Aggregate Supply Views Summary LRAS economics

neoclassical model of LRAS

1. Neoclassical Model of LRAS and Long run equilibrium What key principles are the neo-classical perspectives for LRAS and long-run equilibrium based on? Why is the LRAS curve vertical? Using diagrams explain the short-run equilibrium positions in relation to the long run. What assumption allows the economy to automatically correct iteself and return to the long run equilibrium level of output? Outline what the long run equilibrium says about the level of unemployment. Example Paper 1 question Using a diagram, explain why inflationary gaps cannont persist in the long run according to the neo-classical perspective.

2. Neo-classical perspective Stable and self-regulating system Automatic tendency towards LR equilibrium (Yfe/NRU) Role of government is unnecessary to fix short-term fluctuations Government should promote competitive markets (limit intervention) and keep markets free of potential barriers to their efficient operation Government should look to influence supply side of the economy (+ rGDP w/o causing inflation)

3. AS and equilibrium in the Keyneisan model What did Keynes question about the classical economists view of the economic system? Describe what it means to “get stuck in the short run”? Does Keynes suggest that wages and prices can never fall? What are some conclusions that the Keynesian model arrives at that are different from the neo-classical model? Using a real life example, explain movement through the three equilibrium states of the economy using the Keynesian model. Are policy recommendations different when looking at the two models and managing macroeconomic objectives? Example Paper 1 question Explain what is means for the shape of the AS curve if wages and prices are inflexible in the downward direction.

4. Introduction to Keynes AS

5. Role of the Gov’t – Neoclassical Promoting competitive and efficient market operations D eregulation Reduce power of labour unions/min wage Free trade Reduce welfare/EI benefits Privatisation

6. Keynesian AS 6 Segment 1: Spare capacity in the economy, LRAS perfectly elastic

7. Keynesian AS 7 Segment 1: Spare capacity in the economy, LRAS perfectly elastic Segment 3: Economy at maximum capacity LRAS perfectly inelastic Real GDP reaches a level beyond which it cannot increase anymore; and at this point the price level rises very rapidly Why can real GDP no longer increase? The reason is that firms are no using the maximum amount of labour and all other resources that are available in the economy. GDP can no longer increase; firm efforts only give rise to greater increases in the price level Spare capacity Real GDP is low Price level is constant as GDP increases Lots of unemployment of resources Ease of employing labour and other unemployed resources without worry of increase in wages and other resource prices Spare capacity utilized FOPs prices rise Real GDP continues to increase AS curve begins to rise Real GDP increase are accompanied with increases in price level As output increases, so does employment of resources, and eventually bottlenecks in resources supplies begin to appear Firms are forced to use less and less efficient resources driving up the cost of production per unit, leading to an increase in prices

8. Keynesian perspective Unstable system (s-term fluctuations) w/o automatic correction Fluctuations arise mainly due to changes in AD (C, I) Investment – main cause of fluctuations Role of government is necessary to fix s-term fluctuations Many factors presenting market forces from self-correcting Government should focus on policies to influence AD Keynesians place a greater role for expansionary fiscal policy (government intervention) to overcome a recession

9. Keynesian AS Spare capacity + unemployment of resources allows rGDP to increase with constant price levels in Section 1 In Section 2 , as output continues to increase bottlenecks in resources start to present themselves as the spare capacity is diminished (increase in costs of production) Firms will only increase their output if it can be sold for higher prices (profitability)

10. Keynesian AS At rGDP output of Yp, NRU = unemployment rGDP can surpass Yp until Section 3 (Ymax) In Section 3 , AS is vertical and any increase in rGDP is only inflationary (price level rises rapidly) -> max. employment of labour and other resources in the economy

11. Three Equilibrium States of the Keynesian AS Model

12. Keynesian AS 12 Keynes argued that as there is nothing inherent in the economy to move the SR into the LR, then SRAS = LRAS Recessionary gaps can occur for long periods of time – inability of wages/prices to fall + insufficient AD Keynesian lacks the neo-classical long run analysis as the economy does not shift towards full employment equilibrium

13. AS Views – Special Notes 13 In diagrams taking a Keynesian you may see the AS curve labeled Keynesian AS -Potential Output and NRU are monetarist concepts -Inflationary/Deflationary gaps are Keynesian concepts

14. Keynesian vs Neo-classical models summary Neo-classical economics emphasizes the fact that free markets lead to an efficient outcome and are self-regulating. In macroeconomics, neo-classical economics assumes the long run aggregate supply curve is inelastic; therefore any deviation from full employment will only be temporary. The neo-classical model stresses the importance of limiting government intervention and striving to keep markets free of potential barriers to their efficient operation. Keynesians argue that the economy can be below full capacity for a considerable time due to imperfect markets ( labour ) Keynesians place a greater role for expansionary fiscal policy (government intervention) to overcome recession.

