2.3.3 Long-Run Aggregate Supply

This Edexcel economics study note looks at Long-Run Aggregate Supply (LRAS).

Introduction

The long-run aggregate supply (AS) curve represents the relationship between the total quantity of goods and services that firms in an economy are willing to produce and the price level, assuming that all prices, including nominal wages, are flexible.

Two primary models of the long-run AS curve are the Keynesian and Classical perspectives, each offering distinct insights into how economies operate over time.

Keynesian AS Curve

• Shape: The Keynesian AS curve is typically depicted as a backward-L shape.
  • Horizontal Segment: At low levels of output and employment, the curve is horizontal. This indicates that firms can increase production without raising prices due to unused capacity and high unemployment.
  • Upward Sloping Segment: As the economy approaches full employment, the curve starts to slope upwards, reflecting increasing pressure on wages and prices.
  • Vertical Segment: At full employment, the curve becomes vertical, indicating that output is at its maximum sustainable level, and any further demand increase will only lead to higher prices.
• Key Insights:
  • Emphasizes the existence of unemployment and idle capacity in the economy.
  • Suggests that in the short run, output can be increased without causing inflation until full employment is reached.
  • Government intervention, such as fiscal policy, can help achieve full employment without causing inflation in the short run.
• Real-World Example: The Great Depression of the 1930s. High unemployment and unused capacity meant that increased government spending could boost output without causing inflation.

Classical AS Curve

• Shape: The Classical AS curve is vertical at the full-employment level of output.
  • Reflects the belief that in the long run, the economy is always at full employment due to the flexibility of prices and wages.
  • Output is determined by factors such as technology, resources, and institutional structures, not by the price level.
• Key Insights:
  • Assumes that markets clear and that supply creates its own demand (Say's Law).
  • Long-term output is not affected by changes in the price level.
  • Suggests that any government intervention is unnecessary and potentially harmful, as the economy self-adjusts to full employment.
• Real-World Example: Post-World War II economic expansions, where economies quickly returned to full employment without significant government intervention.

Key Economists

• John Maynard Keynes (1883-1946):
  • Advocated for government intervention to manage economic cycles.
  • Key work: "The General Theory of Employment, Interest and Money" (1936).
  • Introduced concepts such as aggregate demand and the Keynesian AS curve.
• Classical Economists:
  • Adam Smith (1723-1790):
    • Known as the father of modern economics.
    • Key work: "An Inquiry into the Nature and Causes of the Wealth of Nations" (1776).
  • David Ricardo (1772-1823):
    • Developed the theory of comparative advantage.
    • Key work: "Principles of Political Economy and Taxation" (1817).
  • Jean-Baptiste Say (1767-1832):
    • Formulated Say's Law, which posits that supply creates its own demand.

Glossary

• Aggregate Supply (AS) Curve: A graph showing the total quantity of goods and services that firms in an economy are willing to produce at different price levels.
• Full Employment: The level of employment at which virtually all individuals who are willing and able to work at prevailing wages are employed.
• Fiscal Policy: Government adjustments to its spending levels and tax rates to influence a nation's economy.
• Say's Law: The principle that supply creates its own demand.

Possible Essay-Style Questions

1. Compare and contrast the Keynesian and Classical views of the long-run aggregate supply curve. Discuss the implications of each view for fiscal policy.
2. How does the concept of price and wage flexibility influence the shape of the long-run aggregate supply curve in Classical economics?
3. Analyze the role of government intervention in achieving full employment according to Keynesian economics. Use historical examples to support your argument.
4. Discuss the impact of technological advancements on the long-run aggregate supply curve in both Keynesian and Classical frameworks.

Further Reading

• The General Theory of Employment, Interest and Money by John Maynard Keynes
• An Inquiry into the Nature and Causes of the Wealth of Nations by Adam Smith
• Principles of Political Economy and Taxation by David Ricardo