Aggregate Supply Research Paper Starter

Aggregate Supply

(Research Starters)

The conventional "bipolar" view of supply and demand macroeconomics becomes more complex, particularly on the supply side, when a nation enters into an international trade relationship. Nations may, in an effort to bolster their domestic product or enhance their international standing, employ a number of policies to satisfy the needs of their internal infrastructure — under certain conditions, these efforts may prove fruitful (although controversial to foreign parties).

Keywords Aggregate Supply; Currency Devaluation; Foreign Demand; Inflation; International Trade; Most Favored Nation; Tariffs

Economics: Aggregate Supply


The French economist, statesman and author Frederic Bastiat (1801-1850) once said, "By virtue of exchange, one man's prosperity is beneficial to all others" (, 2007). Indeed, international trade is arguably the most integral component of the now-global economy. However, as difficult as it is to fathom, the present era of global networks and international trade among virtually every nation around the world is relatively young in human historical terms. As recently as the pre-World War II era, the world was a much more disjointed place with factions trading selectively with their allies, and others not trading at all. Even more mind-boggling is the fact that these arrangements were made by choice. Trade relationships, if not long-standing (such as those between the US and its allies in Europe), were often established not by diplomatic missions, but through wars and post-war negotiations.

Japan, for example, sought to garner many of its most prized resources through military operations in the 1930s. Its strongest trade ally (until its militaristic leanings became apparent) was the US, through an exclusive, bilateral arrangement made at the end of the Tokugawa era in the late 1860s. After the war and the dismantling of Japan's military machine, the US largely rebuilt nearly every facet of that country. The US, whose economy leapt out of the Depression, gave new fiscal life to the Japanese people, including a military-based consumer demand (thousands of US soldiers and personnel became part of the Japanese economy after the war through the present). The Korean War exacerbated that dependence, as not just American personnel but troops from 15 other nations descended on Japan as a staging area. Japan did not need to proactively establish trade relationships on the international stage — the world came to Japan.

When the Japanese economic engine restarted in the post-war era, the country looked disproportionately inward at using its aggregate supply to satisfy domestic demand, despite the fact that it has long produced high-quality, exportable goods. Japanese policy has been to focus those products on an intrastate basis and maintain strict import restrictions. Their trade imbalances have also reached significant proportions, as that nation, in 2000, maintained foreign reserves of nearly $300 billion (National Economies Encyclopedia, 2007). Since then, international clamoring over opening Japanese markets to foreign imports has achieved some success, but a clear imbalance remains.

Japan's example above is indicative of the intricacies and delicate nature of international trade and of a sort of "tug-of-war" in economics over aggregate supply. As this paper will demonstrate, international trade tends to pull supply in different and often conflicting directions. To maintain supply for both trading partners and domestic consumers, nations may employ a number of policies to satisfy the needs of their internal infrastructure — under certain conditions, these efforts may prove fruitful (although controversial to foreign parties).

Aggregate Supply

Plutarch once recalled a fable of Menenius Agrippa about an attempted mutiny by other human organs against the stomach, which they accused of being "the only idle, uncontributing part in the whole body." Only after they ousted the stomach did the organs realize their mistake, as they were left with the arduous task of generating the large supply their appetites demanded (Bartlett, 2005).

As Plutarch's story of Coriolanus suggests, supply plays an absolutely essential role in any macroeconomy. Aggregate supply, the total sum of goods and services produced by an economic system, is a vital counterbalance to consumer demand. There are a variety of elements that influence supply as it relates to demand. Among these factors are the available labor force, employee salaries, corporate and commercial taxes (and, on the positive side, government subsidies), new technologies and consumer investment (, 2007).

Without a labor force and the ability to pay them, industries cannot meet the needs of the customer. Likewise, if the government applies a disproportionate tax levy on doing business rather than providing tax incentives or exemptions, business may falter. New technologies also play a role, often making the difference between cost-effectiveness and inefficiency. Furthermore, investment, from either a domestic source or from foreign entrepreneurs, help provide vital resources for manufacturers and service providers to meet the demands of consumers. Still another contributing factor is inflation: If consumer incomes are high and product stock cannot meet customer desire to buy, the imbalance can adversely impact manufacturers and service providers by instigating an increase in prices. Put simply, the supply side of a macroeconomy, as it relates to domestic demand, is already sensitive to a variety of potentially beneficial or harmful influences.

Exacerbating the significant draws on supply resources is international trade. When adding interstate relationships to the mix, the supply side is not only subject to the demands of domestic consumers, but to the needs of consumers in partner systems. In trade relations, therefore, supply is fluid and dynamic, subject not only to internal forces but to external elements as well. If one views macroeconomics as a teeter-totter (with supply and demand in opposing seats), trade acts as a force pulling the supply side in a different direction while it contends with its polar counterpart.

Because of the many directions from which supply is pulled in international trade contexts, it is therefore sensitive and reactive. Nowhere in international economics is this statement truer than it is with oil prices. After all, the price of oil affects transportation, heating, manufacturing and countless other industries. It is no wonder that any spike in oil prices causes a ripple effect in an economy. In a study of the 1973-74 energy crisis (and subsequent inflation), one economist echoes the view that "an increase in oil's relative price will cause an adverse shift in the aggregate supply curve that produces a higher price level and lower output" (Darby, 1982). Judging from the impact of oil price spikes on a wide range of industries (as well as the cost of living in any industrialized country) in the early 21st century, this method of thought seems validated.

Are there other factors that can impact aggregate supply in an international trade relationship? Although the oil example provided above, demonstrative of the effectiveness of pricing as a trade mechanism, is a well-established "x-factor" in industry and therefore supply-side economics; it is certainly not alone.


The trade of goods and services between states necessitates the exchange of currency. The translation of currency plays an integral role in a successful trade relationship. Currency exchange rates (and controls thereof) therefore represent significant influences on aggregate supply.

As stated earlier, an imbalance between large quantities of money and short supply creates inflationary circumstances. If private demand for currency exceeds supply (with domestic central banks making up the difference); that currency is said to be overvalued. This element can wreak havoc on trade relationships for a number of reasons.

  • First, as Edna Carew suggests, traders and speculators would be wary of buying currency that is likely to fall (or slough).
  • Second, foreign exporters would be unlikely to make payments using their own currency, as that currency would likely be used to offset the differential between the current exchange rate and the actual value of that currency (Carew, 1988).

After the end of World War I, the issue of overvalued currency remained a latent concern for redeveloping countries (including the industrialized European states). Popular belief, which carried into post-World War II reconstruction efforts as well, held that any policy response that entailed devaluation was a recipe for disaster. "Devaluation raises the domestic prices of imports and of exports …" warned one expert, adding, "[it] will tend to raise the prices of import substitutes, of potential exports, and of intermediate goods required for their production" (Sohmen, 1958).

Nevertheless, devaluation (particularly in light of a currency's overvaluation) remains a viable option for those countries seeking to tighten trade relationships and reemerge from economic malaise and/or collapse. In Latvia, this issue has reached a near boiling point in light of an account deficit of over 25 percent of the country's gross domestic product (GDP). With a heavy reliance on the euro as a borrowing currency, fears abound that any attempt at...

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