Long-run aggregate supply

LRAS: total amount of goods and sevices produced by all firms in an economy, when the costs of the FoPs are variable.

Assumption: workers will demand higher wages or accept lower wages to match changes in the APL.

Increase in APL = increase in revenue per unit LR (workers demand higher wages) Increase in profit = Increase in income

Decrease in APL = decrease in revenue per unit LR (workers accept lower wages) Decrease in profit = decrease in income

This means that profit per unit is unchanged and firms keep output the same.

Classical economic viewpoint: if there is no minimum wage, benefits etc, wages will always adjust so output will never reduce and nobody who wants to work will be unemployed.

Yf: Full employment level of output (potential output) that the economy pproduces when all available FoPs are used efficiently.

Keynesian aggregate suppply

Assumption:

  • increase in APL = increase in wages - as workers demand pay rises

  • decrease in APL = ‘wage stickiness’ - some factors that make workers unwilling ( benefits, trade unions, contracts) / unable (minimum wage) to accept lower wages.

Increase in APL = increase in revenue per unit Increase in wages = increase in costs per unit Profit per unit unchanged Firms keep output the same

Decrease in APL = decrease in revenue per unit Wage stickiness = costs per unit unchanged Decrease in profit per unit Firms produce less output Wage stickiness may force firms to fire some workers, reducing output below Yf.

Shifts in Yf:

Yf: all available resources are used efficiently

Yf shifts if there is an increase in quantity of the FoPs

  • Immigration: increase quantity of labour

  • Increase in participants in the labour force: increase in quantity of labour

  • Any investment: increase in quantity of capital

  • Increase in infranstructure (capital provided by the government that is necessary for economic activity) : increase in quantity of capital

If there is an increase in quality of FoPs

  • Education/ training : increase in quality of labour

  • Healthcare: increase in quality of labour

  • Technology: increase in quality of capital

Deflationary gap: occurs when the economy’s actual output is below its potential output. We want to avoid a deflationary gap, as it is associated with higher unemployment. Solution (for LRAS) - wait; unemployed workers accept lower wages → increase in SRAS → gap closed. Solution (for Keynesian AS) - government intervenes to increase AD (e.g. increase in G). Equilibrium (AD1=AS) is at Yf → gap is closed.

Inflationary gap: occurs when the economy’s actual output is above its potential output. We want to avoid an inflationary gap, as it is associated with high inflation. Solution - return to Yf before workers start demanding higher wages → this will cause an increase in APL. Intervention to decrease AD → increase in interest rate → decrease in C and I.