ECON2: The National Economy 2.8 Determinants of Long-Run Aggregate Supply How easy is it to increase supply in the long-run? ECON2: The National Economy

The concept of long-run aggregate supply 2.8 What you need to know The concept of long-run aggregate supply The determinants of the long-run aggregate supply curve They Keynesian aggregate supply curve The institutional structure of the economy The role of the banking system in the economy

2.8 You should be able to: Define long-run aggregate supply Explain and analyse the determinants of long-run aggregate supply Illustrate the effects of changes in long-run aggregate supply on a diagram Understand why the long-run aggregate supply curve is assumed to be vertical Understand and explain the Keynesian long-run aggregate supply curve Understand the importance of the institutional structure of the economy Understand and explain the role of the banking system in providing business investment funds

The Difference Between Short and Long-Run Recap. In the short-run, all factors of production are fixed, with the exception of labour which can be hired to cover increases in aggregate demand In the long-run, all factors of production are variable and can be increased over time In effect, long-run aggregate supply represents the maximum possible output an economy can produce as determined by its available land, labour, capital and entrepreneurial resources

The Long-Run Aggregate Supply Curve Price Level This is known as the classical view of long-run aggregate supply. LRAS Y represents the maximum capacity of the economy to produce goods and services i.e. there is full employment and all resources are being used efficiently. P Y Real National Output

Factors Affecting LRAS (1) Long-run aggregate supply can shift when there is a change in the quantity and/or quality of the factors of production Land If additional land for production becomes available, or new primary raw materials are discovered or become available, the productive potential of the economy will improve and LRAS will increase Labour If there is an increase in the size of the labour force, then it might be expected that output will increase If there is an increase in the quality of the labour force e.g. through training and education then efficiency and productivity is enhanced and LRAS will increase If there is improved occupational or geographical mobility of labour this gives firms more flexibility in production

Factors Affecting LRAS (2) Capital An increase in the quantity, quality and productivity of capital will boost LRAS This can often arise from improvements in technology and improved research and development Entrepreneurship Improved incentives to set up new businesses, or invest in the development of new goods and services, can lead to a boost in LRAS And....Government Intervention Governments will often use regulatory frameworks to improve the level of competition in different markets If successful, then greater competition can drive efficiency gains amongst firms as they strive to maximise their profits

Shifts of the LRAS Curve A decrease in the quantity and/or quality of factors of production will shift LRAS from LRAS to LRAS2. Price Level LRAS2 LRAS LRAS1 An increase in the quantity and/or quality of factors of production will shift LRAS from LRAS to LRAS1. P Y2 Y Y1 Real National Output

For each of the following examples, identify the impact on LRAS. Will there be an increase or decrease in LRAS? Impact Increase or Decrease? The government introduces new immigration laws to limit the ability of migrant workers to seek employment in the UK The government introduces tax breaks for companies that invest a portion of their profits in research and development An extra £2bn is made available for education and training The government raises the retirement age to 70 Pressure groups successfully block the development of “fracking” The government invest £1bn to widen broadband coverage

The Keynesian AS Curve The classical view of LRAS suggests that the economy will always produce the maximum that its factor resources will allow Classical economists believe that markets will always function efficiently over the long-run, and so an economy will produce on the outer boundary of its production possibility curve, thus the LRAS curve is vertical, marking a maximum limit of production John Maynard Keynes however, believed that an economy could be in equilibrium below full employment Through his study of The Great Depression of the 1930’s, he concluded that the LRAS curve was upward sloping, and did have a vertical section (like the classical LRAS curve), but at times an economy could settle at a level of output below full employment

The Keynesian AS Diagram LRAS A = Unused capacity Firms can increase output without increasing costs. Price Level C B = Limited spare capacity As the economy nears full employment, firms find it more difficult to attract scarce resources, so prices begin to rise. B A P C = Full capacity There is full employment and all resources are used. FE Real National Output Draw a production possibility diagram to help explain the LRAS curve.

Shifts in the Keynesian LRAS Curve Price Level As per the classical LRAS curve, any change in either the quantity or quality of factors of production will shift LRAS. P FE2 FE FE1 Real National Output

Which LRAS Curve Should You Use? It depends! It is crucial to understand the difference between the short-run and long-run aggregate supply curves, this is a common area of testing on Section A of the ECON2 paper In terms of the long-run, you should have an understanding of both models, as this will allow you to explain and evaluate more fully the impact of economic policy The Keynesian version is arguably more “realistic” in its approach and can often be applied to a range of explanations regarding the behaviour of an economy, but it is worth noting that neither the classical nor Keynesian model are free from problems, and both have a number of assumptions lying behind their theory The crucial point to note is that they are “models” and should be used as such, rather than perfect predictors of how an economy might behave

The Institutional Structure of the Economy Institutions, such as the banks, play an important role in the economy These organisations act as a support mechanism for businesses providing legal, technical or other support They also provide access to financial support that will help businesses to invest This gives businesses the confidence to develop their business plans, helping to increase the productive potential of the economy

The Role of the Banking System The banking system provides the investment funds required for businesses This allows for investment in capital goods such as machinery Increased capital stock will lead to a shift to the right of the LRAS curve A strong banking system is essential in creating the conditions required for investment http://www.bbc.co.uk/news/business-24086650 What happens when the banking system is not “strong”?

Multiple Choice 1 Which one of the following developments is most likely to cause the shift in the long-run aggregate supply curve from LRAS1 to LRAS2? Growth in export markets Improvements in the banking system that increase the funds available for investment An improvement in consumer confidence A sustained increase in government spending on welfare benefits Can you explain your answer? Price Level LRAS1 LRAS2 B Real National Output

the growth of labour productivity interest rates Multiple Choice 2 The shift in the LRAS curve is most likely to have been caused by a fall in the capital stock income tax rates the growth of labour productivity interest rates Can you explain your answer? Price Level LRAS2 LRAS1 A Real National Output

as a source of investment funds for business Multiple Choice 3 A country’s banking system is an important part of the institutional structure of the economy because of its role as a source of investment funds for business in determining the economy's target rate of inflation in managing the country’s balance of payments as a major employer of labour in the economy Can you explain your answer? A

the number of immigrants entering the country the rate of interest Multiple Choice 4 All other things being equal, which one of the following is most likely to cause a simultaneous shift to the right in both an economy’s short-run and long-run aggregate supply curves? An increase in the number of immigrants entering the country the rate of interest the rate of VAT the minimum wage rate Can you explain your answer? A

2.8 You should be able to: Define long-run aggregate supply Explain and analyse the determinants of long-run aggregate supply Illustrate the effects of changes in long-run aggregate supply on a diagram Understand why the long-run aggregate supply curve is assumed to be vertical Understand and explain the Keynesian long-run aggregate supply curve Understand the importance of the institutional structure of the economy Understand and explain the role of the banking system in providing business investment funds