Aggregate Supply

Aims and Objectives

Aim: Understand aggregate supply. Objectives: Define aggregate supply. Explain why SRAS shifts and LRAS becomes vertical. Analyse the difference in classical and Keynesian supply curves.

Starter
Construct AD diagrams to show the following:
A fall in the interest rate A decline in consumer confidence A rise in house prices The election of a government committed to cutting government spending A fall in economic growth rates across the European Union

Aggregate Supply

Total supply in the economy.

Classical Short Run Aggregate Supply (SRAS)

SRAS is the relationship between real GDP and the price level.
Shows how much output an economy can generate in the short run at each price level. A rise in price should stimulate an expansion of supply. Wages remain fixed & prices of all other factors do too.

Changes in AD cause either a contraction or expansion along the SRAS curve.

Classical SRAS Curve

Price Level
P2

SRAS

P1

A rise in P will cause an expansion of AS in the economy. Producers are responding to higher prices driven by increased demand. Real output increases from Y1 to Y2.

Y1

Y2

Real Output

Inward Shift of SRAS Curve

Price Level SRAS1 SRAS
P1

Inward shift of SRAS. Less output can be supplied at each level. 0

Y1

Y2

Real Output

Crude Oil Prices Changing Shift SRAS

Shifting SRAS
Any changes in firm costs will shift the SRAS.
Wage rates Raw materials Interest rates cost of borrowing Corporation tax

Long Run Aggregate Supply

LRAS is located at potential GDP. At this level all resources are fully employed The economy is on its PPF.

LRAS becomes vertical when all FofP are fully employed.

Long Run Aggregate Supply

Becomes vertical before full employment is reached. In an economy some people would rather be on benefits then work voluntarily unemployed. Therefore output will reach its maximum level before full employment is achieved.

This level of output known as natural rate of unemployment.

LRAS
Price Level LRAS

Real Output

SRAS & LRAS

Price Level LRAS SRAS
Positive Output Gap short run GDP exceeds potential Potential GDP

Negative Output Gap short run GDP below potential

Real Output

Classical Macroeconomic Equilibrium

Price Level LRAS SRAS

P1

AD 0
Y

Real Output

Classical Macroeconomic Equilibrium

Price Level
P3 P2 P1

LRAS

SRAS1 SRAS

AD1 AD 0
Y Y1

Real Output

Keynesian Aggregate Supply

LRAS Price Level
As prices increase firms will increase output while there is labour available to be employed. Becomes more inelastic as there is less labour in the market. Wages and prices rise until the economy reaches full employment (YFe)

YFe

Real Output

Keynesian Aggregate Supply

AD4

LRAS

Price Level

AD3

AD2
AD1 AD

Movement from AD to AD3 results in inflation and increases in output and employment. But a movement from AD3 to AD4 has no effect on output and employment only causes inflation. Need to contract AD.

YFe

Real Output

Keynesian Aggregate Supply

Price Level LRAS Fall in production costs could shift the AS curve right. An increase in costs will shift it left.

YFe

Real Output

Plenary