1. What is Aggregate Supply
And what is SRAS and LRAS?

2. Lets recap on Aggregate Supply from last time…..

3. Aggregate Supply
the total volume of goods and services produced within the economy at a given price level
Price Level
Point 1: Changes in the price level, shift the level of real GDP in the economy.
Movement along the curve is simply due to price level changes
We assume these movements along the curve occur when ONLY price level changes
SRAS
Pl 1
Pl 0
Pl2
Real GDP
Y 2
Y 0
Y 1

4. Shifts in Aggregate Supply
SRAS shifts from changes in production costs (labour, raw materials, taxes, subsidies)
Point 2: SRAS curve will SHIFT outwards to the right if any of the following happen:
 wage costs  raw material costs  taxes  productivity  subsidies to firms
FIRMS happy to expand production
Price Level
SRAS
SRAS1
Real GDP

5. Shifts in the SRAS curve
Why do changes in production costs mean a shift in SRAS?
For example, if wage rates are raised by 10%, firms’ costs of production will increase, and many will respond by raising prices, so the average price level will increase
What about productivity?
Productivity means output per unit of input. So labour productivity is output per worker (say per hour). With better technology, or a better educated worker, output per worker will increase. This means cost per unit will fall (same wages, more output)
Any sneaky ones?
How about a fall in the value of the pound – this means imported raw materials will be more expensive.

6. Challenge in groups: SRAS movement or shift and why
Government levies a tax on firms to pay for apprenticeships (Autumn Statement 2015)
Stronger public finances means investors are more optimistic about the UK, and so the pound rises in value
Unemployment falls to 5.4%, leading to faster growth in wages (and why would this happen?)
Increased demand leads to an increase in the general price level
The conflict in the Middle East leads to higher oil prices (and why would this happen)
It is estimated that use of smartphones and tablets has raised productivity by 5% over the last year

7. AD & AS – equilibrium (actual) Real National Output
A shift in one curve causes a movement along the other curve
The same economic event may cause both curves to shift (you need to know which one is the primary shift and which is secondary)
Price Level
Price Level
SRAS
SRAS1
SRAS P1 P1 P
AD1 P AD AD
Real GDP Y Y1
Real GDP Y1 Y

8. Long run aggregate supply
If demand increases, firms will supply more (as long as the average price level increases)
Is there a limit to how much they can supply?
In the long run, it doesn’t matter what the price level is, since firms will run into capacity constraints – workers cannot work overtime for too long, there may be no unemployed workers to hire, all machinery will be fully and efficiently utilised
Therefore the long run aggregate supply must be fixed

9. Long run aggregate supply curve
Price
Level
LRAS
Real Output Yf

10. LRAS also means The LRAS curve is linked to or represents:
Full capacity of the economy. Resources are fully and efficiently utilised
It is possible to produce more than this for a period of time – eg workers working overtime, machinery not being maintained – but not in the long run!
The PPF. The LRAS is the level of output shown on the PPF – where all resources are fully and efficiently utilised
Trend growth (we will look at later)

11. SRAS to LRAS
The vertical long run aggregate supply curve is often referred to as the Classical long run aggregate supply curve
It is based on flexible prices particularly flexible wages, and the idea that markets always work to bring supply and demand into equilibrium
This means that prices in all markets, including the labour market will adjust to bring supply and demand into equilibrium
There can be unemployment in the short run, but this should lead to falling (real) wages, and so unemployment should only be temporary

12. SRAS to LRAS Price Level Real Output P Y Yf LRAS SRAS SRAS1 AD
Let’s say we are at the equilibrium formed by AD = SRAS, so price level P and real output Y. This is less than full employment Yf which is the LRAS
Price
Level
LRAS
SRAS
SRAS1 P AD Y
Real Output Yf

13. Classical LRAS and Unemployment
Price
Level
In the long run we assume the prices of factors of production (eg wages) are flexible, so since there is unemployment, there will be downward pressure on wages. This means firms costs will fall, which means SRAS shifts out, and we reach a long run equilibrium with full employment
LRAS
SRAS
SRAS1 P AD
Yactual
Real Output
Yfull

