3.2 Aggregate supply and macroeconomic equilibrium

using the Keynesian model and diagrams, show the three short-run equilibrium states of the economy, describing recessionary (deflationary) and inflationary gaps and their relationship to the full employment equilibrium position of the economy (potential output)

(a) - the AD curve intersects the AS curve in its horizontal section, determining Ye, which is less than Yp (potential GDP), indicating a deflationary (recessionary) gap w the unemployment greater than the natural rate - AD is too weak to induce firms to produce at Yp (b) - the conomy is producing at Ye, which is greater than Yp and is experiencing an inflationary gap - strong AD, unemployment has fallen below its natural rate, and as the economy approaches its maximum capacity, the price level has increased (c) - the economy has achieved full employment equilibrium, at Yp - if there is an increase in AD, then the outcome will be "purely inflationary"

explain that the AS curve shifts over the long run (new classical LRAS model) or over the long term (Keynesian model) due to • technological improvements

- an improved technology of production means that the FOPs using it can produce more output, and the AS curves shift to the right

explain that the AS curve shifts over the long run (new classical LRAS model) or over the long term (Keynesian model) due to • changes in quality and/or quantity of FOPs

- an increase in the quantity of physcial capital, or the quantity of land (discovery of new oil reserves) means that the economy is capable of producing more real GDP -> LRAS shifts to the right - eg greater level of education, skills or health lead to an improvement in the quality of labour resources - more highly educated workers or healthier workers can produce more output than the same number of unskilled or less healthy workers -> shift the LRAS and AS curves to the right

identify some factors that can affect the SRAS curve but not the LRAS curve

- bad weather conditions that cause a drop in agricultural output -> the SRAS curve shifts to the left for that season, but then moves back to the original position when the weather changes back to normal patterns; the LRAS curve remains unaffected - changes in firms' costs of production, such as changes in wages, or changes in the price of other key inputs (such as oil), may similarly affect only the SRAS curve - applies to temporary changes that do not have a lasting impact on real GDP produced

explain that the AS curve shifts over the long run (new classical LRAS model) or over the long term (Keynesian model) due to • institutional changes

- efficiency in resource use - eg the degree of private ownership as opposed to public ownership of resources, the degree of competition in the economy, the degree and quality of government regulation of private sector activities and the amount of bureaucracy can each affect the quantity of output produced

explain how the Keynesian model differs from the new classical model in its prediction of rising price levels following an increase in AD

- in the monetarist model, increases in AD always result in price level increases - in the short run, as AD shifts to the right causing a movement along an upward-sloping SRAS curve, an increase in real GDP and an increase in the price level result - in the long run, increases in aggregate demand give rise only to incrases in the price level, leaving real GDP unaffected however - in the Keynesian model, when the economy is in the horizontal part of the AS curve, increases in aggregate demand lead to increases in real GDP w/out affecting the price level - it is only when the Keynesian AS curve begins to slope upward, when it is close the the full level of ouput, that further increases in AD begin to result in changes in the price level as well - when the AS curve becomes vertical, increases in AD result in rapid price level increases while leaving real GDP unchanged

using diagrams and the concept of potential output, explain the relationship between long-term economic growth an the LRAS and Keynesian AS curves

- point a in both parts determines full employment equilibrium output, or potential GDP - point b in both parts represents a recessionary gap, which occurs due to low aggregate demand, given by AD2 - point c in both parts represents an inflationary gap, which arises due to strong aggregate demand, given by AD3 - economic growth is illustrated in both parts by the rightward pointing arrows -> in part (a) it is represented by a rightward shift of the LRAS curve; in part (b) by a rightward shift of the Keynesian AS curveI

explain why use of the LRAS curve to account for economic growth leads to the policy implication that governments should focus on policies that try to influence the supply side of the economy

