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


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


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


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


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.


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.


We Are All Dead

“In the long run we are all dead”

-John Maynard Keynes

Over the past couple of days I have taken a greater focus on long run aggregate supply (LRAS) and short run aggregate supply (SRAS). I quickly fell upon the arguments posed by both the Monetarists and Neo-Classicists versus those of Keynesians.

I felt quite comfortable with the monetarist and neo-classicist outlook, as it followed what I would consider as logical. The markets will manage to clear themselves, yes there will be unemployment and other economic repercussions, but in the “long term” the economy will be better off. This is on the basis that inefficient and unproductive firms will fall out of the market, whereas the firms that are stronger will maintain their position. The fall in prices will encourage investment and renewal if the industry if there is still demand within that market.

I personally agree with above, but in that sense I could also agree with Communism. Theoretically it is a very sound and strong argument, however when put into practice the results are not as comforting. It will take a long time for the market to clear itself, and during this period there will be social unrest (as a result of unemployment), lack of rational decision making (human quality), and depending on the case an economic standstill until the market forces begin moving again. There is also the issue of downward inflexible prices (sticky) which means that suppliers will wait out the market and won’t drop their prices, thereby further delaying the clearing process.

With continued unemployment there is almost an inevitable drop-off in aggregate demand, so the overall sight of the economy by leaving the market forces to clear it does not seem too bright.

Keynes would argue that it is essential to “prop up” demand through government spending, with this it is important to note that this is the only point at which Keynes argues that government spending is vital (he is a free marketer). Keynes would further mention the need to keep maximum employment, ensuring that there is effective demand which would push aggregate demand along the Keynesian LRAS curve.

As usual with economic theory it is difficult to argue which one is in a sense “correct”, as we tend to always end up intervening. This is a result of the nature of government and democracy, as it is unlikely a party will be voted into power during the market clearing period.

On most occasions, I take a monetarist point of view, but at this point I would prefer to take the Keynesian stance. This is as a result for the overall benefit of the people functioning in the economy, as economics mainly seeks to maximize welfare. A true monetarist would argue that in the long term the market is not better off as unproductive and inefficient firms have been allowed to survive.

This brings me on to an issue that seems to almost be at the heart of all economic theory, and one I find myself running into often. It is the issue of human frailty, and furthermore our inability to truly consider the long term.

Eurozone Unemployment

As a result of the financial crisis in 2007 countries within the European Union have struggled to maintain low levels of unemployment, this is the outcome of retracting economies and austerity measures. Across the Eurozone the average unemployment rate has reached a peak of 12%. The article identifies the occurrence of this peak as countries such as Greece, Spain, and Portugal all have unemployment rates around 25%. There are also fears that unemployment will further increase during April as a result of the Cypriot crisis.

Unemployment can be defined as “Those out of work, actively seeking work at the current wage rate”. This can be calculated in two ways, the first being through a claimant count (those requiring unemployment benefits) and the second being through a labour force survey. The labour force survey most often releases figures higher than through the claimant count, which is why governments tend to publish the claimant count unemployment rate.


As the current unemployment rate of the Eurozone is at 12% it is understood that there is a clear surplus of people willing to work. This can be clearly shown through the demand and supply relationship for labour.


The highlighted triangle represents the unemployment as labour is demanded at LD but supplied at LS. This shows a simple representation of the current unemployment, but it does not display the causes of it.

The causes of this unemployment can be recognised through the article as cyclical and structural. Germany maintains to be the manufacturing powerhouse of the Eurozone helping keep unemployment of the country down, however countries such as Greece and Portugal do not have strong industry. This is the presence of structural unemployment as the economies require people to work jobs that they are not trained for or overqualified. The cyclical unemployment was initially the result of the initial financial crisis recession, but double-dip recession has magnified the impact on unemployment. Countries that struggle to create economic growth tend to struggle creating jobs.

The article identifies that as a result of this continuous unemployment, the Eurozone has fallen back into recession. Manufacturing industries and other business have seen a decline in business activity, thereby showing a lack of aggregate demand throughout the European Union.


The graph above shows how unemployment in the region has affected growth prospects for the future, as shown through the movement from Eq to Eq1. The shift in aggregate demand inwards is a result of unemployment, as when people do not have a salary their effective demand is further restricted.


There are clear limitations to the initial demand and supply of labour model above, this model fails to show where the unemployment is allocated (i.e. agriculture, finance, or manufacturing). Furthermore, it does not accurately represent the actual quantity of those currently unemployed. However, it does help establish the significance of unemployment as it contributes to understanding that there is a fall in aggregate demand, and therefore a dampening on growth prospects for the European Union.

