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IB Economics What is the Aggregate Supply (AS) curve and how can it be influenced? Short Run Aggregate Supply (SRAS) • SRAS is the relationship between real GDP and the price level – SRAS shows how much output the economy can generate in the short term at each price level – A rise in the price level should stimulate an expansion of supply • We hold the following constant: – Wage rates for labour (W) – Other resource prices such as raw material prices and components – Long run potential GDP (see later notes on LRAS) • Changes in aggregate demand cause either a contraction or an expansion along the SRAS curve Short Run Aggregate Supply Curve Price Level SRAS1 P2 P1 Y1 Y2 Real National Output Short Run Aggregate Supply Curve Price Level SRAS1 A rise in the price level will cause an expansion of aggregate supply in the economy P2 Producers are responding to higher prices (driven up by increased demand) P1 Real national output will increase from Y1 to Y2 Y1 Y2 Real National Output Shifts in short run aggregate supply • Changes in unit labour costs (ULCs) – Unit labour costs are defined as wage costs adjusted for the level of productivity • Changes to raw material costs and other components – Fluctuations in the world price of oil, copper, aluminum and other essential inputs in many production processes – These costs might be affected by movements in the exchange rate which cause fluctuations in the prices of imports • Changes to producer taxes and subsidies levied by the government as part of their fiscal policy – Changes in VAT on building materials or duty on fuels Inward Shift in SRAS SRAS2 Price Level SRAS1 P2 Inward shift of SRAS Less output can be supplied at each price level Y2 Y1 RNO How do changes in wages affect the SRAS? Sources: • http://news.bbc.co.uk/2/hi/business/913245.stm | 8th September 2000 • http://news.bbc.co.uk/2/hi/europe/895217.stm | 24th August 2000 How do changes in wages affect the SRAS? Price Level RNO Long Run Aggregate Supply (LRAS) • LRAS is located at potential GDP – it represents a level of real national output in the economy • Potential GDP is assumed to be independent of the price level – The price level is fixed – Technology does not change – All resources are fully employed – The economy is on its production possibilities curve Long Run Aggregate Supply (LRAS) • Changes in potential GDP are brought about by: – Changes in full-employment labour supply available for production (i.e. more people join the labour force) – Changes in the stock of capital inputs – affected by the level of gross capital investment – Changes in the productivity of factor inputs e.g. higher labour productivity or an increase in capital productivity – Advances in the general state of technology • An outward shift of LRAS signifies an increase in long-run potential “full-employment” output Short Run (SRAS) and Long Run Aggregate Supply (LRAS) Price Level LRAS SRAS Short run GDP exceeds potential Potential GDP Yp RNO Short Run (SRAS) and Long Run Aggregate Supply (LRAS) Price Level LRAS SRAS Short run GDP exceeds potential Potential GDP Short run GDP below potential Yp RNO Short Run (SRAS) and Long Run Aggregate Supply (LRAS) Price Level LRAS SRAS Positive output gap Short run GDP exceeds potential Potential GDP Short run GDP below potential Yp RNO Short Run (SRAS) and Long Run Aggregate Supply (LRAS) LRAS Price Level SRAS Positive output gap Short run GDP exceeds potential Negative output gap Potential GDP Short run GDP below potential Yp RNO Macroeconomic equilibrium General Price Level LRAS SRAS AD Yp Real National Output Macroeconomic equilibrium General Price Level LRAS SRAS P1 AD2 AD Yp Y2 Real National Output Inter-relationships between SRAS and LRAS General Price Level LRAS SRAS P1 AD2 AD Yp Y2 Real National Output Inter-relationships between SRAS and LRAS General Price Level LRAS SRAS2 SRAS P2 P1 AD2 AD Yp Y2 Real National Output Inter-relationships between SRAS and LRAS General Price Level LRAS SRAS2 SRAS P2 P1 AD2 AD Yp Y2 Real National Output IB Economics The Keynesian non-linear aggregate supply (LRAS) curve A different way of showing aggregate supply The Keynesian LRAS Curve LRAS Price Level AD2 AD1 Yfe The Keynesian LRAS Curve LRAS Price Level AD6 AD5 AD4 AD3 AD2 AD1 Yfe An Increase in Neo-Classical LRAS with corresponding increases in AD Price Level LAS1 LAS2 LAS3 Ad1 Ad2 Ad3 RNO How does AD/ LRAS relate to PPF? LRAS AD1 AD2 Yfe Market Orientated Supply-Side Policies • Reduction in income taxes • Reduction in corporation taxes • Reduction in trade union power (early 80’s in UK) • Reduction / elimination of minimum wages • Reduction in unemployment benefits • De-regulation & Privatisation TAKE A MOMENT TO EVALUATE: Market orientated policies emphasize the reduced role of the government. Such economic schools of thought (e.g. the view of the IEA) believe that private operation is more efficient and will react quicker than government run organisations. These views are often the basis of political debate. Interventionist Supply-Side Policies • Education and training • Research and development (R&D) • Provision of infrastructure • Improved information TAKE A MOMENT TO EVALUATE: Interventionist policies have significant opportunity costs associated with them. Time lags will mean that the policies are likely only to last in the long run. How does a lack of spending affect the productive capacity? Source: http://news.bbc.co.uk/2/hi/business/4197874.stm 30th August 2005 How does a lack of spending affect the productive capacity? How does increased spending on education affect the LRAS? Source: http://news.bbc.co.uk/2/hi/business/2 029708.stm | 6th June 2002 TAKE A MOMENT TO EVALUATE: Many supply side policies take a long time to come into affect and cost huge sums of money. Think how long it will take for this policy to come into affect and as a policy maker does this mean that you need some short run tools too? Keynes said that “In the long run we are all dead.” I would tend to agree with him. How does increased spending on education affect the LRAS? Tasks Today’s Classwork • Complete student workpoint 17.2 (page 182) • Complete SRQ # 2 (page 185) • Complete SRQ # 3 (page 185) Homework • Plan Essay Question # 1 (Page 185) • Read Essential of Economics 4th Ed., Sloman J. Pages 260 - 264 (available in the library or photocopy)