- rapid increases in the price level (or inflation) are undesirable - in the new classsical view, since increases in AD will always lead to increases in the price level, economic policy should focus on policies to achieve long-run growth, wich are based on efforts to shift the LRAS curve to the right

outline what the flat section of the Keynesian AS curve indicates about the relationship between the price level and real GDP

- real GDP is low, and the price level remains constant as real GDP increases

explain why use of the Keynesian three-section AS curve leads to the policy implication that governments should focus on the policies that try to influence the demand side of the economy

- since increases in aggregate demand do not lead to price elvel increases when the economy is in a deflationary gap, policies focusing on increasing AD are not only harmless, but in fact essential in order to both prevent and reduce the size of both deflationary and inflationary gaps

explain that the AS curve shifts over the long run (new classical LRAS model) or over the long term (Keynesian model) due to • changes in efficiency

- when an economy increases its efficiency in production, it makes better use of its scarce resources, and can produce a greater quantity of output -> potential output increases, and the AS curves shift to the right

using the Keynesian model, explain when increase in AD can be expected to lead to increases in the price level (inflation) and when they are unlikely to do so

- when the economy is in the horizontal part of the AS curve, increases in AD lead to increases in real GDP w/out affecting the price level - it is only when the AS curve begins to slope upward, when it is close to the full employment level of ouput, that further increases in aggregate demand begin to resylt in changes in the price level as well - when the AS curve becomes vertical, increases in AD result in rapid price level changes while leaving real GDP unchanged

explain equilibrium in the Keynesian model

According to the Keynesian economists, the equilibrium level of output may occur at different levels. They believe that the economy may be in long-run equilibrium at a level of ouptut below the full employment level of national income. This will be the case if the economy is operating at a level when there is a spare capacity. The equilibrium level of output depends mainly on the level of aggregate demand in the economy.

explain that in the monetarist/ new classical model macroeconomic equilibrium in the long run is determined at full employment (or potential) output

According to the monetarist/new classical perspective, the long-run aggregate supply curve (LRAS) is vertical at the full employment level of output, indicating that in the long run the economy produces potential GDP, which is independent of the price level. Long-run equilibrium occurs when the SRAS and AD curves intersect on the LRAS curve at the level of full employment or potential output.

explain the monetarist/ new classical perspective on the long-run aggregate supply (LRAS) curve

Both perspectives are based on the following key principles: the importnce of the price mechanism in co-ordinating economic activities; the concept of competitive market equilibrium; and thinking about the economy as a harmonious system that automatically tends towards full employment. It examines what happens to aggregate supply when the economy moves in the long run, when all resource prices incl. wages change to match changes in the price level. The long-run relationship between the price level and aggregate output is referred to as long-run aggregate supply (LRAS). The LRAS curve is vertical at potential GDP, Yp, as shown in the Fig. A vertical LRAS curve means that in the long run any change in AD results only in changes in the price level while the quantity of real GDP produced remains the same.

explain the Keynesian perspective of the AS curve

Keynes questioned the classical economists' view of the economic system as a harmoniou system that automatically tends towards full employment, and showed that it is possible for economies to remain in a position of short-run equilibrium for long periods of time

using diagrams explain why inflationary or deflationary gaps (short-term fluctuations) cannot persist in the long run according to the monetarist/ new classical perspective

If the LRAS curve is vertical at potential GDP, it follows that inflationary and deflationary gaps are only short-run phenomena and cannot persist in the long run. As soon as the economy moves into the long run, the gaps disappear, and the economy achieves full employment equilibrium.

explain macroeconomic equilibrium in the short run

In the AD-AS model, the equilibrium level of output occurs where aggregate demand intersects aggregate supply. Short-run equilibrium is given by the point of intersection of the AD and SRAS curves, and determines the price level, the level of real GDP and the level of employment. This is shown in the FIg. where Ple is the equilibrium price level and Ye is the equilibrium level of real GDP. At any price level and real GDP other tan Ple and Ye, the economy is in disequilibrium.

explain what it means for the shape of the AS curve if wages and prices are inflexible in the downward direction

