Long Run Aggregate Supply

There are two theoretical outlooks on long run aggregate supply; there is the neo-classical/monetarist model and then the Keynesian model.

Neo-classical/Monetarist Model

Picture1

In the short run producers will respond to a change in price, but also higher demand by bringing in more inputs of production and utilising existing means of production. But in the long run in this model it can be note that supply is independent of price.

This makes the assumption that all prices are flexible, and if some prices go up others will go down. Furthermore, this displays that the potential of an economy to grow is based on four central factors land, labour, capital, and enterprise. There can also be an increase in productivity and efficiency which is the better utilisation of already existing factors of production.

An outward shift would be considered an increase in productive potential. This particular model also states that at that given point all resources are being employed and there is a point of full employment.

As a result of this model monetarists would argue that stimulating aggregate demand is artificial manner of promoting growth, and therefore shows that fiscal policy is ineffective.

Equilibrium Neo-classical/Monetarist Model

Picture3

This diagram determines that at the point aggregate demand meets long run aggregate supply that it is at the point of full employment of all resources including labour.  There can only be short term fluctuations as ultimately prices are completely flexible so there are no inflationary or recessionary gaps. The economy should always go back to the point of full employment level of output.

It also shows that increasing aggregate demand only invokes an inflationary response, rather than growth. This shows how supply side policies are extremely effective in regards to the monetarist model as an outward shift of LRAS would mean that there is great output at lower prices if it were to meet the same level of demand.

Keynesian model

Picture2

This model contains an element of the neo-classical model, but otherwise there are two significant differences. These differences are highlighted as this model can be separated into three different sections.

The first section is the horizontal line this is recognition that there are downward inflexible prices (sticky prices). This is because of factors such as labour contracts, unions, minimum wage, etc. At any point of alongside the horizontal line it is the recognition that some resources are not being employed and that there is production capacity which is not utilised.

Then there is the curve section which introduces the concept that there is still some response to price in the long run.  As the output increases so does the employment of resources, this causes prices to rise. To continue output firms must be able to continue increasing prices.

Finally there vertical section where there is the potential of full employment of resources. This is where prices can increase rapidly and GDP can’t increase as all aspects are being utilised.

Similar to the monetarist model, there can be an outward shift in long run aggregate supply. This is where the four main factors land, labour, capital, and enterprise are being utilised in a more efficient or productive manner. There may also be an introduction of new resources, which would cause the expansion. This particular model shows the benefits of using fiscal policy to stimulate aggregate demand as you achieve growth without an inflationary response.

An outward shift would mean an increase in productive potential, as the economy can utilise more resources in order to produce more. In this model however there are inflationary and deflationary gaps, as a result of the price sensitivity.

Equilibrium Keynesian model

Picture4

As shown in the diagram it can be noted that the economy can be at equilibrium at a variety of points where the economy is not at the point of full employment level of output. For AD1 it can be noted that there is not the full utilisation of resources.

Then the following point of AD2 it reaches the beginning of the section which is considered the deflationary gap. In this model the economy can stay at this gap. This is shown at the equilibrium with AD3. The economy can remain at this point because the model argues that without intervention the economy will not tend towards the point of full employment of output.

AD4 in contrast is presiding in the inflationary gap, where any increase in demand results in inflation rather than growth. At the turning point between the curve and the vertical line it can be considered the maximum potential output in the long run as it is the point that coincides with the greatest value of real output.

It is important to look at the point between AD1 and AD2 as this is the justification for the use of fiscal policy to increase aggregate demand. It can be seen that there is only an increase in real output between the two points, and not an inflationary response. This is because while shifting alongside this point the economy is simply using already existing spare capacity. The only point where there is a price increase is the deflationary and inflationary segments.

Evaluation

It is clear that there are strong arguments proposed for both models, the question to apply in the scenario is which one is more relevant to our current economic state. This however leads to a obvious split in decision making in regards to which model is followed, in brief terms Keynes’ model suggest that you must spend to save, whereas the monetarist model argues that there is the cyclical nature and any changes we make are artificial.

The main downfall of the monetarist model in regards to solving recessionary crisis or promoting growth is the extent to which it requires long-term planing. The Keynesian model creates a short-term effect as well as long-term which can make it seem more favorable for economic policy. However to apply the Keynesian model to today’s economic situation in Britain there is a curious result. In regards to aggregate demand there is expansionary monetary policy (low interest rates, increasing money supply i.e. QE) but there is an environment of deficit control which could be counteracting any effects on AD. But in regards to aggregate supply, in the current scenario I would support the Keynesian model as there is currently clear unfulfilled capacity.

 

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