Alternative Views of Aggregate Supply (AS) (DP IB Economics)

Revision Note

Steve Vorster

Written by: Steve Vorster

Reviewed by: Jenna Quinn

Monetarist/New Classical View of the Long-run Aggregate Supply (LRAS) Curve

  • Classical and Keynesian economists have different views on the long-run aggregate supply 

  • Classical economists believe that the LRAS is perfectly inelastic (vertical) at a point of full employment (YFE) of all available resources

    • This point corresponds to the maximum possible output on a production possibilities curve (PPC)

  • The classical view believes that in the long-run an economy will always return to this full employment level of output (YFE), and all that will change in the long run will be the average price level

    • During extreme periods of economic growth there can be an inflationary gap that develops

      • 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 that develops

      • In the long-run this will self-correct and return to the long-run level of output, but at a lower average price level

2-3-3-classical-view-of-lras


The Classical View of long-run aggregate supply (LRAS) with a vertical aggregate supply curve at the full employment level of output (YFE)
 

Diagram Analysis

  • Using all available factors of production, the long-term output of this economy (LRAS) occurs at YFE

  • The economy is initially in equilibrium at the intersection of AD1 and LRAS (P1, YFE)

  • A slowdown reduces output from AD1→AD2 and creates a short term recessionary gap

  • This self corrects in the long term and returns the economy to the long-run equilibrium at the intersection of AD2 and LRAS (P2, YFE) - a lower price and back to the full employment level of output

Keynesian View of the AS Curve

  • Keynes believed that the long-run aggregate supply curve (LRAS) was more L shaped, having 3 distinct sections 

  1. An elastic section in which supply is elastic at lower levels of output as there is a lot of spare production capacity in the economy. Struggling firms will increase output without raising prices

  2. A relatively price elastic section in which firms are starting to bid with each other for available resources. Price levels begin to rise

  3. A perfectly inelastic (vertical) section at a point of full employment (YFE) of all available resources. The closer the economy gets to this point the more price inflation will occur as firms compete for scarce resources

3-2-3-keynesian-view-of-as

 The Keynesian View of long-run aggregate supply (LRAS) with a vertical aggregate supply curve at the full employment level of output (YFE) becoming more elastic at lower levels of output
  

Diagram Analysis 

  • The vertical portion of the LRAS curve corresponds to the classical view of LRAS

    • The Keynesian view believes there is a maximum level of possible output

  • The LRAS curve becomes elastic at a certain price level as prices cannot fall further

    • Possibly due to minimum wage laws, the existence of trade unions, or long-term employment contracts preventing wage decreases

  • Real output national equilibrium can occur at any level of output

  • The Keynesian view believes that an economy will not always self-correct and return to the full employment level of output (YFE)

    • It can get stuck at an equilibrium well below the full employment level of output e.g. Great Depression

  • The Keynesian view believes that there is a role for the government to increase its expenditure so as to shift aggregate demand and change the confidence (animal spirits) in the economy

Inflationary & Deflationary Output Gaps

  • An output gap is the difference between the actual level of output (real GDP) and the maximum potential level of output
      

  • An inflationary output gap occurs when the real GDP is greater than the potential real GDP

  • A deflationary (recessionary) output gap occurs when the real GDP is less than the potential real GDP

    • There is spare capacity in the economy to produce more goods/services that are being produced
       

  • It is difficult to measure output gaps accurately

    • This is because it is hard to know exactly what the maximum productive potential of an economy is

    • Rapidly rising prices can indicate a positive gap is developing

    • Rising unemployment and slowdown in economic growth can indicate that a negative gap is increasing

A deflationary (recessionary) output gap

  • A deflationary gap can be illustrated using either a Classical or Keynesian diagram

3-2-3---deflationary-gap
2-5-2-negative-output-gap_2

Keynesian (top) and Classical (bottom) diagrams illustrating an economy that has a deflationary output gap (Y1- YFE) and is currently producing less than its potential output
 

Diagram Analysis

  • The potential output of this economy is at YFE

  • The economy is in a short-run equilibrium at AP1Y1

    • A negative output gap exists at  YFE - Y1

      • This effectively gives the economy additional spare capacity in the short-term

    • One cause of this may be that AD has recently decreased due to a fall in consumption

    • The Classical view is that the output will return to YFE  in the long-run, but at a lower average price level

    • The Keynesian view is that an economy may be stuck in a negative output gap for a long period of time

 

An inflationary output gap

  • An inflationary gap can be illustrated using either a Classical or Keynesian diagram

2-5-2---positive-output-gap

A Classical illustration of an inflationary output gap (Y1 - YFE) where the economy is currently producing more than its potential output
 

Diagram Analysis

  • The potential output of this economy is at YFE

  • The economy is in a short-run equilibrium at AP1Y1

    • A positive output gap exists at Y1 - YFE

      • This economy is producing beyond its capacity in the short-term

    • One cause of this may be that workers are willing to work overtime once full capacity is reached

      • It is not sustainable and the Classical view is that the output will return to YFE, but at a higher price level

Examiner Tips and Tricks

When writing about an inflationary output gap, students often confuse it with the concept of inflation (an increase in the average price level). Output gaps focus on output, not price levels. An inflationary output gap means that the economy is producing beyond its full employment level of output.

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Steve Vorster

Author: Steve Vorster

Expertise: Economics & Business Subject Lead

Steve has taught A Level, GCSE, IGCSE Business and Economics - as well as IBDP Economics and Business Management. He is an IBDP Examiner and IGCSE textbook author. His students regularly achieve 90-100% in their final exams. Steve has been the Assistant Head of Sixth Form for a school in Devon, and Head of Economics at the world's largest International school in Singapore. He loves to create resources which speed up student learning and are easily accessible by all.

Jenna Quinn

Author: Jenna Quinn

Expertise: Head of New Subjects

Jenna studied at Cardiff University before training to become a science teacher at the University of Bath specialising in Biology (although she loves teaching all three sciences at GCSE level!). Teaching is her passion, and with 10 years experience teaching across a wide range of specifications – from GCSE and A Level Biology in the UK to IGCSE and IB Biology internationally – she knows what is required to pass those Biology exams.