Aggregate demand and aggregate supply SBC Economics Aggregate demand and aggregate supply Learning outcome W Define aggregate demand and understand its components Explain what causes AD to shift Define aggregate supply Define the different versions of LRAS Explain what causes AS to shift Explain the interaction of AD and AS in the determination of equilibrium output Draw AD/AS curves to illustrate the shifts in the economy Reading: Units 33 & 34

Aggregate supply Aggregate means total, aggregate supply therefore means the total of all the supply in the economy

Aggregate supply Aggregate supply can be shown as a curve showing the relationship between the price level and the level of real expenditure in the economy Price level is the average prices in the economy, an increase in the price level is known as inflation Real output is equal to real expenditure and real income (O=E=Y)

The aggregate supply curve Price level SRAS P2 P1 O Y1 Y2 Real output

What causes the AS curve to shift? A change in costs would cause the aggregate supply curve to shift An increase in costs would cause the AS curve to shift upwards (SRAS1 to SRAS2) A decrease in costs would cause the AS curve to shift downwards (SRAS1 to SRAS3) Factors that could affect costs include: Wage rates Cost of raw materials Taxation

The aggregate supply curve Price level SRAS2 SRAS1 P2 SRAS3 P1 P3 O Y Real output

Classical view of long run aggregate supply In the long run there is a limit as to how much firms can increase their supply Firms face limits on the amount of labour that can be hired, labour productivity is maximised and capital equipment is fixed in supply It is argued that in the long run aggregate supply is fixed at a given level of output, whatever the price level This means the LRAS curve is drawn as a vertical line

Classical view of long run aggregate supply LRAS Price level O Y Real output

What causes the classical LRAS curve to shift? An economy operating on the LRAS curve is at its’ maximum potential output i.e. on the edge on the production possibility frontier Economic growth therefore will increase the potential output of the economy and the LRAS curve will shift to the right (outwards) LRAS1 to LRAS2 A fall in potential output however would cause the LRAS curve to shift to the left (inwards) LRAS1 to LRAS3

Shifts in the classical LRAS curve Price level O Y3 Y1 Y2 Real output

Keynesian view of the long run aggregate supply curve Keynesian economists disagree with the classical view that in the labour market will clear They argue that even if there is unemployment there will be not be a fall in real wages When there is mass unemployment the LRAS curve will be horizontal because output can be increased without experiencing an increase in costs (O to A) When the economy nears full employment the LRAS curve will be upward sloping as workers will be able to negotiate higher pay and therefore increase costs to the firm (A to B) At full employment firms will not be able to take on more labour whatever they pay, therefore the LRAS curve is vertical (B)

Keynesian view of long run aggregate supply LRAS Price level Mass unemployment Full employment O A B Real output