Long Run Aggregate Supply

MACRO – AS&AD Analysis

• The maximum potential output of the economy (with given resources and technology) is known as the ‘full employment’ level of output

• All resources are being fully utilised (although there will still be ‘natural unemployment’- structural, seasonal and frictional unemployment- more on this later..)

• We show this using the LRAS curve

The Neo- classical LRAS

• Neo- classical economist believe that in the long- run the economy will operate at the full employment level of output (Yfe).

• They believe that free- market forces result in an optimal allocation of resources.

• In the short- run the economy may be operating above or below full capacity, but this will result in changes in prices in factor markets (eg. labour) and eventually output will return to full employment…

• The concept of wage and price flexibility is key to this model as is the idea that people do not suffer from ‘money illusion’ (i.e. they are fully aware of price and wage changes)

Price Level

Real National Output (Y)

LRAS

AD1

AD2

SRAS1

PL1

Yfe

In the short-run a rise in AD will temporarily result in output being above Yfe.This results in a rise in the PL from PL1 to PL2The difference between actual and potential output here is called an inflationary gapAs higher prices feed through to the economy (eg. Higher wages) the SRAS curve shifts to the left returning the economy to Yfe

Y1

SRAS2

PL2

PL3

Price Level

Real National Output (Y)

LRAS

AD2

AD1

SRAS2

PL3

Yfe

In the short-run a fall in AD will temporarily result in output being below Yfe.This results in a fall in the PL from PL1 to PL2The difference between actual and potential output here is called a deflationary/ recessionary gapAs lower prices feed through to the economy (eg. lower wages) the SRAS curve shifts to the right returning the economy to Yfe

Y2

SRAS1

PL2

PL1

• Neo- classical economists therefore believe that any change in AD will only have a temporary effect on the level of output and employment

• Therefore when there is a fall in AD, no government intervention is needed.• In fact they believe that government intervention in the economy usually

hinders economic activity• Without minimum wages or laws making it difficult or expensive for firms to

reduce wages or fire and hire workers, firms faced with falling demand will simply lower their employees’ wages and reduce the prices of their products to maintain their output.

• If there is no more demand for some products, those firms will shut down and their workers will go to work for firms whose products are still in demand, at whatever wage rate the market is offering.

• Without government intervention, wages and prices rise and fall with the level of demand in the economy, but output remains constant at its full employment level

• Neoclassical economists advocate policies that help markets work eg. reducing trade union power, abolishing minimum wages and unemployment benefits, reducing tax rates… (market- orientated supply side policies)

• The key to long-term stable growth is therefore:• Ensure free markets with no imperfections (through supply-side policies)• Control the growth of the money supply to ensure low inflation

Supply Side Policy and the Neo- Classical LRAS

• Supply-side policies can be used to reduce market imperfections. This should have the effect of increasing the capacity of the economy to produce (the LRAS). If the level of aggregate supply increases then demand will also increase. This will be the only non-inflationary way to get increases in output.

• They may include:• Improving education & training to make the work-force more

occupationally mobile• Reducing the level of benefits to increase the incentive for people to

work• Reducing taxation to encourage enterprise and encourage hard work• Policies to make people more geographically mobile (scrapping rent

controls, simplifying house buying to speed it up, ......)• Reducing the power of trade unions to allow wages to be more

flexible• Getting rid of any capital controls• Removing unnecessary regulations

Shifts of the Neo- Classical LRAS

Price Level

Real National Output (Y)

LRAS1

AD1

P1

Yfe1

LRAS2

P2

Yfe2

Famous Economists?

* Hayek is often associated with Monetarists because of the nature of his views on money supply, but he disagreed with Friedman over many aspects of macroeconomics and methodology. We have classified him as a Monetarist here for simplicity.

