An Aggregate Supply puzzle

A rather fascinating debate has been raging in my department office since we returned from the Christmas holidays. Surprisingly, it doesn’t concern the ‘big news’ items such as the VAT rise or the government’s austerity measures, but instead we seem to have found a bit of a theoretical conundrum.

The debate started as a result of a puzzling entry in the original AQA Unit 2 specification, which stated that candidates must have an understanding of the Keynesian LRAS curve. To our relief, this has been updated to just ‘an understanding of the Keynesian AS curve’, although candidates (unlike for any of the other major exam boards) must still use both the ‘classical’ upwards sloping SRAS and vertical LRAS, as well.

Our conundrum deepened when we started to think about representing output gaps using the AD/AS framework, and it is this part of the puzzle that we think would benefit from input from the readers of this blog.

One way of thinking about an output gap considers the fluctuations in GDP as being fluctuations around the economy’s full-employment maximum potential output (as shown by the classical vertical LRAS, or the perfectly inelastic section of the Keynesian AS curve).

The classical model allows for this as, in the short run, the SRAS can reach equilibrium with AD to the right of the vertical LRAS curve, as factors of production are paid overtime to incentivise them to work beyond what they would normally be capable of doing. This would be a positive output gap, and could also be represented by a point outside the production possibility frontier. Similarly, a negative output gap would be shown as occuring when SRAS intersects with AD to the left of the vertical LRAS curve (and when the economy is operating at a point inside the production possibility frontier). There is no output gap when SRAS, LRAS and AD coincide; this point is achieved when the money markets, the goods markets and the labour market all clear. In this model, the level of output, and therefore the output gap, is driven by the level of aggregate supply.

However, when we started thinking about applying this understanding of the output gap to the Keynesian framework, we hit a snag.

With no distinction between SRAS and LRAS, and with aggregate demand being the main determinant of the level of output in this view of the economic world, it is difficult to see how we could represent the output gap as being the fluctuations in GDP around the maximum potential level of output, using the AD/AS framework. Since we cannot derive a short-run equilibrium to the right of the AS curve, it seems that we can’t have a positive output gap. This result simply can’t be right (and is the main focus of our department debate!).

As a result, I started some quite extensive research, and so far, have not found any satisfactory explanations in any of my advanced level textbooks or any journals. However, as a way of fudging a solution to this puzzle, I started to think about an alternative way of representing an output gap, in which I considered the fluctuations in GDP as being fluctuations around a trend. This trend level of GDP will, for most economies, be below the maximum potential level of output; this, I think, fits well with the Keyneisan view that whilst money and goods markets may clear, the labour market does not tend to as a result of sticky wages and other imperfections.

So, using the AD/AS framework, the trend level of GDP will be represented as being a point where AD meets AS, to the left of the perfectly inelastic section of the AS curve. A positive output gap, therefore, would exist when AD increases, and the equilibrium point is to the right of this trend point (conversely, the negative output gap would be caused by a fall in AD). Again, this seems to fit well with the Keynesian view that aggregate demand is the main driver of the level of output (rather than the classical perspective that aggregate supply is the more important).

These are just musings on my part, however, and I have not found anything in the literature that I’ve reviewed that really helps to explain away our puzzle. The debate has already spread to other economic departments around the UK following phone calls and emails from me to try and get an adequate answer to the question; it would be great if blog readers could offer their opinion and comment on the validity (or otherwise!) of my interpretation.

At the very least, it should be an interesting debate for Monday morning breaktime!