Download Classical Long Run Aggregate Supply

Aggregate Supply
Aggregate Supply
 The relationship between the price level
in the economy and the level of total
output.
 So now the question is: How much can
the economy produce, not buy.
Short term and long term
 Short term – at least one factor of production is
fixed
 Long term – all factors of production are
variable.
Supply curve in an
individual industry
Do you get the same shape
for aggregate supply?
 In the short run, yes
What causes shifts in the
short run aggregate supply
curve
 1. Changes in wage rates
 2. Changes in the cost of raw materials.
Commodities.
 3. Taxation
 These come up a lot on 4 point
questionss.
 If it is not one of these factors, it is long
run supply.
Supply Side Shock
 A large change in wage rates, raw
material prices or taxation.
 This can have an effect on short run
aggregate supply by pushing the supply
curve upwards and to the left.
Long run aggregate supply
curve
 Firms face limitations in acquiring the land,
labour, capital and enterprise they need.
 There are only so many computer
programmers available to work for your IT
company.
 There is a limit to the amount of mahonagy you
can get your hands on to continue making
expensive furniture
So, Long Run Aggregate
Supply Curve is Vertical or
Fixed
It is similar to the PPF.
What does the LRAS
show?
 Production Possibility Frontier of an
economy.
 It can show an output gap (be careful
looking at the output gap diagram)
 Shows an economy at full capacity
Output Gap
 An economic measure of the difference
between the actual output of an economy
and the output it could achieve when it is
most efficient, or at full capacity. There
are two types of output gaps: positive
and negative. A positive output gap
occurs when actual output is more than
the full-capacity output. Negative output
gap occurs when actual output is less
than full-capacity output.
Negative Output Gap
 A negative output gap can be followed by
a relatively elastic aggregate supply. This
is because the economy is operating
under a spare capacity.
Shifts in LRAS
 Improvements in education
 Technological advancement (assembly line
automation has resulted in far greater
production than before
 Wise investment in capital equipment.
 LRAS will shift for basically the same reasons a
PPF will shift.
LRAS Shifts continued
 The invention of the air conditioner has
shifted the LRAS of southern American
states outwards, some would say at the
expense of the northern industrial belt.
 Good industrial relations
 Pro-business government policy
 Saudi Arabia’s LRAS could shift right if
half their workforce were allowed to work
outside the home.
Classical LRAS
 What effect does
loose fiscal and
monetary policy have
on the economy
according to the
Classical
Economists.
Classical Thinking
 Loose fiscal and
monetary policy only
have the effect of
increasing prices.
Real output in the
long run stays the
same.
Classical Long Run
Aggregate Supply
 No matter how low
the price level – the
productive possibility
of the economy
remains the same.
Classical Long Run
Aggregate Supply
 Is that realistic?
Unemployment in the US
Unemployment in the US
Simple economics
 If there is an excess supply of labour, it is
very simple, cut the wages – and the
demand for labour will go up again.
Labour is basically the same as oranges,
foot massages or plane tickets.
However.....
However, not everyone
thinks that the LRAS curve is
vertical.
 Guess who this is?
 Labour markets don’t
clear, or find a new
equilibrium, as easily
as Classical
Economists would
have us believe.
 The economy is not flexible enough to
provide full continuous employment.
 When downward pressure is put on
wages, the Price Elasticity of Demand of
labour is inelastic.
Or putting it more easily.
 Wages are sticky downwards.
 Markets could set at a long run
disequilibrium.
Why are wages sticky
downwards?
 There may be a national minimum wage
which sets price floors.
 There may be limited mobility of labour.
Why are wages sticky
downwards?
 1. Trade Unions may fight to keep higher
price levels.
 2. Managers may not treat labour like
steel or oranges, and will not necessarily
pay less and hire more workers in times
of high unemployment.
 This might demotivate the staff.
Keynes’ LRAS curve
 In between Y1 and Y2, labour is
becoming scarce enough for an increase
in the demand for labour to push up
wages. This then leads to a higher price
level. The nearer output gets to Y2, the
full employment level of the output, the
greater the effect of an increase in
demand for labour on wages and
therefore price level.
Classical Economists
 Classical economists have argued that
the economy always converges rapidly
on an equilibrium at the natural rate of
output, implying that policies affecting
aggregate demand have an impact on
prices only, leaving real output
unnaffected. Aggregate supply remains
vertical.
Keynsian View
 The Keynsian view is that the economy
may settle at an equilibrium that is below
full employment, and there is some range
where aggregate supply shifts upwards.
 Analyse the impact of a rise in the price
of oil on the national economic output
and price level. Use a diagram in your
answer.
 Analyse the impact of increased
spending on university education by the
government on the national economic
output and price level. Use a diagram in
your answer.