The aggregate demand and supply diagram clearly shows the effect of unemployment on the European economies, and it also shows how the price level has gone down. This is true to an extent as European inflation is estimated to be at 1.8%. This identifies that in the short run disinflation is occurring within the Eurozone. This low level of inflation as a result of the drop in aggregate demand signifies that the European Union economies are struggling to achieve growth and employment. However, in the long run there may be the occurrence of reflation as the economies pursue growth, through creating more jobs and reducing unemployment.

The continuous unemployment and resultant fall in aggregate demand will have a negative effect on European manufacturing. There are already signs that business activity is diminishing (PMI=46.8 Contraction), and further unemployment will only hinder European manufacturers.

Currently across the Eurozone governments are pursuing austerity budgets to attempt to reduce debt, and climb out of recession. However, this is keeping unemployment at high rates. This attributes to a Keynesian solution of spending more to save more. If governments were to create more debt in pursuit of structural investments there may be a spur in economic growth. This can take the form of updating road networks, creating new airports, and building factories. This would help significantly aid in reducing unemployment rates in countries such as Greece, which need an infrastructural upgrade regardless.

South Africa: Sink or Swim

South Africa is currently suffering from a high rate of unemployment making it difficult for the economy to grow. Forecasted growth rates have already been downscaled as the largest economy in Africa is struggling to meet targets. The countries main contributor to GDP can be identified as consumer spending and this is why the persistent unemployment is having a considerable effect on growth forecasts.

Key Terms:

Unemployment – “Those out of work, actively seeking work at the current wage rate”

GDP/Growth – Measured by the output of an economy (gross domestic product)

Consumer Spending – Spending on retail goods, energy consumption, transportation, housing costs, and other areas where disposable income is spent.

Due to the high levels of unemployment it can be noted that there is a decline in aggregate demand within the economy. Colen Garrow states that the retail sector is weakening and there is going to be pressure overall as there is a lack of demand. It can be noted that to an extent the South African economy is contracting as there has been increased inflation as a result of a cost-push and fall in aggregate demand (shown below).


The shift for aggregate demand from AD to AD1 is a result of the rise in unemployment, the people have less spending power and therefore there is an overall decrease in consumer demand. The shift of aggregate supply is a result of the tightening credit environment as firms struggle to meet their costs. The red rectangle represents the inflationary response in the economy as a result of the shift in aggregate supply. So as a whole the South African economy has retracted as output has significantly decreased (resulting in forecasts for future growth to decline) and there has been an inflationary response, as the price level has increased.

There is also the factor of unemployment which is 24.9% falling from the peak during Q4 of 2012 at 25.5%.This is shown simply below with a demand and supply relationship of labour in South Africa.


Currently in the market labour is only being demanded at the point of LD but the supply is at LS. This surplus of labour is the current unemployment. With so many out of work and seeking work it is clear that economy is not working to full capacity. If a production possibility frontier for the economy was shown it would be operating within the curve. This further explains the economies inability to have substantial growth.

Consumer spending has radically decreased, making it difficult for the economy to grow and therefore attempt to combat the unemployment. This is realised by the fact that private sector demand for credit dropped from 10.09% to 8.64%. This is why the retail sector is struggling, as the unemployment and inflation has led to the decline of demand.

The unemployment in South Africa can be seen as a combination of structural and cyclical unemployment. Mining has been one of the major consumers of labour in the region, and recent closing of mines and movement by companies to other African regions for mining has meant a structural change in labour demand. The cyclical unemployment is a result of the struggling economy, as different firms reduce the amount of people they employ to meet the higher costs of production.

In the short run the economy is not likely to recover, growth is a must if the government aims to combat the high rate of unemployment. It is essential to restore consumer confidence in the economy, and also enable people to obtain credit more easily as to restore the aggregate demand of the economy.

In the long run for the economy to attempt to maintain growth, eliminating unemployment is essential to attempt to get the economy working back at a point of the PPF. However this could lead to an inflationary response in the form of a demand pull, and the government will need to begin considering how to reduce already increasing inflation as a result of increasing production costs.

Currently in the South African economy the rate of unemployment is pulling it down, in this situation there are no winners within the country. Exports may become more favourable as the inflation will weaken the South African Rand, but make investing in South Africa unlikely. To solve the unemployment in South Africa is difficult as a result of its cyclical and structural qualities; the first step would be to create more job opportunities. However, it is also essential that a greater majority of people achieve education and training whether it is academic or vocational to help improve employability prospects.

