Transcript ASAD long run

Long Run Aggregate Supply
MACRO – AS&AD Analysis
• The maximum potential output of the economy
(with given resources and technology) is known as
the ‘full employment’ level of output
• All resources are being fully utilised (although
there will still be ‘natural unemployment’structural, seasonal and frictional
unemployment- more on this later..)
• We show this using the LRAS curve
The Neo- classical LRAS
• Neo- classical economist believe that in the long- run the
economy will operate at the full employment level of output
(Yfe).
• They believe that free- market forces result in an optimal
allocation of resources.
• In the short- run the economy may be operating above or
below full capacity, but this will result in changes in prices in
factor markets (eg. labour) and eventually output will return
to full employment…
• The concept of wage and price flexibility is key to this
model as is the idea that people do not suffer from ‘money
illusion’ (i.e. they are fully aware of price and wage changes)
Price
Level
LRAS
SRAS2
SRAS1
PL3
PL2
PL1
AD2
In the short-run a rise in
AD will temporarily result
in output being above Yfe.
This results in a rise in the
PL from PL1 to PL2
The difference between
actual and potential output
here is called an
inflationary gap
As higher prices feed
through to the economy
(eg. Higher wages) the
SRAS curve shifts to the
left returning the economy
to Yfe
AD1
Yfe
Y1
Real National Output (Y)
LRAS
Price
Level
SRAS1
SRAS2
PL1
PL2
PL3
AD1
In the short-run a fall in
AD will temporarily result
in output being below Yfe.
This results in a fall in the
PL from PL1 to PL2
The difference between
actual and potential output
here is called a
deflationary/
recessionary gap
As lower prices feed
through to the economy
(eg. lower wages) the
SRAS curve shifts to the
right returning the
economy to Yfe
AD2
Y2
Yfe
Real National Output (Y)
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Neo- classical economists therefore believe that any change in AD will only have a
temporary effect on the level of output and employment
Therefore when there is a fall in AD, no government intervention is needed.
In fact they believe that government intervention in the economy usually hinders
economic activity
Without minimum wages or laws making it difficult or expensive for firms to reduce
wages or fire and hire workers, firms faced with falling demand will simply lower their
employees’ wages and reduce the prices of their products to maintain their output.
If there is no more demand for some products, those firms will shut down and their
workers will go to work for firms whose products are still in demand, at whatever
wage rate the market is offering.
Without government intervention, wages and prices rise and fall with the level of
demand in the economy, but output remains constant at its full employment level
Neoclassical economists advocate policies that help markets work eg. reducing trade
union power, abolishing minimum wages and unemployment benefits, reducing tax
rates… (market- orientated supply side policies)
The key to long-term stable growth is therefore:
Ensure free markets with no imperfections (through supply-side policies)
Control the growth of the money supply to ensure low inflation
Supply Side Policy and the Neo- Classical
LRAS
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Supply-side policies can be used to reduce market imperfections. This
should have the effect of increasing the capacity of the economy to
produce (the LRAS). If the level of aggregate supply increases then
demand will also increase. This will be the only non-inflationary way to
get increases in output.
They may include:
Improving education & training to make the work-force more
occupationally mobile
Reducing the level of benefits to increase the incentive for people to
work
Reducing taxation to encourage enterprise and encourage hard work
Policies to make people more geographically mobile (scrapping rent
controls, simplifying house buying to speed it up, ......)
Reducing the power of trade unions to allow wages to be more flexible
Getting rid of any capital controls
Removing unnecessary regulations
Shifts of the Neo- Classical LRAS
LRAS1
LRAS2
Price Level
P1
P2
AD1
Yfe1
Yfe2
Real National Output (Y)
Famous Economists?
* Hayek is often associated with Monetarists because of the nature of his views on money supply, but he disagreed with
Friedman over many aspects of macroeconomics and methodology. We have classified him as a Monetarist here for
simplicity.
