Chapter 20 - Aggregate supply and the interaction of aggregate demand and supply Flashcards
(20 cards)
How does short run aggregate supply work?
In the short run, firms may have little flexibility to vary their inputs. Wages are likely to be fixed, and firms will not be able to expand the amount of capital needed in the production process.
Also, raw materials may be in short supply, and firms may find that hiring more workers brings less additional output than is received from existing workers because of the lack of additional machinery.
However, at a higher price level firms will want to produce more in order to increase their profits. This suggests that in the short run, aggregate supply may be upward sloping, where SRAS represents short-run aggregate supply.
What must firms take into account in the short run to maximise profits?
- The state of technology and how effectively the factors are used
- The total supply of factors of production.
How does cost of inputs affect SRAS?
If a key raw material becomes more limited in supply, perhaps because reserves are exhausted, then the prices of inputs will tend to rise, raising firms’ costs of production. They may then choose to supply less output at any given product price — and the aggregate supply curve will shift to the left.
Oil is a key input for many firms, and an increase in the price of oil affects the cost of energy and transport. It also affects the economy, as oil is a key input in the production of many fertilisers used in the agricultural sector. The price of oil has a large impact on the position of aggregate supply in the short run by affecting the costs faced by firms.
Another key input for firms is labour, so an increase in labour costs will also affect the position of the SRAS.
How does exchange rate affect SRAS?
When firms rely on imported goods used in production, a change in the exchange rate affects aggregate supply due to the domestic (local) price of imported inputs, which affects the costs faced by firms. This could be favourable, depending on which direction the exchange rate changes. It could be that the exchange rate rises (appreciates), so reducing the domestic price of imports. Firms may then be prepared to supply more output at any given price.
The exchange rate can change in the short run for different reasons, so firms may face some sudden changes in their costs. One way that firms can protect themselves is through the type of contracts they have with their foreign suppliers, so future prices can be specified in a way that protects against possible exchange rate fluctuations.
How does government intervention affect SRAS?
There are some forms of government intervention that can affect firms’ costs in the short run. An increase in regulation that forced firms to spend more on health and safety measures would raise costs. An increase in the rate of corporation tax would have similar effects.
How does shifts in the SRAS work?
An increase in costs means that firms will be prepared to supply less output at any given price, so the SRAS curve shifts to the left.
What are neoclassical economists?
Economists who argued that markets allows the economy to adjust to equilibrium.
What is the Monetarist School?
Economists who argued that the economy always meets on an equilibrium level of output.
What is the natural rate of output?
The long-run equilibrium level of output that matches to full employment.
What are the views of aggregate supply?
Early economic thinkers (the so-called ‘classical’ economists such as Adam Smith) argued that prices would adjust to ensure that resources were efficiently allocated in society. This idea was used by neoclassical economists, who argued that the government should use a laissez faire approach to the economy - in other words, the market could be left alone to find its way to equilibrium. Keynes disputed this approach, and this disagreement started a debate about the shape of the long-run aggregate supply curve.
The Monetarist School, argued along neoclassical lines that the economy would always meet on an equilibrium level of output that they referred to as the natural rate of output. The monetarists had a major impact on the policies used by Margaret Thatcher in the UK and Ronald Reagan in the USA in the 80s.
Some economists argued, along neoclassical lines, that the economy would always find its way to overall equilibrium, where economy is at full employment. Full employment is when the economy is making full use of its factors of production, and is therefore producing at the full capacity level of output, the maximum that the economy could produce.
What is the Keynesian School?
Economists who believed that the macroeconomy could stay at an equilibrium below full employment.
What are the comparisons between Neoclassical view and Keynesian view?
Neoclassical view:
- LRAS is vertical at the full employment
- The economy meets rapidly to full employment.
- Policy intervention is not needed because the economy adjusts rapidly.
- Aggregate supply is not sensitive to the price level.
Keynesian view:
- LRAS is upward-sloping for a range of output below full employment.
- The economy could settle at a level of output below full employment.
- Policy intervention may be needed to move towards full employment.
- Aggregate supply is sensitive to the price level when the economy is below full employment.
How does the quantity of factor inputs cause shifts in the LRAS curve?