In the Keynesian model, inflexible wages and prices in the downward direction mean that the economy cannot move into the long run when experiencing a deflationary gap. Inflexible wages and prices are shown graphsically by a horizontal section of the Keynesian aggregate supply (AS) curve.

explain how in the monetarist/ new classical perspective the economy automatically adjusts to full employment output

In the monetarist/new classical perspective, recessionary and inflationary gaps are eliminated in the long run. This ensures that in the long run the LRAS curve is vertical at the level of potential GDP. The economy has a built-in tendency towards full employment equilibrium. In the monetarist/new classical perspective, changes in aggregate demand can have an influence on real GDP only in the short run; in the long run, the only impact of a change in aggregate demand is to change the price level, having no impact on real GDP, as this remains constant at the level of potential or full employment output. The assumption of wage and price flexibility in the long run has allowed the economy ot automatically come back to its long-run equilibrium level of ouput.

outline what the horizontal section of the AS curve tells us about spare capacity in the economy

Phase 1 - the aggregate supply curve will be perfectly elastic at low levels of economic activity - producers in the economy can raise their level of output w/out incurring higher average costs bc of the existence of "spare capacity" in the economy - there are high levels of unused factors such as unemployed labour and underutilized capital

outline what the upward-sloping section of the Keynesian AS curve indicates about the relationship between the price level and real GDP

Phase 2 - real GDP increases are accompanied by increases in the price level - as output increases, so does employment of resources, and evenutally bottlenckes in resource supplies begin to appear as there is no longer spare capacity in the economy - as the economy approaches its potential output (Yf) and the spare capacity is "used up", the economy's available FOPs become increasingly scarce - as producers continue to increase output, they will have to bid for the increasingly scarce factors - higher prices for the FOPs mean higher costs for the producers, and the price level will rise to compensate for the higher costs

outline what the vertical section of the Keynesian AS curve indicates about the relationship between the price level and real GDP

Phase 3 - the AS curve becomes vertical at Yf, indicating that real GDP reaches a level beyond which it cannot increase anymore - AS is perfectly inelastic - the price level rises very rapidly - real GDP can no longer increase bc firms are using the maximum amount of labour and all other resources in the economy - at this stage output cannot be increased w/out an increase in the quantity or improvement in the quality of the FOPs

explain inflationary and deflationary (recessionary) gaps

Recessionary (deflationary) and inflationary gaps represent short-run equilibrium positions of the economy. A deflationary (recessionary) gap is a situation where real GDP is less than potential GDP (and unemployment is greater than the natural rate of unemployment) due to insufficient aggregate demand. An inflationary gap is a situation where real GDP is greater than potential GDP (and unemployment is smaller than the natural rate unemployment) due to excess aggregate demand. When the economy is at its full employment equilibrium level of GDP, the AD curve intersects the SRAS curve at the level of potential GDP, and there is no deflationary or inflationary gap. This si the economy's full employment level of output, also known as potential output.

outline what the vertical shape of the LRAS curve tells us about the relationship between the price level and real GDP in the long run

Since wages (and other resource prices) are now changing to match output price changes, firms' costs of production remain constant even as the price level changes. Therefore, as the price level increases or decreases, w constant real costs, firms' profits are also constant, and firms no longer have any incentive to increase or decrease their output levels.

explain that when the economy is at long-run equilibrium (full employment equilibrium) unemployment is equal to the natural rate of unemployment

When the economy produces at potential output, we say that the economy is experiencing 'full employment'. While we call this "full employment output' the economy still has unemployed labour and other resources. The unemployment that exists when the economy is producing its full employment output is known as the natural rate of unemployment.