Friedrich August von Hayek (18991992)
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At the University of Vienna, he earned doctorates in law and political science in
1921 and 1923 respectively, and he also studied philosophy, psychology, and
economics
In 1933 he joined the LSE faculty
In 1932, Hayek suggested that private investment in the public markets was a
better road to wealth and economic coordination in Britain than government
spending programs, as argued in a letter he co-signed with Lionel Robbins and
others in an exchange of letters with John Maynard Keynes in The Times.[] The
global Great Depression formed a crucial backdrop against which Hayek
formulated his positions, especially in opposition to the views of Keynes.[
During depressions, Hayek believed that government could only make things
worse by trying to intervene to restore full employment. At any and all
times, government’s best action would be to lower taxes, reduce its spending on
goods and services, and thereby encourage private entrepreneurs to provide the
nation’s households with the output they demand.
John Maynard Keynes (18831946)
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John Maynard Keynes was born on 5 June 1883 in Cambridge into a well-to-do
academic family. His father was an economist and a philosopher, his mother became
the town's first female mayor. He excelled academically at Eton as well as Cambridge
University, where he studied mathematics.
Keynes' best-known work, 'The General Theory of Employment, Interest and Money',
was published in 1936, and became a benchmark for future economic thought. It also
secured his position as Britain's most influential economist, and with the advent of
World War Two, he again worked for the treasury. In 1942, he was made a member of
the house of lords.
During the war years, Keynes played a decisive role in the negotiations that were to
shape the post-war international economic order. In 1944, he led the British
delegation to the Bretton Woods conference in the United States. At the conference
he played a significant part in the planning of the World Bank and the International
Monetary Fund. He died on 21 April 1946.
His view of how the economy operates in the long- run differs significantly from the
neo- classical perspective… The crucial difference is that wages and prices are not
flexible…
The Keynesian LRAS Curve
• In the long- run Keynesian economists believe that the economy can
be operating at a level of output below full- employment
• Keynes argued that AD determined the overall level of economic
activity, and that inadequate AD could lead to prolonged periods of
high unemployment
• Keynes argued that wages would be 'sticky downwards'. In other
words workers would not be happy about taking wage cuts and
would resist this. This would mean that wages would not necessarily
fall enough to clear the market and unemployment would linger.
• If the private sector was not prepared to spend to boost demand,
the government should instead. He advocated the use of demandside policies (fiscal and monetary policy)
• In response to the view of the neo- classical economists Keynes is
famously quoted as stating
• 'In the long-run we are all dead'
Keynesian LRAS
Price
Level
At low levels of
economic activity
the AS curve is
perfectly elastic,
lots of spare
capacity- producers
can expand output
without incurring
higher costs
As the economy LRAS
When the economy
approaches it’s
reaches its full
potential output,
capacity (YFE) it is
there is less spare
impossible to
capacity, factors
increase output
of production are
any further
becoming more
because all factors
scarce, which
of production are
leads to higher
fully employed, the
prices for factors,
LRAS becomes
this leads to
perfectly inelastic
higher costs hence
higher prices
YFE
Real National Output (Y)
Increases in AD
• Unlike the classical economists, a rise in
AD can lead to a rise in real output
• Demand side policies (fiscal and monetary)
• Fiscal- use of taxation and government
spending
• Monetary- the manipulation of the money
supply or interest rates
Long Run Equilibrium in the Keynesian model
Price
Level
LRAS
SRAS
In the long- run
there can be
equilibrium at an
output level
below the full
employment level
of output.
There can be
unemployment
Ye to Yfe
represents a
deflationary gap
AD
Ye
Yfe
Real National Output
• Wed 9th May
Quick Quiz
Illustrate the long- run macroeconomic
equilibrium in the neoclassical model
Show and explain what happens when
there is a rise in AD
Explaining the Keynesian LRAS
Price
Level
LRAS
PL1
AD1
Y1
Y2
AD2
Yfe
Real National Output
Explaining the Keynesian LRAS
Price
Level
LRAS
PL2
PL1
AD2
AD1
Y1
Y2 Yfe
Real National Output
Explaining the Keynesian LRAS
Price
Level
LRAS
SRAS2
PL2
SRAS1
PL1
AD2
AD1
Yfe
Y2
Yfe to Y2
represents
an
inflationary
gap
Real National Output
Long Run Equilibrium in the Keynesian model
Price
Level
Real National Output
Explaining the Keynesian LRAS and the Multiplier effect
Price
Level
PL1
AD1
Y1
Y2
AD3
AD2
Y3
Real National Output
Handout
• Keynes Vs Hayek