Chapter 20 - Aggregate supply and the interaction of aggregate demand and supply Flashcards
How does short run aggregate supply work?
In the short run, firms may have relatively little flexibility to vary their inputs. Money wages are likely to be fixed, and firms will not be able to expand the amount of capital needed in the production process.
Furthermore, raw materials may be in short supply, and firms may find that hiring additional workers brings less additional output than is obtained from existing workers because of the lack of additional machinery. However, at a higher price level firms will want to produce more in order to increase their profits. This suggests that in the short run, aggregate supply may be upward sloping, where SRAS represents short-run aggregate supply.
What must firms take in the short run to maximise profits?
- The state of technology and the effectiveness with which factors are used
- The total supply of factors of production.
How does cost of inputs affect SRAS?
Suppose there is a change in the cost of raw materials. If a key raw material becomes more limited in supply, perhaps because reserves are exhausted, then the prices of inputs will tend to rise, so raising firms’ costs of production. They may then choose to supply less output at any given product price — and the aggregate supply curve will shift to the left.
The price of oil has been subject to significant variations over time. Oil is a key input for many firms, and an increase in the price of oil affects the cost of energy and transport. It also affects the economy in many other ways, as oil is a key input in the production of many fertilisers used in the agricultural sector. The price of oil may therefore have a significant impact on the position of aggregate supply in the short run by affecting the costs faced by firms.
Another key input for firms is labour, so an increase in labour costs will also affect the position of the SRAS.
How does exchange rate affect SRAS?
Where firms rely on imported inputs of raw materials, energy or component parts used in production, a change in the exchange rate could affect aggregate supply by affecting the domestic price of imported inputs, and in turn affecting the costs faced by firms. This could be favourable, of course, depending on the direction in which the exchange rate changes. It could be that the exchange rate rises (appreciates), so reducing the domestic price of imports. Firms may then be prepared to supply more output at any given price.
The exchange rate can change in the short run for a variety of different reasons, so firms may face some quite sudden changes in their costs. One way that firms can guard against this is through the nature of the contracts drawn up with their foreign suppliers, if future prices can be specified in a way that hedges against possible exchange rate fluctuations.
How does government intervention affect SRAS?
There are some forms of government intervention that can affect firms’ costs in the short run. An increase in regulation that forced firms to spend more on health and safety measures would raise costs. An increase in the rate of corporation tax would have similar effects.
How does shifts in the SRAS work?
An increase in costs means that firms will be prepared to supply less output at any given price, so the SRAS curve shifts to the left.
What are neoclassical economists?
Economists who argued that markets would allow the economy to adjust to equilibrium.
What is the Monetarist School?
Group of economists who argued that the economy would always converge on an equilibrium level of output.
What is the natural rate of output?
The long-run equilibrium level of output that corresponds to full employment.
What are the views of aggregate supply?
Early economic thinkers (the so-called ‘classical’ economists such as Adam Smith) argued that prices would adjust to ensure that resources were efficiently allocated in society. As economic theory developed, this idea was adopted by neoclassical economists, who argued that the government should adopt a laissez faire approach to the economy - in other words, the market could be left alone to find its way to equilibrium. Keynes disputed this approach, and it is this disagreement that sparked off a debate about the shape of the long-run aggregate supply curve.
An influential school of macroeconomists, known as the Monetarist School, argued along neoclassical lines that the economy would always converge on an equilibrium level of output that they referred to as the natural rate of output.
The debate developed during the 1970s, and is significant because of the implications for the conduct and effectiveness of policy options. Indeed the monetarists had a major impact on the policies adopted by Margaret Thatcher in the UK and Ronald Reagan in the USA in the 1980s.
Some economists argued, along neoclassical lines, that the economy would always find its way to overall equilibrium, which corresponds to a situation in which the economy is at full employment. Full employment is a situation in which the economy is making full use of its factors of production, and is therefore producing at the full capacity level of output the maximum that the economy could produce.
What is the Keynesian School?
A group of economists who believed that the macroeconomy could settle at an equilibrium that was below full employment.
What are the comparisons between Neoclassical view and Keynesian view?
Neoclassical view:
- LRAS is vertical at the full employment LRAS is upward-sloping for a range of level.
- The economy converges rapidly to full employment.
- Policy intervention is not needed because the economy adjusts rapidly.
- Aggregate supply is not sensitive to the price level.
Keynesian view:
- LRAS is upward-sloping for a range of output below full employment.
- The economy could settle at a level of output below full employment.
- Policy intervention may be needed to move towards full employment.
- Aggregate supply is sensitive to the price level when the economy is below full employment.
How does the quantity of factor inputs cause shifts in the LRAS curve?
As far as labour input is concerned, an increase in the size of the workforce will affect the position of aggregate supply. In practice, the size of the labour force tends to change relatively slowly unless substantial international migration is taking place: for example, the expansion of membership of the EU in May 2004 led to significant migration into the UK.