15. Changes in the long-run AS How can potential output change? What does a shift of the LRAS represent? What factors cause economic growth in the context of the PPC? How can the LRAS shift to the right? How can continued growth occur? 15

16. Key points about LRAS shifts Rightward shifts of the LRAS curve illustrate an increase in potential output and economic growth. They result from similar factors that cause economic growth in the PPC. The LRAS curve can shift to the right as a result of increases in efficiency and reductions in the LRAS. Over extended periods of time, rightward shifts of the LRAS curve depend upon increases in the economy’s production possibilities, which may arise from increases in FOP, improvements in quality of FOP and technological improvements. ** Note the difference in SRAS curve shifts that don’t have a lasting impact on real GDP produced. 16

17. Test Your Understanding Illustrate with a diagram the following impacts: There is a widespread introduction of a new technology that increases labour productivity The government provides training programmes for workers to retrain and improve their skills A developing country receives large amounts of foreign aid, which allows it to purchase a large quantity of capital goods An extensive nationwide public health campaign undertaken by the government improves levels of health of the population The government introduces anti-monopoly legislation, reducing the monopoly power of firms and increasing the economy’s productive efficiency 17

18. Sticky Wages and Prices Both wages and prices are unlikely to fall even if the economy is in a recessionary gap, and even if the recessionary gap persists over long periods of time. Why the wage and price downward inflexibility? Min Wage Unions Contracts Reduction in profits (firms) Price wars 18

19. Getting Stuck in the Short Run In the Keynesian Perspective, inflexible wages and prices mean that the economy cannot move into the long run. Inflexible wages and prices are shown graphically by a horizontal segment of the Keynesian supply AS curve. Keynesians do not suggest that wages/prices never fall Long lasting recessions would be very costly in terms of unemployment, low incomes and lost output Requirement of government intervention 19

20. Natural Rate of Unemployment Unemployment that occurs when the economy is producing at its potential or full employment level of output (real GDP), and is equal to the sum of frictional, structural, and seasonal unemployment. 20

21. Economic Growth: Improved Quantity & Quality of FOPs 21

22. Test Your Understanding Explain what it means for the shape of the AS curve if wages and prices are inflexible in the downward direction. Can the economy move into the long run? Draw a diagram of Keynesian AS curve and label and explain the three segments and their relationship with real GDP and price level. Using the Keynesian perspective and diagrams, show the 3 s-run equilibrium states of the economy, noting recessionary and inflationary gaps and their relationship to the full employment equilibrium position of the economy. Why can an economy remain in equilibrium position when there is less than full employment for long periods of time in the Keynesian perspective? How would you illustrate economic growth in the Keynesian perspective? 22

23. Impacts on economy’s LRAS and the Keynesian AS curve There is widespread introduction of a new technology that increases labour productivity The government provides training programmes for workers to retain and improve their skills A developing country receives large amounts of foreign aid, which allows it to purchase a large quantity of capital goods An extensive nationwide public health campaign undertaken by the government improves levels of health of the population The government introduces anti-monopoly legislation, reducing the monopoly power of firms and increasing the economy’s productive efficiency

24. Test Your Understanding Using diagrams and the concept of potential output, explain the relatinoship between the LRAS and Keynesian AS curves and long term economic growth C an you think of some factors that can affect the SRAS curve but not the LRAS curve? Using diagrams, explain the different between long-term economic growth and short-term economic growth due to economic fluctuations Describe the causes of each How does each potential change/not change in each case?

25. Test Your Understanding Explain why the use of the LRAS curve to account for economic growth leads to the policy implication that governments should focus on policies that try to influence the supply side of the economy. Explain why the use of the Keynesian 3-section AS curve leads to the policy implication that governments should focus on the policies that try to influence the demand side of the economy.