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3.2.7 Alternative views of aggregate supply (AS)

In section 3.2.5, we introduced the difference between the short-run and long-run in macroeconomics:

  1. In the short-run, the cost of factors of production (especially wages) are fixed (they are not affected by changes in price levels).
  2. In the long-run, the costs of factors of production are variable (they adjust to the price level).

There two main different views on how the aggregate supply looks like in the long-run:

  1. The monetarist/new classical view.
  2. The Keynesian view.

Note

There is not a "correct" view on the aggregate supply. Throughout the IB Economics course, you can use both interchangeably, as you may prefer.

Monetarist/new classical view of the long-run aggregate supply (LRAS) curve

  1. The monetarist/new classical approach to aggregate supply focuses on the distinction between the short run and long run in macroeconomics.
  2. It advocates that there is a different relationship between the aggregate supply and price level in the long-run and the short-run.
  3. The relationship between the price level and aggregate supply in the long run is represented by the long-run aggregate supply (LRAS) curve (Figure 1 below).
Figure 1: long-run aggregate supply curve
Figure 1: long-run aggregate supply curve

As can be seen by Figure 1 above:

  1. The LRAS curve is vertical at potential output (Yp).
  2. Potential output is the level of output an economy produces in the long run, when all costs of production are variable.

Note

In Price Level vs Total Output diagrams, you can label the 'X axis' as:

  1. Real GDP.
  2. Y.

This is because, as we saw in our discussion of national income accounting, the national income (Y) = national output (real GDP).

Why is the LRAS curve vertical?

  1. In the long run, over time, wages and all other costs of factors of production prices adjust to match the changes in the price level. For example:
    1. If the price level rises, workers demand higher wages to keep up with the increase in price level (inflation).
    2. If the price level falls, resource prices decrease proportionally, and firms also decrease wages to maintain profit margins.
  2. Therefore, when wages and input prices fully adjust to match the price level changes, firms’ real costs of production stay the same: the price level has changed, but the profitability of producing goods remains constant.
  3. With constant real costs and profits, firms have no reason to increase or decrease their output.
  4. Therefore, the total quantity of output produced in the long run remains the same, regardless of changes in the price level.
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Note

Introduction to Aggregate Supply Views

  • The aggregate supply (AS) curve shows the total quantity of goods and services that firms in an economy are willing and able to produce at different price levels.
  • There are two main perspectives on how the AS curve behaves in the long run:
    • The Monetarist/New Classical view
    • The Keynesian view
  • These perspectives differ primarily in their assumptions about how prices and wages adjust over time.

Analogy

Think of the economy like a car engine. The Monetarist view sees it as a well-tuned machine that always returns to its maximum speed, while the Keynesian view sees it as a more complex system with speed limits that depend on road conditions.

Definition
Aggregate Supply (AS) Curve
A graphical representation showing the total output that firms are willing to produce at different price levels in an economy.

Example

In a simplified economy, if all firms can produce 100 units of goods at a price level of 1.0, but only 80 units at a price level of 0.8, the AS curve would show this relationship.