2.3.3 Long-Run Aggregate Supply

The long-run aggregate supply (AS) curve

represents the relationship between the total quantity of goods and services that firms in an economy are willing to produce and the price level, assuming that all prices, including nominal wages, are flexible.

Two primary models of the long-run AS curve are the Keynesian and Classical perspectives, each offering distinct insights into how economies operate over time.

Keynesian AS Curve

Shape: The Keynesian AS curve is typically depicted as a backward-L shape.

Horizontal Segment:

At low levels of output and employment, the curve is horizontal. This indicates that firms can increase production without raising prices due to unused capacity and high unemployment.

Upward Sloping Segment:

As the economy approaches full employment, the curve starts to slope upwards, reflecting increasing pressure on wages and prices.

Vertical Segment

At full employment, the curve becomes vertical, indicating that output is at its maximum sustainable level, and any further demand increase will only lead to higher prices.

Key Insights:

Emphasizes the existence of unemployment and idle capacity in the economy.

Suggests that in the short run, output can be increased without causing inflation until full employment is reached.

Government intervention, such as fiscal policy

can help achieve full employment without causing inflation in the short run.

Real-World Example:

The Great Depression of the 1930s. High unemployment and unused capacity meant that increased government spending could boost output without causing inflation.

Classical AS Curve

Shape: The Classical AS curve is vertical at the full-employment level of output.

Reflects the belief that in the long run, the economy is always at full employment due to the flexibility of prices and wages.

Output

is determined by factors such as technology, resources, and institutional structures, not by the price level.

Key Insights:

Assumes that markets clear and that supply creates its own demand (Say's Law).

Long-term output is not affected by changes in the price level.

Suggests that any government intervention is unnecessary and potentially harmful, as the economy self-adjusts to full employment.