14. Classical LRAS A similar concept to the PPF…
An increase in long-term potential of the whole economy (doesn’t necessarily mean we will actually grow!)
LRAS1
Price Level
GDP
A similar concept to the PPF…

15. What would shift LRAS outward? (and can it shift inward?)
technological advances
changes in relative productivity
changes in education and skills
changes in government regulations
demographic changes and migration
competition policy
These are all long run changes affecting supply

16. SRAS – in reality it’s probably curved…
When AD is very low, it is easier (cheaper) for firms to expand output (lots of unemployed people and resources) so an increase in AD (AD – AD1)may encourage a larger increase in output with little increase in price level
When AD is very high, it is harder (more expensive) for firms to expand output therefore attempts to meet extra AD (AD2 – AD3) at this stage are likely to be more inflationary as it is harder (more expensive) to have more labour or resources
Price Level
SRAS
AD3
AD2
AD1 AD
Real GDP

17. Keynesian LRAS
If the classical view was correct, unemployment should only be temporary
Yet we have had periods of mass unemployment (1930s depression; Greece & Spain today)
John Maynard Keynes wrote on why this unemployment persisted in his book, ‘The General Theory of Employment, Interest and Money’ in 1936
There are several reasons he believed unemployment can persist, but we look for the moment at just one:
Wages are ‘sticky’, ie they do not fall – or do not fall sufficiently
This may be because of laws such as minimum wages, or legal protection, or because firms do not want to demotivate their workers
This means SRAS will not shift out, and SRAS is effectively the same as the LRAS

18. Keynesian LRAS and unemployment
Keynsians think that unemployment may persist because wages don’t actually drop. So, when there is mass unemployment, output can increase or decrease without having an impact on price level.
LRAS
Price Level
Mass unemployment
Full employment
GDP

19. Classical LRAS & SRAS and inflationary pressure
If AD increases such that the equilibrium is beyond LRAS (beyond max-capacity), firms will have to pay overtime, machines will break from overuse, etc – all of which will increase costs and reduce SRAS back to the LRAS equilibrium, but at a higher price level.
Price Level
LRAS
SRAS 1
SRAS
AD1 AD
GDP

20. Trend Growth
Previously we saw that SRAS could briefly be above LRAS, but that this was unsustainable in the long run.
Production above LR maximum capacity cannot be sustained and producers move the SRAS curve to the left, reducing Real GDP and raising prices
Short term GDP growth above trend is pulled back to trend by rising price level
Trend in growth
Real GDP ->
Short term GDP growth below trend is pulled back to trend by falling price level
Time->

21. Keynesian LRAS and inflationary pressure
AD to AD1 – because of mass unemployment, firms can expand output without putting up prices (lots of extra workers to hire at low wages)
AD2 to AD3 – workers are starting to become more scarce so any increase in output will require paying slightly higher wages, increasing prices a bit
AD4 to AD5 – the economy is at full capacity. Any increase in AD will only lead to increased prices and no extra output.
LRAS
Price Level
AD5
AD4
AD3
AD1
AD2 AD
GDP

22. Movement or shift? Which direction and and why
Curve shift left – tax on firms so less produced at a given price level
£ stronger – imported raw materials are cheaper, SRAS curve shifts right
Wages higher as firms compete for labour (Unemployment is low). SRAS curve shifts left
General price level rises. Huzzah! Firms produce more, to make more profit. Movement along curve.
World worried that future Oil supply will be interrupted, panic buying to secure supplies. As Oil is a raw material firms costs rise – leftwards shift in SRAS curve
Improved productivity (ie more output per worker (or other unit of input)). SRAS shifts right.
Government levies a tax on firms to pay for apprenticeships (Autumn Statement 2015)
Stronger public finances means investors are more optimistic about the UK, and so the pound rises in value
Unemployment falls to 5.4%, leading to faster growth in wages (and why would this happen?)
Increased demand leads to an increase in the general price level
The conflict in the Middle East leads to higher oil prices (and why would this happen)
It is estimated that use of smartphones and tablets has raised productivity by 5% over the last year