How Does an Increase in Wages Affect Aggregate Supply?

The aggregate supply of an economy is the amount of goods and services produced at a specific price level measured over a specific time. Movements in production costs, which include the costs of labor and raw materials, have an impact on long-term and short-term aggregate supply.

Aggregate supply, along with aggregate demand, measures an economy’s real gross domestic product (GDP). The real GDP is the value of all goods and services produced by an economy in a specific period, adjusted for inflation. Economists measure the real GDP of a current year by using the prices of a predetermined base year. GDP is a measure of economic output and is an indicator of economic growth or economic contraction. Changes in the aggregate supply can help economists determine whether an economy is growing or contracting.

Short-run aggregate supply (SRAS) is the measure of aggregate supply that begins when price levels of goods and services increase but input prices, such as wages and raw materials, remain constant. SRAS ends when input prices increase the same percentage as, or in proportion to, price level increases. When wages increase, the SRAS decreases, and as wages decrease, SRAS increases.

Long-run aggregate supply (LRAS) is the measure of the aggregate real production of goods and services at full-employment levels and when wages are responsive to, or move in conjunction with, price levels. Economists generally characterize full employment as a time when the unemployment rate is 5.5 percent or lower and when the country’s capacity utilization rate is 85 percent or higher. Major determinants on the effect to wages on long-run aggregate supply are the quantity and quality of the labor market.

During times of low unemployment, the overall labor market is small. This often induces employers to offer higher wages to attract the best-qualified applicants. As the quantity of people available for work decreases, LRAS decreases. During times of high unemployment, employers do not necessarily have to offer increased wages to attract the best-qualified applicants, because the labor market is relatively large. As the quantity of people available for work increases, LRAS increases.