2.3.3 Long-run Aggregate Supply Flashcards
Long Run Aggregate Supply (LRAS)
The total value of goods and services produced in an economy in the long term.
Two types of LRAS
- Classical (developed by Adam Smith).
- Keynesian (developed by Jogn Maynard Keynes).
Factors determing LRAS
- Available land and raw materials
- Quantity and productivity of labour
- Quantity and productivity of capital
- Technological improvements which affect productivity and output.
- The level of entrepreneurship in the economy.
Classical LRAS
The classical LRAS curve shows that LRAS is perfectly inelastic (vertical) at a point of maximum productive capacity (full use of all factors of production).
With the classical model, there may be short-run output gaps in the economy.
- During periods of economic growth, an ‘inflationary gap’ can develop. In the long run, this will self-correct and return to the long run level of output, but at a higher average price level.
- During slowdowns or recessions there can be a ‘recessionary gap’. In the long-run, this will self-correct and return to the long-run level of output, but at a lower average price level.
In the long run, an economy will always return to the full employment level of output.
Keynesian LRAS
The Keynesian view believes the economy can be below the full employment level, even in the long run.
For example, in recession, there is excess saving, leading to a decline in aggregate demand.
Explanation of Keynesian LRAS curve
At low levels of output, aggregate supply is completely elastic (where the curve is horizontal) – this means there is spare capacity in the economy, so output can increase without a rise in the price level.
- For example, if there’s a lot of unemployment in an economy firms will be able to employ more workers and increase output, without increasing price levels.
When the curve begins to slope upwards, this shows that the economy is experiencing problems with supply (known as supply bottlenecks), which are causing increases in costs.
- For example, this might be due to a shortage of labour, or a shortage of certain raw material.
The curve becomes vertical when the economy is at full capacity (Yf) – here, AS is completely inelastic. All resources are being used to their maximum potential and output can’t increase any more.
What is LRAS determined by?
Factors of production– the LRAS curve will shift if there’s a change in the factors of production which affects the capacity of the economy.
What will an improvement in the factors of production do to a keynesian LRAS?
Increase the capacity of the economy, and will shift the LRAS curve to the right, e.g. from LRAS to LRAS1.
This increases output (economic growth) from Yf to Yf1 – the same price level now corresponds to a higher level of output.
Examples of improvements in factors of production (which will shift the AS curve to the right)
- An improvement in education and skills
- Demographic changes
- A supply of new resources
- Improvements in healthcare
- Changes in government regulation
- An increase in competition
- Promoting enterprise
- Increasing factor mobility
What will a deterioration in the factors of production do to LRAS?
It will reduce an economy’s capacity and cause the LRAS curve to shift to the left.
Relationship between LRAS and PPF
They both show the productive capacity in the economy.
Why do economies never operate at full productive capacity?
Because unemployment exists in all economies. (Also there is often unused resources).
This means increasing the capacity to supply in an economy, by things such as:
- Building infrastructure
- Government investments in industry and transport
- Trade opportunities/deals
Why is the Keynesian LRAS curved?
The Classical view believes LRAS is inelasic, whereas the Keynesian view suggests it is elastic at a point up to inelastic.
The Keynesian LRAS shows that there is a point in the economy of spare capacity where firms can use more. There also comes a point where full capacity is reached.
Methods to increase the productive capacity of an economy
- Increasing labour
- Innovation and new technology
- Building new infrastructure
What policies can increasing labour supply? Therefore increasing the productive capacity of an economy
- Increase your labour force, which can be done by bringing in migrant workers.
- Increase the skills of the existing labour force through education and reskilling.
- Social policy change can increase the number of people eligible to work. For example, Saudi Arabia allowing women to work or the Equalities Act 2010 prohibiting discrimination.
Keynes’ beliefs about Aggregate Supply
John Maynard Keynes argued that all economies, in normal times, operate between Y1 and Y2 (on the graph below). Economies operate between these points because the economy is not at its maximum productive capacity (there is unemployment and underutilised resources).
Keynes believed that the government were the only economic agents who could boost employment. For example, US President Franklin D. Roosevelt’s New Deal in the 1930s created significant numbers of jobs after a number of infrastructure projects (including the Hoover Dam and the Golden Gate Bridge).
Keynes argued that all economies needed government intervention to move from point Y1 to Y2 on the graph.
In 2008/2009, US President Barack Obama spent trillions of dollars on infrastructure, in contrast to UK PM Gordon Brown, who bought (partially nationalised) some UK banks to stop them from collapsing.
As an economy approaches its LRAS limit (at point Y2) it becomes harder for it to fully utilise its resources due to logistics, profiteering and “sticky” unemployment – making the AS curve vertical.
