Aggregate Supply

What is aggregate supply? AS is the total output that all producers in an economy are willing and able to supply at each price level It is important to distinguish between short run (SRAS) and long run (LRAS) SRAS is when money wage rates are FIXED LRAS is the output supplied assuming money wage rates are variable (but there are two approaches to LRAS)

SRAS Real GDP Price Level P P1 YY1

Causes of shifts in SRAS Wage rates Raw material prices Taxation

Shift left (cost increase) Real GDP Price Level SRAS SRAS1

Shifts of SRAS Sudden, unexpected events such as a sudden rise in the price of oil or a hurricane are sometimes referred to as supply shocks, especially if these are large changes

Long run aggregate supply (LRAS) There are 2 main views on the shape of the LRAS curve Keynesians believes that market failure is a common occurrence, is a serious problem and needs government intervention to improve the workings of the market. New classical economists believe that markets usually work efficiently. They think that government intervention can make a situation worse so should be kept to a minimum. The government should ensure that laws, regulations and institutions operate in such a way as to enable market forces to provide economic agents with sufficient information and incentives.

Keynesian LRAS Keynesians believe that the LRAS supply curve is perfectly elastic at low levels of output, elastic as output rises, inelastic as output approaches full capacity and then perfectly inelastic as full employment of resources is reached. When output is low, forms can purchase more factors of production without raising their prices, so more can be produced without increasing average cost. As output rises, firms start to compete for resources, their prices rise and the cost of production increases. As shortage of resources increase, the LRAS curve becomes increasingly inelastic until the economy is producing its maximum output with all existing resources employed and given technological knowledge.

Keynesian LRAS Real GDP Price Level LRAS

New classical LRAS curve New classical economists believe that the economy will operate at full capacity in the long run, so they think the LRAS curve is a vertical line.

New classical LRAS curve Price Level Real GDP LRAS

Shifts in Keynesian LRAS Real GDP Price Level LRAS A shift can occur if there are changes in the quantity or quality of resources e.g. changes in the size of the labour force, investment, training, education, healthcare and technology LRAS1

Shifts in New classical LRAS curve Price Level Real GDP LRAS LRAS1 A shift can occur if there are changes in the quantity or quality of resources e.g. changes in the size of the labour force, investment, training, education, healthcare and technology

Activity 1 In 2001, while the world’s 500 biggest companies increased their capital expenditure by 17%, the UK’s top 500 companies increased their spending by only 12% a)What effect will an increase in investment have on a country’s i) aggregate demand ii) potential output b)Identify two reasons why the world’s 500 biggest companies might have invested more on percentage terms that the UK’s top 500 biggest companies

Activity 2 Explain what effect the following are likely to have on the SRAS curve; a) An increase in the price of oil b) A rise in wages matched by an increase in productivity c) A fall in corporation tax

Activity 3 In 2001, output in Greece rose by 3.8%, inflation was 3.7% and unemployment was 11.2%. Using this information, draw and decide at which point on a Keynesian LRAS curve Figure 5 appeared to be producing at in 2001