Aggregate Supply

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Aggregate Supply This diagram shows an all-purpose aggregate supply curve that slopes upward from left to right just as the normal supply curve. This time however it is not straight! The curve shows the total output that the economy can produce using available factors of production at a given price level The curve shows that as prices increase firms will increase output Aggregate Supply – The total value of goods and services supplied in the economy

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Aggregate Supply While there is labour to employ, prices will increase only by a small amount as there is plenty of labour available at existing rates We can see this from O to A As the labour market tightens and the required labour becomes scarce wages begin to increase and prices rise (between OA and OB) At some stage the economy reaches full employment and is unable to produce/supply any more goods and services – at OB when the aggregate supply curve becomes vertical. FE

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Aggregate Supply This diagram is sometimes referred to as a Keynesian AS supply The Keynesian view was that wages would remain fairly stable up to full employment and then rise as labour became scarce causing sharp rises in price levels When we talk about Keynesian we mean the views of John Maynard Keynes, a very influential UK economist (1883-1946)

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Aggregate Supply There is an alternative view of aggregate supply – the classical view This view distinguishes between short-run aggregate supply and long-run aggregate supply SRAS = Short Run AS LRAS = Long Run AS

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Aggregate Supply In the short run money wages remain constant and the price of all other factors in the economy remain fixed We assume that in the short run firms can pay their workers overtime to get them to produce more (increase output) This will increase prices but the increase in demand will have a larger effect on output than prices The SRAS is drawn on the assumption that firm’s costs remain the same

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Aggregate Supply in the Short Run This diagram shows shifts of the SRAS Just as we learned before the shifts will be caused by anything that increases the costs of the firm A fall in costs will cause a shift to the right (moRe) - increase in AS An increase in costs will cause a shift to the left (Less) – decrease in AS Factors affecting the SRAS are An increase in wages will increase firm’s costs and shift to the left (less) An increase in the rate of interest will make it more expensive to borrow and reduce SRAS (shift left) A rise in the price of imported raw material will increase firm’s costs (shift left) An increase in corporation tax will increase firm’s costs (shift left) while a fall will decrease costs (shift right)

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Which diagram to draw? There is lots of argument over which to use but you don’t need to worry about that You just use the diagram that is most suitable to illustrate your point Most of the time use the Keynesian curve (use this to illustrate demand pull inflation) When you use this curve draw the Fe dotted line (Full employment) Sometimes you will see this labelled LRAS (it’s the bit at the top of the curve where it straightens that is the long run bit) If you want to illustrate a shift of the SRAS due to changes in costs draw the straight classical curve (use this for cost push inflation) Fe

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Aggregate Supply in the Long Run (LRAS) When all factors of production are fully employed the AS curve become vertical – the productive capacity of the economy is reached Classical economists believe it will become vertical and reach its productive capacity before full employment is reached They reason that there will be some workers who would prefer not to work and stay on benefits rather than work for low wages (voluntarily unemployed) This means that actual output may not reach the economy’s productive capacity (it’s potential output) This level of output where the AS curve becomes vertical is called the natural rate of unemployment and is the normal capacity output for the economy Firm’s are unable to increase output as the economy is on the production possibility boundary Put in diagram 13.6 P155 The LRAS is the equivalent of the PPB

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Factors affecting the LRAS The LRAS can shift over time Factors that influence it are things that either increase the quality or increase the quantity of factors of production An increase in the amount of capital equipment. (could be caused by a lower rate of interest causing an increase in investment that causes a shift in the AD and then in the long run the LRAS Improved technology producing capital equipment that is more productive which increases labour productivity. Anything that increases labour output causes a shift to the right e.g. education and training When the AD curve shifts to the right we get short run growth When the LRAS shifts to the right we get long run growth (much more sustainable growth)

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Factors affecting the LRAS More factors that influence the LRAS Attitudes – and entrepreneurial culture can increase supply of goods and services. Economic incentives will help such as low taxes for individuals that set up firms Policies that persuade a larger proportion of the labour force to work will reduce the natural rate of unemployment (shift right) – reduce income tax, reduce benefits etc Productivity – as said before anything that increases productivity will shift the LRAS to the right . Natural disasters can wipe out capital equipment (shift left)