2.3.3 Long-run AS

• Long run aggregate supply (LRAS) is influenced by a change in the productive capacity of the economy
  • Productive capacity is changed by changes to the quantity or quality of the factors of production
• Economists have two opposing views on how LRAS works in an economy
  • The original view is called the classical view
  • The insights developed by John Meynard Keynes in 1936 are called the Keynesian view
    
    

 The Classical LRAS View

• The classical view believes that the LRAS is perfectly inelastic (vertical) at a point of full employment of all available resources
  • This point corresponds to the maximum possible output on a production possibilities frontier (PPF)
    
    
• The classical view believes that in the long-run an economy will always return to this full employment level of output
  
  
• There may be short-run output gaps in the economy
  • During extreme periods of economic growth there can be an inflationary gap that develops
    • In the long run this will self-correct and return to the long-run level of output, but at a higher average price level
  • During slowdowns or recessions there can be a recessionary gap that develops
    • In the long-run this will self-correct and return to the long-run level of output, but at a lower average price level

A diagram that shows the Classical View of long-run aggregate supply (LRAS) with a vertical aggregate supply curve at the full employment level of output (Y_FE)

Diagram Analysis

• Using all available factors of production, the long-term output of this economy (LRAS) occurs at Y_FE
• The economy is initially in equilibrium at the intersection of AD₁ and LRAS (P₁, Y_FE)
• A slowdown reduces output from AD₁→AD₂ and creates a short term recessionary gap
• This self corrects in the long term and returns the economy to the long-run equilibrium at the intersection of AD₂ and LRAS (P₂, Y_FE)

 The Keynesian LRAS View

• Keynes believed that the long-run aggregate supply curve (LRAS) was more L shaped
  • Supply is elastic at lower levels of output as there is a lot of spare production capacity in the economy
    • Struggling firms will increase output without raising prices
  • Supply is perfectly inelastic (vertical) at a point of full employment (Y_FE) of all available resources
    • The closer the economy gets to this point the more price inflation will occur as firms compete for scarce resources
      
      
• The Keynesian view believes that an economy will not always self-correct and return to the full employment level of output (Y_FE)
  • It can get stuck at an equilibrium well below the full employment level of output e.g. Great Depression
    
    
• The Keynesian view believes that there is role for the government to increase its expenditure so as to shift aggregate demand and change the negative 'animal spirits' in the economy
  

A diagram that shows the Keynesian View of long-run aggregate supply (LRAS) with a vertical aggregate supply curve at the full employment level of output (Y_FE) becoming more elastic at lower levels of output

Diagram Analysis

• Using all available factors of production, the long-term output of this economy (LRAS) occurs at Y_FE
• The economy is initially in equilibrium at the intersection of AD₁ and LRAS (P₁, Y_FE)
• A slowdown reduces output from AD₁→AD₂ and creates a recessionary gap Y_1-Y_FE
  • The economy may reach a point where average prices stop falling (P₂), but output continues to fall
  • This economy may not self-correct to Y_FE for years
  • The low output leads to high unemployment and low confidence in the economy
    • This stops further investment and further reduces consumption
      
      
• Keynes argued that this was where governments needed to intervene with significant expenditure e.g. Roosevelt's New Deal; response to financial crisis of 2008
  
  

• Any factor that changes the quantity or quality of a factor of production will impact the long-run aggregate supply (LRAS) of an economy: 
  • This corresponds to an outward or inward shift of the potential output of an economy on the production possibilities frontier
• The following factors will shift the entire LRAS curve outwards and increase the potential output of the economy:

1. Technological advances: these often improve the quality of the factors of production e.g. development of metal alloys
2. Changes in relative productivity: process innovation often results in productivity improvement e.g. moving from labour intensive car production to automated car production
3. Changes in education and skills: over time this increases the quality of labour in an economy
4. Changes in government regulations: these can improve the quantity of the factors of production. e.g. deregulation of fracking (extracting oil from shale deposits) increased oil reserves
5. Demographic changes and migration: a positive net birth rate or positive net migration rate will increase the quantity of labour available
6. Competition policy: regulating industries so as to prevent monopoly power results in more firms supplying goods/services in an economy and this increases the potential output of an economy