long run aggregate supply macro – as&ad analysis
TRANSCRIPT
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