4.10.6 - Determinants of LRAS Flashcards
What is the LRAS influenced by?
The economy’s production potential. (not the price level)
What is the normal capacity level of output?
The level of output at which the full production potential of the economy is being used.
What is the position of the LRAS curve determined by?
- State of techincal progress
- Quantities of FoP in the economy
- Mobility of FoP (particularly labour)
- Productivity of FoP
- Personal enterprise
- Appropriate economic incentives
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What is happening in this graph? How is this happening?
The economy is temporarily producing a level of real output higher than the ‘normal capacity’ level of output.
An increase in AD from AD 1 to AD2 will bring about a new short-run macroeconomic equilibrium at point Y. At this new equilibrium, real output has risen to Y2, above the ‘normal capacity’ level of output.
This level of output cannot be sustained unless the LRAS shifts rightward. This is due to money wages determining the position of an SRAS curve. At Y2, there are shortages of labour and other FoPs and therefore excess demand in the labour market and other factor markets leading to rising factor prices to reduce excess demand. To persuade workers to work, money wages must rise as the price level has risen to P2. Once this happens, SRAS falls back to SRAS 2. All that has happened are price levels rising from P1 to P3, with no increase in real national output resulting in inflation.
What are the two theories for the LRAS curve?
- The vertical LRAS curve
- The ‘inverted L-shape’ LRAS curve
Who theorised the inverted L-shape LRAS curve?
John Maynard Keynes.
What was Keynes’ rationale for the inverted L-shape LRAS curve?
Wages are ‘sticky downwards’. (i.e. at the vertical and upward turning section) Employees will not accept lower wages just because unemployment is lower. As a result, the economy can settle in equilibrium in the long-run below the level of full employment.
Alongside this, at low levels of output, (i.e. the horizontal section) it is possible to expand output without putting any upward pressure on the price level whatsoever.