Friedrich August von Hayek (1899-1992)

• At the University of Vienna, he earned doctorates in law and political science in 1921 and 1923 respectively, and he also studied philosophy, psychology, and economics

• In 1933 he joined the LSE faculty• In 1932, Hayek suggested that private investment in the public markets was a

better road to wealth and economic coordination in Britain than government spending programs, as argued in a letter he co-signed with Lionel Robbins and others in an exchange of letters with John Maynard Keynes in The Times.[] The global Great Depression formed a crucial backdrop against which Hayek formulated his positions, especially in opposition to the views of Keynes.[

• During depressions, Hayek believed that government could only make things worse by trying to intervene to restore full employment. At any and all times, government’s best action would be to lower taxes, reduce its spending on goods and services, and thereby encourage private entrepreneurs to provide the nation’s households with the output they demand.

John Maynard Keynes (1883-1946)

• John Maynard Keynes was born on 5 June 1883 in Cambridge into a well-to-do academic family. His father was an economist and a philosopher, his mother became the town's first female mayor. He excelled academically at Eton as well as Cambridge University, where he studied mathematics.

• Keynes' best-known work, 'The General Theory of Employment, Interest and Money', was published in 1936, and became a benchmark for future economic thought. It also secured his position as Britain's most influential economist, and with the advent of World War Two, he again worked for the treasury. In 1942, he was made a member of the house of lords.

• During the war years, Keynes played a decisive role in the negotiations that were to shape the post-war international economic order. In 1944, he led the British delegation to the Bretton Woods conference in the United States. At the conference he played a significant part in the planning of the World Bank and the International Monetary Fund. He died on 21 April 1946.

• His view of how the economy operates in the long- run differs significantly from the neo- classical perspective… The crucial difference is that wages and prices are not flexible…

The Keynesian LRAS Curve• In the long- run Keynesian economists believe that the economy

can be operating at a level of output below full- employment• Keynes argued that AD determined the overall level of economic

activity, and that inadequate AD could lead to prolonged periods of high unemployment

• Keynes argued that wages would be 'sticky downwards'. In other words workers would not be happy about taking wage cuts and would resist this. This would mean that wages would not necessarily fall enough to clear the market and unemployment would linger.

• If the private sector was not prepared to spend to boost demand, the government should instead. He advocated the use of demand- side policies (fiscal and monetary policy)

• In response to the view of the neo- classical economists Keynes is famously quoted as stating

• 'In the long-run we are all dead'

Keynesian LRAS

Price

Level

LRAS

YFE

At low levels of economic activity the AS curve is perfectly elastic, lots of spare capacity- producers can expand output without incurring higher costs

As the economy approaches it’s potential output, there is less spare capacity, factors of production are becoming more scarce, which leads to higher prices for factors, this leads to higher costs hence higher prices

When the economy reaches its full capacity (YFE) it is impossible to increase output any further because all factors of production are fully employed, the LRAS becomes perfectly inelastic

Real National Output (Y)

Increases in AD

• Unlike the classical economists, a rise in AD can lead to a rise in real output

• Demand side policies (fiscal and monetary)

• Fiscal- use of taxation and government spending

• Monetary- the manipulation of the money supply or interest rates

Long Run Equilibrium in the Keynesian model

YfeYe

LRAS

AD

Price Level

In the long- run there can be equilibrium at an output level below the full employment level of output. There can be unemployment

Ye to Yfe represents a deflationary gap

Real National Output

SRAS

• Wed 9th May

Quick Quiz

Illustrate the long- run macroeconomic equilibrium in the neoclassical model

Show and explain what happens when there is a rise in AD

Explaining the Keynesian LRAS

Y1 Y2

LRASPrice Level

Real National Output

Yfe

AD1 AD2

PL1

Explaining the Keynesian LRAS

Y1

Y2

LRASPrice Level

Real National Output

Yfe

AD1

AD2

PL1

PL2

Explaining the Keynesian LRAS

PL1

PL2

LRASPrice Level

Real National Output

Yfe

AD1

AD2

Y2

Yfe to Y2 represents an inflationary gap

SRAS2

SRAS1

Long Run Equilibrium in the Keynesian model

Price Level

Real National Output

Explaining the Keynesian LRAS and the Multiplier effect

Y1 Y2

Price Level

Real National Output

AD1 AD2

PL1

AD3

Y3

Handout

• Keynes Vs Hayek