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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

SRAS

P2

P1

0

Y1

Y2

• 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.

Real Output

Inward Shift of SRAS Curve Price Level

SRAS1 SRAS • Inward shift of SRAS. • Less output can be supplied at each level.

P1

0

Y2

Y1

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 LRAS

Price Level

0

Y

Real Output

SRAS & LRAS LRAS

Price Level

Positive Output Gap – short run GDP exceeds potential

Negative Output Gap – short run GDP below potential

0

SRAS

Potential GDP

Y

Real Output

Classical Macroeconomic Equilibrium LRAS

Price Level

SRAS

P1

AD 0

Y

Real Output

Classical Macroeconomic Equilibrium LRAS

Price Level

SRAS1 SRAS

P3 P2 P1

AD1 AD 0

Y

Y1

Real Output

Keynesian Aggregate Supply LRAS Price Level

0

YFe

• 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)

Real Output

Keynesian Aggregate Supply AD4

Price Level

LRAS

AD3

AD2 AD1 AD

0

YFe

• 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.

Real Output

Keynesian Aggregate Supply LRAS • Fall in production costs could shift the AS curve right.

Price Level

• An increase in costs will shift it left.

0

YFe

Real Output

Plenary