its natural rate, with no further sticky-wage advantage left to exploit. Short-run surprises in the price level push output away from that point temporarily; once contracts catch up, output returns to it. This is the hinge for Unit 3's next moves, recessionary and inflationary gaps and the fiscal policy used to close them.