Long-Run Aggregate Supply & the Keynesian AS Model

Question 1

What is the long-run in macroeconomics?

Answer 1

The long run in macroeconomics is the period of time when the prices of all resources (especially wages) are flexible (that is, they change with price level)

Question 2

What is the main characteristic of the LRAS curve according to neo-classical economists?

Answer 2

The long-run aggregate supply curve (LRAS) is vertical at potential GDP (the full employment level of GDP)

Question 3

What is full employment level?

Answer 3

An economy is considered to have full employment when the economy’s unemployment level is equal to the natural rate of unemployment

Question 4

What is the significance of the shape of LRAS curve in neo-classical model?

Answer 4

A vertical LRAS curve mean that in the long run, a change in the price level does not result in any change in the quantity of real GDP produced.

Question 5

Why is the shape of LRAS curve vertical according to neo-classical economists?

Answer 5

According to neo-classical economists, wages are flexible in the long run. So, if:
the price level increases => wages will increase=> higher cost of production for firms => no incentive to produce more than output at full employment
Or, if:
the price levels decrease => wages will decrease => firms will have no incentive to fire workers or produce lower output, and thus output remains at full employment

Question 6

How do Keynesian economists disagree with neo-classical economists?

Answer 6

Keynesian economists argue that an economy would be unable to return to the full-employment level of output on its own due to the downwardly inflexible nature of prices and wages (i.e. sticky prices and wages). This results in firms laying off workers to reduce costs of production.

Question 7

What are the two key features of the Keynes AS model?

Answer 7

1. Economy can remain in recession over long periods of time due to sticky wages
   So if economy is in recession:
   price level decreases => wages remain constant => firms lay off workers => firms produce lower quantity and remains there as wages do not reduce and so output does not increase to full employment level
2. Increase in AD need not cause increase in price level
   As an economy is recovering from a recession, there is excess capacity which allows firms to employ resources without increasing costs of production

Question 8

What are the three sections on the Keynesian AS curve?

Answer 8

Section 1: Horizontal Section (i.e. elastic)
- During a recessionary gap (producing below full employment), there is a lot of spare capacity. Therefore, output can increase without price increasing

Section 2: Upward Sloping; real GDP increases along with an increase in price level
- spare capacity reducing => shortage of labour => increase in labour wages => increase in price level to maintain profits

Section 3: Vertical, indicating GDP reaches a full employment level beyond which it cannot increase anymore

Question 9

What are the 6 factors that change aggregate supply (shifts AS curves) over the long run

Answer 9

1. Increases in quantities of factors of production
   - discovery of new oil reserves, immigration of new workers, etc.
2. Improvements in the quality of factors of production
   - better level of education => more efficient task force
3. Improvements in technology (and other investments in capital goods by firms)
4. Degreee of competition in the economy
5. Degree and quality of government regulation
6. Improved transport infrastructure