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

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 (Y_FE) 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 (Y_FE), 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 (Y_FE)
 

Diagram Analysis

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

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

• 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, Y_FE) - 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 (Y_FE) 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 (Y_FE) 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 (Y_FE)

  • 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- Y_FE) and is currently producing less than its potential output
 

Diagram Analysis

• The potential output of this economy is at Y_FE

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

  • A negative output gap exists at  Y_FE - 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 Y_FE  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 - Y_FE) where the economy is currently producing more than its potential output
 

Diagram Analysis

• The potential output of this economy is at Y_FE

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

  • A positive output gap exists at Y₁ - Y_FE

    • 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 Y_FE, but at a higher price level