For labour input, an increase in the size of the workforce affects the position of aggregate supply. In practice, the size of the labour force changes slowly unless large international migration takes place: for example, the expansion of membership of the EU in May 2004 led to large migration into the UK.
An increase in the quantity of capital will also have this effect, by increasing the capacity of the economy to produce. However, such an increase requires firms to have undertaken investment activity. In other words, the balance between consumption and investment may affect the position of the aggregate supply curve in the future.
Demographic changes and migration can also affect the size of the workforce in the long run. The UK and other economies have been shown to have an ageing population in recent years. As more people live longer into retirement, the working population falls, and the LRAS curve may shift to the left. One response to this pattern has been the changes to the retirement age.
Until 2011, the default retirement age in the UK was 65 years, but this was abolished so that those who wanted to work after 65 could do so. In many developing countries in sub-Saharan Africa, the HIV/AIDS epidemic effected people of working age, so reduced the size and effectiveness of the labour force. In-migration can also affect the size of the workforce.
How does the effectiveness with which factor inputs are used cause shifts in the LRAS curve?
The effectiveness of inputs being utilised influences the position of the aggregate supply curve. Advances in technology causes inputs to be more effectively utilised. New machinery improves efficiency when other inputs are used, and the development of new materials can also have an impact. Such developments reduces firms’ costs and increase the amount of aggregate output that can be produced, leading to a shift in the long-run aggregate supply curve.
Labour as a factor of production also becomes more effective and productive, and can be seen as a form of human capital. Improvements to education and skills training improves productivity of labour, causing a rightward shift of long-run aggregate supply. Training and education is important for an economy that is undergoing structural change, so that workers need to be prepared to move between occupations. Government encouragement or provision of such training improves the flexibility of the labour market and affects aggregate supply.
How does the effect of a supply shock in the short run cause changes in the macroeconomic equilibrium?
The AD/AS model can be used to analyse the effects of an external shock affecting aggregate supply. For example, suppose there is increasing oil prices because of a disruption to supplies in the Middle East. This raises firms’ costs, and leads to a reduction in aggregate supply. We can see the likely effects on equilibrium.
During the first oil price crisis in 1973-74, the UK government tried to maintain the previous level of real output by stimulating aggregate demand. This increased the price level, but did not have any effect on real output. In the long run, the impact of a supply shock would depend upon whether the shock was a temporary or a permanent change. If permanent, there could be a shift in long-run aggregate supply.
How does shifts of and movements along the AD and AS curves cause changes in the macroeconomic equilibrium?
Normally, if a shock affects the position of one of the curves, it will lead to a movement along the other. For example, if the AS curve shifts as a result of a supply shock, the response is a movement along the AD curve, and vice versa. When trying to analyse the effects of a shock, first think about whether the shock affects AD or AS, and then analyse whether the shock is positive or negative: which way would the curve shift. The move towards a new equilibrium can then be investigated.
What are the indicators associated with the targets of macroeconomic policy?
- Stability in prices
- Full employment
- Economic growth
- Stability on the balance of payments
- A balanced government budget
- A fair distribution of income
- Safeguarding the environment
How does stability in prices affect changes in AD and AS?
The AD/AS model explains how the equilibrium price level for an economy is reached. It also explains how an increase in aggregate demand when the economy is at full employment will result in a higher equilibrium price level, but with no change in the level of real output. If aggregate demand continues to increase, then the price level will continue to rise, and the result is inflation.
How does full employment affect changes in AD and AS?
When the macroeconomy is in equilibrium at a given level of real output, there is an implied level of employment — meaning a level of unemployment. The position of the AD/AS equilibrium determines whether the economy is at full employment. With a neoclassical vertical LRAS curve, the economy always returns rapidly to full employment. However, with a Keynesian interpretation of the AD/AS model the macroeconomy could settle in equilibrium below the full employment level. In this situation, a shift in aggregate demand is needed to take the economy back to full employment.
How does economic growth affect changes in AD and AS?
Long-run economic growth causes a shift to the right of the long-run aggregate supply curve. This may be caused by an increase in the quantity of factors of production available in the economy, or more efficient use of them. Short-run economic growth in the AD/AS model may be a short-run response to an increase in aggregate demand, which may not be sustainable if it takes the economy temporarily beyond the full employment level. Alternatively, the macroeconomy could return to equilibrium having been positioned below full employment.
