2.3 Aggregate Supply (Macro)

Aggregate supply

The total supply of goods/services produced within an economy at a given price level at a given time.

Short run Aggregate Supply

Shifts in short run AS represents changes in the costs of production on the economy in the short run (immediate effects that will occur due to cost of production increasing).

The distinction between a movement along, and a shift of, the AS curve

SHIFTS of aggregate supply are caused by changes in the COSTS for firms.

Example:

• changes in costs of raw materials and energy

• changes in exchange rates

• changes in tax rates

MOVEMENT ALONG the aggregate supply curve is caused by shifts in AGGREGATE DEMAND

Example:

• Decrease in Consumer Spending (due to inflation etc)

• Government policies ie tariffs

Why would and Aggregate Supply Curve be Upwards Sloping

Firms will increase their short-term costs if they increase their short-term output. (e.g. Overtime)

These short-term costs will then be passed onto the consumer through higher prices.

 

The relationship between short-run AS and long-run AS

• In the short run at least one of the factors of production is fixed, whereas in the long run all factors of production are variable.

• Long run AS (LRAS) deals with the long-term impact on the PRODUCTIVE CAPACITY of the economy. Whereas shifts in short run AS represents changes in the costs of production on the economy in the short run.

Long Run aggregate supply

Long run AS (LRAS) deals with the long-term impact on the PRODUCTIVE CAPACITY of the economy

Keynesian vs Classical Models and Policies

Classical Economics

• Believes free markets work best and naturally lead to efficient outcomes.

• Markets are self-regulating, so the economy will correct itself without intervention.

• Assumes the long-run aggregate supply (LRAS) is inelastic, meaning the economy tends to return to full employment.

• Any unemployment or recession is seen as temporary.

• Argues that government intervention should be limited, as it can distort markets and reduce efficiency.

Keynesian Economics

• Believes markets are imperfect and do not always self-correct quickly.

• Argues the economy can operate below full capacity for a long time, causing persistent unemployment.

• Supports government intervention to stabilise the economy.

• Places strong emphasis on expansionary fiscal policy (higher government spending and/or lower taxes) to boost demand during a recession.

Elastic demand

Means consumers are highly responsive to price changes

Inelastic demand

Means consumers are less responsive to price changes

Classical view of Long Run Aggregate Supply

The Classical view is that Long Run Aggregate Supply (LRAS) is perfectly inelastic. This has important implications.

The classical view suggests that real GDP is determined by supply-side factors (any policy that increases the quality or quantity of factor inputs in a supply side policy) – the level of investment, the level of capital and the productivity of labour

Classical economists suggest that in the long-term, an increase in aggregate demand (faster than growth in LRAS), will just cause inflation and will not increase real GDP

Keynesian view of Long Run Aggregate Supply

The Keynesian view of long-run aggregate supply is different.

They argue that the economy can be below full capacity in the long term. Keynesians argue output can be below full capacity for various reasons:

• Wages are sticky downwards (labour markets don’t clear)

• Negative multiplier effect. Once there is a fall in aggregate demand, this causes others to have less

income and reduce their spending creating a negative knock-on effect.

 

A paradox of thrift. In a recession, people lose confidence and therefore save more. By spending less this causes a further fall in demand.

Keynesians argue greater emphasis on the role of aggregate demand in causing and overcoming a recession.

FACTORS INFLUENCING LONG RUN AGGREGATE SUPPLY

Long-run AS in an economy will be affected by factors that change the quantity or quality of the factors of production; for example:

• Improved education will (in time) increase the quality of labour in the economy and increase LRAS. 

• Immigration would increase the quantity (ignoring any effects on the average quality) of labour in the economy, also leading to an increase in LRAS.

OTHER FACTORS THAT WILL SHIFT LONG RUN AGGREGATE SUPPLY

• technological advances

• changes in relative productivity

• changes in education and skills

• changes in government regulations

• demographic changes and migration

• competition policy