An increase in the quantity of capital will also have this effect, by increasing the capacity of the economy to produce. However, such an increase requires firms to have undertaken investment activity. In other words, the balance of spending between consumption and investment may affect the position of the aggregate supply curve in future periods.
Demographic changes and migration can also affect the size of the workforce in the long run. The UK and many other advanced economies have been characterised by an ageing population in recent years. As more people live longer into retirement, the working population falls as a proportion of the total, and the LRAS curve may shift to the left. One response to this pattern has been the changes to the retirement age.
Until 2011, the default retirement age in the UK was 65 years, but this was abolished so that those who wished to continue to work beyond 65 could do so. In many developing countries in sub-Saharan Africa, the HIV/AIDS epidemic was especially devastating to people of working age, so reduced the size and effectiveness of the labour force. In-migration can also affect the size of the workforce.
How does the effectiveness with which factor inputs are used cause shifts in the LRAS curve?
The effectiveness with which inputs are utilised is another important influence on the position of the aggregate supply curve. Advances in technology are one route through which inputs can be more effectively utilised. New machinery can improve the efficiency with which other inputs are used, and the development of new materials can also have an impact. Such developments can reduce firms’ costs and increase the amount of aggregate output that can be produced, leading to a shift in the long-run aggregate supply curve.
Labour as a factor of production can also become more effective and productive, and can be seen as a form of human capital. Improvements to education and the provision of skills training can improve the productivity of labour, again leading to a rightward shift of long-run aggregate supply. Training and education may be especially important for an economy that is undergoing structural change, so that workers need to be prepared to move between occupations. Government encouragement or provision of such training can improve the flexibility of the labour market and affect aggregate supply.
How does the effect of a supply shock in the short run cause changes in the macroeconomic equilibrium?
The AD/AS model can also be used to analyse the effects of an external shock that affects aggregate supply. For example, suppose there is an increase in oil prices arising from a disruption to supplies in the Middle East. This raises firms’ costs, and leads to a reduction in aggregate supply. Again, we can examine the likely effects on equilibrium.
Figure 20.12 analyses the short-run situation. The economy begins in equilibrium with output at Y0 and the overall level of prices at P0. The increase in oil prices causes a movement of the aggregate supply curve from SRAS-0 to SRAS-1 with aggregate demand unchanged at AD. After the economy returns to equilibrium, the new output level has fallen to Y1 and the overall price level has increased to P1.
At the time of the first oil price crisis back in 1973-74, the UK government of the day tried to maintain the previous level of real output by stimulating aggregate demand. This had the effect of pushing up the price level, but did not have any noticeable effect on real output. In the long run, the impact of a supply shock would depend upon whether the shock was a temporary or a permanent change. If this change turns out to be permanent, there could be a shift in long-run aggregate supply.
How does shifts of and movements along the AD and AS curves cause changes in the macroeconomic equilibrium?
As in many other circumstances, it is important to be aware of the distinction between shifts of the AD and AS curves, and movements along them. Typically, if a shock affects the position of one of the curves, it will lead to a movement along the other. For example, if the AS curve shifts as a result of a supply shock, the response is a movement along the AD curve, and vice versa. Thus, in trying to analyse the effects of a shock, the first step is to think about whether the shock affects AD or AS, and the second is to analyse whether the shock is positive or negative: that is, which way the relevant curve will shift. The move towards a new equilibrium can then be investigated.
What are the indicators associated with the targets of macroeconomic policy?
- Stability in prices
- Full employment
- Economic growth
- Stability on the balance of payments
- A balanced government budget
- A fair distribution of income
- Safeguarding the environment
How does stability in prices affect changes in AD and AS?
The AD/AS model explains how the equilibrium overall price level for an economy is reached. It also explains how an increase in aggregate demand when the economy is at full employment will result in a higher equilibrium price level, but with no change in the level of real output. If aggregate demand continues to increase, then the price level will continue to rise, and the result is inflation.
How does full employment affect changes in AD and AS?
When the macroeconomy is in equilibrium at a given level of real output, there is an implied level of employment — and hence a level of unemployment. The position of the AD/AS equilibrium therefore determines whether the economy is at full employment. With a neoclassical vertical LRAS curve, the economy always returns rapidly to full employment. However, with a Keynesian interpretation of the AD/AS model it is possible for the macroeconomy to settle in equilibrium below the full employment level. In this situation, a shift in aggregate demand is needed to take the economy back towards full employment.
How does economic growth affect changes in AD and AS?
Long-run economic growth can be seen as a shift to the right of the long-run aggregate supply curve. This may be caused by an increase in the quantity of factors of production available in the economy, or an improvement in the efficiency with which they are utilised. Short-run economic growth in the AD/AS model may be a short-run response to an increase in aggregate demand, which may not be sustainable if it takes the economy temporarily beyond the full employment level. Alternatively, it may be a situation in which the macroeconomy is returning to equilibrium having been positioned below full employment.