Expected growth by 2014 is forecasted at around 3.4% which is still considerable in comparison to some countries in the EU. There is still risk though investing within the country and the government must do more to encourage foreign investment and begin a round of serious structural investment such as roads to create jobs and spur on growth.

There is the potential for South Africa to climb out of the current situation, and unemployment stands at the centre of it. The country is still Africa’s biggest economy and will continue to be so if it can achieve consistency with its currency and sustained growth.

Growth & Structural Reform

Production Possibility Frontier & Aggregate Supply:

There are many determinants for a shift in aggregate supply; this would mean an increase in real output without an increase in the price level.


Some examples of the determinants are:

  • Education: Increased productivity, capabilities, and efficiency of the labour force
  • Innovation/R&D: The product may become more useful or easier to manufacture
  • Government Regulation or Subsidy: Encourages production, or deregulates an immobile market.
  • Transport/Infrastructure: If there was better transport then people could work more often rather than waste time in traffic,  development of infrastructure develops efficiency.


Analysis from Article:

Using Evidence from the Article Explain the Impact of Investment on the UK’s PPF?

Increasing the quality of university education and teachers may mean that the workforce becomes more efficient and productive. The article highlights the need to invest in human capital. This would lead to an outward shit for the PPF because there is a greater potential for production. If this potential were to be realised there would be a shift to the right for the aggregate supply curve.

The article mentions that the government should target investment towards equipment rather than property, increasing government investment into R&D and general innovation. The lack of innovation is identified through the lack of patents submitted. The issue surrounding R&D and capital investments are the long pay-off periods, whereas financial products pay-off in the short term. If more money were to be invested in long term research and development projects there is an outward shift for the PPF as there is a higher possibility of products being manufactured with greater efficiency.

Finally, the article recognises that British infrastructure is considered “mediocre” being ranked 24th in the world. It relates this to government failure, and the amount of time it takes to get energy bills through and the time it takes for projects to come to fruition. If there were to a boost in infrastructure spending, then there is the potential for an increase in productivity leading to an outward shift in the PPF.

Evaluate the Argument That Structural Investments Alone Are Not Enough to Stimulate Growth?

There are many theories and manners of approaching how best to stimulate growth, the article heavily leans toward the Salter Cycle. This can be summarised as an increase in productivity and efficiency, resulting in reduced inputs of land, labour, and capital while achieving a great output. This what the article highlights as structural investment, i.e. improving education, improving transport, and stimulating research and development. This does work to stimulate growth however it must be realised that humans can only ever be so efficient or productive, and that factors such as capital and land become scarcer in developed countries.

It is true that the government needs to stimulate development within Britain; it is unacceptable to continue supporting financial institutions that don’t contribute to growth. Energy and energy efficiency are two factors which are integral to stimulating growth within an economy, simply because when there is a greater quantity of energy and at a cheaper price more is used. This is where the American government unlike the British government took a lead and has effectively introduced shale fracking to slash gas prices down and increase consumption. The British government has been slow to develop supporting infrastructure and R&D for the implementation of fracking, when a recent geology report displayed the abundance of shale formation across Britain. This highlights the need for structural investments, but into sectors that have optimistic prospects for the future.

The other methods of approaching growth stimulus can be equally as effective. There is the classical approach of increasing free trade between countries, and the development of trade agreements to stimulate production resulting in general economic growth. In the article there is a display of a real GDP per person graph, it shows that Britain had the highest real GDP in 1870. This was a time when Britain had abundant trade from its colonies (without restriction due to naval dominance and to an extent exploitation), and the expansion of trade into the “new world”.

Structural investment will assist Britain in re-modernising; however it can be argued that it is best suited to developing economies that still have a greater abundance of land, labour, and emerging capital. One possible route is the development of military infrastructure; this would mean creating more aircraft carriers and submarines. This has worked to an extent to help stimulate American growth as it announced that two new aircraft carriers are going to be developed, and the roll out of the successor to the F-22 Raptor.

Another possible approach to growth stimulation is to induce a state of semi-isolationism which had worked for East-Asian economies in the 90s. The crash for the East-Asian economies can be attributed to the liberalization of markets which had stifled growth due to speculation. Creating a state of semi-isolation reduces the inefficiency of market speculation, and makes a country more self-dependent, and this may be realised through structural investment. Overall, it can be recognised that structural investment are a necessity, but it must be coupled with a new economic approach to achieve not only growth but sustainable growth.