IB Economics What is the Aggregate Supply (AS) curve and how can it be influenced?

IB Economics

What is the Aggregate Supply (AS) curve and how can it be influenced?

Short Run Aggregate Supply (SRAS)

• SRAS is the relationship between real GDP and the price level– SRAS shows how much output the economy can

generate in the short term at each price level

– A rise in the price level should stimulate an expansion of supply

• We hold the following constant:– Wage rates for labour (W)

– Other resource prices such as raw material prices and components

– Long run potential GDP (see later notes on LRAS)

• Changes in aggregate demand cause either a contraction or an expansion along the SRAS curve

Short Run Aggregate Supply Curve

Real National Output

Price Level SRAS1

Short Run Aggregate Supply Curve

Real National Output

Price Level SRAS1

A rise in the price level will cause an expansion of aggregate supply in the economy

Producers are responding to higher prices (driven up by increased demand)

Real national output will increase from Y1 to Y2

Shifts in short run aggregate supply

• Changes in unit labour costs (ULCs)– Unit labour costs are defined as wage costs adjusted for

the level of productivity

• Changes to raw material costs and other components – Fluctuations in the world price of oil, copper, aluminum

and other essential inputs in many production processes

– These costs might be affected by movements in the exchange rate which cause fluctuations in the prices of imports

• Changes to producer taxes and subsidies levied by the government as part of their fiscal policy– Changes in VAT on building materials or duty on fuels

Inward Shift in SRAS

Price LevelSRAS1

Inward shift of SRAS

Less output can be supplied at each price

How do changes in wages affect the SRAS?

Sources:• http://news.bbc.co.uk/2/hi/business/913245.stm | 8th September 2000• http://news.bbc.co.uk/2/hi/europe/895217.stm | 24th August 2000

How do changes in wages affect the SRAS?

Price Level

Long Run Aggregate Supply (LRAS)

• LRAS is located at potential GDP – it represents a level of real national output in the economy

• Potential GDP is assumed to be independent of the price level– The price level is fixed

– Technology does not change

– All resources are fully employed

– The economy is on its production possibilities curve

Long Run Aggregate Supply (LRAS)

• Changes in potential GDP are brought about by:– Changes in full-employment labour supply available for

production (i.e. more people join the labour force)

– Changes in the stock of capital inputs – affected by the level of gross capital investment

– Changes in the productivity of factor inputs e.g. higher labour productivity or an increase in capital productivity

– Advances in the general state of technology

• An outward shift of LRAS signifies an increase in long-run potential “full-employment” output

Short Run (SRAS) and Long Run Aggregate Supply (LRAS)

Price Level

Potential GDP

Short run GDP exceeds potential

Price Level

Potential GDP

Short run GDP below potential

Price Level

Potential GDP

Positive output gap

Price Level

Potential GDP

Positive output gap

Negative output gap

Macroeconomic equilibrium

GeneralPrice Level

Real National OutputYp

Macroeconomic equilibrium

GeneralPrice Level

Inter-relationships between SRAS and LRAS

GeneralPrice Level

IB Economics

The Keynesian non-linear aggregate supply (LRAS) curve

A different way of showing aggregate supply

The Keynesian LRAS Curve

Price LevelLRAS

AD1AD2

The Keynesian LRAS Curve

Price LevelLRAS

AD1AD2

AD3AD4

An Increase in Neo-Classical LRAS with corresponding increases in AD

Price Level

LAS1 LAS2 LAS3

Ad1 Ad2Ad3

How does AD/ LRAS relate to PPF?

Market Orientated Supply-Side Policies

• Reduction in income taxes

• Reduction in corporation taxes

• Reduction in trade union power (early 80’s in UK)

• Reduction / elimination of minimum wages

• Reduction in unemployment benefits

• De-regulation & Privatisation

TAKE A MOMENT TO EVALUATE: Market orientated policies emphasize the reduced role of the government. Such economic schools of thought (e.g. the view of the IEA) believe that private operation is more efficient and will react quicker than government run organisations. These views are often the basis of political debate.

Interventionist Supply-Side Policies

• Education and training

• Research and development (R&D)

• Provision of infrastructure

• Improved information

TAKE A MOMENT TO EVALUATE: Interventionist policies have significant opportunity costs associated with them. Time lags will mean that the policies are likely only to last in the long run.

How does a lack of spending affect the productive capacity?

Source: http://news.bbc.co.uk/2/hi/business/4197874.stm 30th August 2005

How does a lack of spending affect the productive capacity?

How does increased spending on education affect the LRAS?

Source: http://news.bbc.co.uk/2/hi/business/2029708.stm | 6th June 2002

TAKE A MOMENT TO EVALUATE: Many supply side policies take a long time to come into affect and cost huge sums of money. Think how long it will take for this policy to come into affect and as a policy maker does this mean that you need some short run tools too? Keynes said that “In the long run we are all dead.” I would tend to agree with him.

How does increased spending on education affect the LRAS?

Today’s Classwork

• Complete student workpoint 17.2 (page 182)

• Complete SRQ # 2 (page 185)

• Complete SRQ # 3 (page 185)

Homework

• Plan Essay Question # 1 (Page 185)

• Read Essential of Economics 4th Ed., Sloman J. Pages 260 - 264 (available in the library or photocopy)

IB Economics What is the Aggregate Supply (AS) curve and how can it be influenced?

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