Alternative Views of Aggregate Supply (AS) (DP IB Economics)
Revision Note
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
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
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
A relatively price elastic section in which firms are starting to bid with each other for available resources. Price levels begin to rise
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
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
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
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 Tip
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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