Aggregate Supply

Short-run aggregate supply

SRAS shows total planned output at each price level when factor prices, especially wages, are fixed. It slopes upwards: with input costs fixed, a higher price level raises profit margins, so firms expand output.

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Shifters of SRAS are anything changing firms' costs of production:

A leftward shift is a supply shock: the price level rises while output falls, cost-push inflation, and if severe, stagflation.

Long-run aggregate supply

LRAS shows the economy's productive potential, what it can produce with all resources fully and efficiently employed. It is independent of the price level and corresponds to the PPF (1.1).

Shifters of LRAS change the quantity or quality of the factors of production:

• Investment in capital stock and infrastructure.
• Technological progress.
• Education, training and skills: human capital.
• The size of the labour force: demographics, participation rates, net migration.
• Enterprise and incentives, including the tax structure.
• Discovery of natural resources.
• Institutions: property rights, competition, rule of law.
• Labour market flexibility and reduced factor immobility.
• Competition policy and the removal of barriers to entry.

These are precisely the targets of supply-side policy (2.6).

Classical and Keynesian LRAS

This disagreement is the most examinable idea in the topic, because the two models give opposite policy conclusions.

The classical LRAS is vertical at the full-employment level of output.

The reasoning: markets clear, because wages and prices are flexible. Any deviation from full employment is temporary, so output is determined solely by supply-side factors.

1. An increase in AD raises output only in the short run. The higher price level erodes real wages
2. workers demand higher nominal wages
3. SRAS shifts left
4. output returns to the full-employment level at a higher price level. Demand management is therefore purely inflationary in the long run.

The Keynesian LRAS has three sections:

1. A horizontal (perfectly elastic) section at low output, with mass unemployment and substantial spare capacity, output can rise with no increase in the price level.
2. An upward-sloping section, as capacity is approached, bottlenecks appear, so expansion raises both output and prices.
3. A vertical section at full capacity, extra demand is entirely inflationary.

The reasoning: wages are sticky downwards, because of contracts, minimum wages, union resistance and reluctance to cut nominal pay. An economy can therefore become stuck in a deflationary gap, an equilibrium below full employment that does not self-correct.

The reconciliation: which model applies depends on where the economy is operating. In a deep recession with a large negative output gap, the Keynesian analysis fits; near full capacity, the classical one does. Saying this explicitly is the highest-level move in an essay on this topic.

Macroeconomic equilibrium

Equilibrium is where AD = AS, determining the equilibrium price level and real output.

• Short-run equilibrium: AD = SRAS; output may be above or below the full-employment level.
• Long-run equilibrium: AD = SRAS = LRAS, with output at potential.

How any AD shift splits between output and prices depends entirely on which section of AS the economy is on, which is why identifying the output gap is the first step in any macro answer.

Worked example

A government cuts income tax to stimulate a sluggish economy.

The Keynesian analysis, assuming a large negative output gap:

1. Lower income tax raises disposable income
2. consumption rises
3. AD shifts right, amplified by the multiplier (2.2)
4. on the horizontal section of LRAS, with substantial spare capacity
5. real output and employment rise with almost no increase in the price level
6. the negative output gap closes.

The classical analysis:

1. The economy is already at full employment on a vertical LRAS
2. AD shifts right
3. output rises above potential in the short run
4. but the higher price level erodes real wages
5. workers bargain for higher nominal wages
6. SRAS shifts left
7. output returns to the full-employment level
8. the only lasting effect is a higher price level.

Evaluation.

• Everything hinges on the size of the output gap, and potential output is estimated, not observed, so the same policy is either effective or purely inflationary depending on a number nobody knows precisely.
• The tax cut may also have supply-side effects: better incentives to work and to participate could shift LRAS right, in which case even the classical model permits a lasting output gain.
• It must be financed. Higher borrowing widens the deficit and may cause crowding out, though that objection is weak when rates are at their floor.
• The distributional design matters: cuts aimed at low earners, with a higher MPC, deliver more demand per pound forgone.
• Time lags mean the stimulus may arrive when the classical prediction has become the relevant one.

Judgement: with a genuine and large negative output gap, the tax cut raises real output at little inflationary cost; near capacity it is inflationary, and the supply-side effects are the only durable gain. The right policy depends on the diagnosis, not on the model chosen in advance.

Common exam mistakes

• Drawing LRAS as upward-sloping; it is vertical (classical) or three-sectioned (Keynesian).
• Shifting LRAS for a change in production costs. Costs shift SRAS; only capacity shifts LRAS.
• Drawing the Keynesian LRAS with only the horizontal section.
• Saying the classical model means demand policy never works, it works in the short run.
• Ignoring where on the AS curve the economy currently sits.
• Confusing a movement along AS with a shift.

Exam technique

Draw AD, SRAS and LRAS on one diagram and mark the full-employment level of output. Nearly every macro question in Theme 2 is answered by locating the current equilibrium relative to it.

State which model you are using and why, "given the large negative output gap in the extract, the Keynesian analysis is the relevant one." Edexcel rewards that explicit justification.

For evaluation, contrast the two models directly and conclude that the answer depends on the output gap, the time horizon, and whether the policy also shifts LRAS.

Quick revision

• SRAS slopes up; shifted by costs, wages, raw materials, exchange rate, taxes, productivity.
• LRAS shows productive potential; shifted by the quantity and quality of factors, investment, technology, skills, labour force, institutions, migration.
• Classical LRAS is vertical: output is supply-determined; demand management is inflationary in the long run.
• Keynesian LRAS has three sections: horizontal, sloping, vertical, because wages are sticky downwards.
• On the horizontal section, AD stimulus raises output with no inflation.
• Equilibrium where AD = AS; the output/price split depends on where on AS the economy is.
• The models are reconciled by the size of the output gap.

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