explain shifts of the SRAS curve by reference to changes in the determinants

a rightward shift from SRAS1 to SRAS2 means that short-run aggregate supply increases: for any particular price level, firms produce a larger quantity of real GDP a leftward shift form SRAS1 to SRAS3 means that aggregate supply decreases: for any particular price level, firms produce a smaller quantity of real GDP over short periods of time, the SRAS curve shifts to the left or to the right mainly as a result of factors that influence firms' costs of production (changes in wages, changes in non-labour resource prices and changes in business taxes or subsidies), as well as supply shocks

define the aggregate supply

aggregate supply is the total amount of goods and services that all industries in the economy will produce at every given price level over a particular time period

discuss the differing assumptions of the Keynesian and new classical models

differing assumptions: • automatic self-correction versus persistence of deflationary gaps over long periods of time • increases in aggregate demand need not cause increases in the price level

explain why the short-run aggregate supply curve is upward-sloping

eg in order to produce more, firms will have to provide incentives to workers to produce a larger amount -> done by paying "overtime" wages - marginal and average costs rise as output increases in the short run - an increase in output will be accompanied by an increase in average costs

discuss the implications of the differing assumptions of the two models for the economy and for policy

implications: - according to the new classical model, governments should try to make markets work as freely as possible, so that wages and product price can respond to the forces of demand and supply, w/out government interference in markets - by contrast, according to the Keynesian model, the government must intervene in the economy w specific measures to help it come out of the deflationary gap

distinguish between the short run and the long run in macroeconomics

the short run in macroeconomics is the period of time when prices of resources are roughly constant or inflexible, in spite of changes in the price level; they do not change together w changes in the price level (applies esp. to wages, or the price of labour) whereas the long run in macroeconomics is the period of time when the prices of all resources, incl. the price of labour (wages), are flexible and change along w changes in the price level

show the short-run aggregate supply (SRAS) curve in a diagram, and explain what relationship it represents

the short-run aggregate supply curve (SRAS) shows the relationship between the price level and the quantity of real output (real GDP) produced by firms when resource prices (esp. wages) do not change

explain the short run aggregate supply (SRAS) curve

the sum of the supply curves of all the industries in the economy

identify the factors that cause shifts in the SRAS curve

• changes in wage rates - if wages increase, w the price level constant, firms' costs of production rise, resulting in a leftward shift in the SRAS curve - if wages decrease, w the price elvel constant, firms' costs drop, giving rise to a rightward shift in the SRAS curve • changes in non-labour resource prices/ changes in the costs of raw materials - such as the price of oil, equipment, capital goods, land inputs - an increase in the price of a resource shifts the SRAS curve to the left; a decrease shifts it to the right • changes in indirect taxes - higher indirect taxes are like increases in production costs -> shift the SRAS curve to the left - lower indirect taxes on profits are like lower produciton costs -> shift the SRAS curve to the right • changes in subsidies offered to businesses - have the opposite effect to taxes, as they involve money transferred from the government to firms - if they increase, the SRAS curve shifts to the left - if they decrease, the SRAS curve shifts to the left • supply side shocks - events that have a sudden impact on short-run aggregate supply - a war or violent conflict can result in destruction of physical capital and disruption of the economy, leading to lower output produced and a leftward shift in the SRAS curve - unfavourable weather conditions -> cause a fall in agricultural output, also shifting the SRAS curve to the left - beneficial supply shocks (unusually good weather) w a positive effect on agricultural output lead to an increase in AS and a rightward shift in the SRAS curve

what are some of the factors that cause wages to be inflexible?

• labour contracts fix wage rates for certain periods of time, perhaps a year or two or more • minimum wage legislation fixes the lowest legally permissible wage rate • workers and labour unions resist wage cuts • wwage cuts have engative effects on worker morale, causing firms to avoid them

explain that in the Keynesian model deflationary/recessionary gaps may persist so that the equilibrium level of output may differ from the full employment level of output

• the economy in the Keynesian model can remain indefinitely stuck in a daflationary gap, unlike in the monetarist model where the economy automatically returns to full employment equilibrium • increases in AD in the Keynesian model need not necessarity result in increases in the price level, unlike in the monetarist model where increases in AD always result in a higher price level