A) Different shapes of the long-run AS curve:
Keynesian argued that the classical theory of wages being variable in the long run was an unrealistic assumption and that it was possible to have a long-run equilibrium where markets don’t clear. Rather than differentiating Aggregate supply from short-run and long-run, in the Keynesian model there is only one Aggregate supply which is determined by the level of spare capacity within the economy. The fact that markets may not clear in the long run is shown by the spare capacity within the economy. As there is spare capacity within the economy, the level of output is able to increase without any change in the price level/inflation. However, as the equilibrium point gets closer and closer to full employment, spare capacity begins to get used up, putting pressure on existing factors of production, thus causing the price level to rise. At a certain stage, the economy will reach a state of full employment and therefore output cannot be increased anymore (shown by LRAS becoming perfectly inelastic). This is one of the few features that both the classical and Keynesian model has in common. An example of how the Keynesian model works can be shown in the diagram below:
Just like the classical model, YFE represents the level of full employment, which an economy cannot operate past sustainably. However, unlike the classical model, there is a point at which Aggregate supply is perfectly elastic as a result of the large amounts of spare capacity within the economy. As there is this large amount of spare capacity, an increase in Aggregate demand will have no inflationary pressures, as little pressure is put on existing factors of production. This can happen in times of economic downturn such as a recession. Keynes made the point that workers would be unwilling to revise down their wages despite large amounts of unemployment “sticky wages”. Due to the Keynesian model not assuming wages will become variable in the long term, active government policy is needed in order to increase AD and move the economy closer to full employment. Therefore, if no active policy is implemented “in the long run we are all dead”. Shown from the diagram, as the long term equilibrium could stay at AD1=LRAS1, governments need to implement expansionary demand side policies to shift AD outwards (AD1 to AD2). The most effective way to do this would be through expansionary fiscal policy as Consumption and Government spending make up the majority of the AD value. This leads to an increase in the general price level (P1 to P2) and an increase in real GDP (Y1 to Y2), reducing the negative output gap from Y1-Y2 to Y2-YFE. The large amount of spare capacity during a recession means that the government is able to increase AD without sacrificing the macroeconomic objective of low and stable inflation.
This diagram shows the effect of expansionary demand side policies to an economy that is near full capacity. The increase in AD (AD1 to AD2) causes a big increase in the price level (P1 to P2) due to the massive amount of pressure that it puts on existing factors of production. This is because they are already working at near full output. Despite the big increase in price level, output only increases by Y1 to YFE as a result of the limited amount of spare capacity left in the economy. As shown by this diagram, there is little benefit to the government of implementing expansionary demand side policies if the economy is near full employment and therefore supply side policies are a better option. This is a good evaluation point to use in exams (for example, the benefit of a decrease in interest rates depends on the level of spare capacity within the economy. This is because…..).
The main difference between classical and Keynesian is that the classical model has both SRAS and LRAS, whereas the Keynesian model only has one supply line. In the classical model wages are fixed in the short run and the long run is determined by wages being variable. Wages are fixed in the short run due to several reasons, the main one being strong trade unions; this is especially true in western countries. A strong trade union will make it very difficult for firms to reduce the wages of its workers due to the fact that the trade union acts in the workers interest and therefore will not accept a pay decrease. Another reason may be a high minimum wage act implemented in the labour market. This will make it illegal for firms to pay workers under a certain wage limit. The last reason is determinant of the existing welfare system. Firms may not be able to reduce workers’ wages as it would push their salary close or below that of welfare payments. Therefore, by doing this there would be no incentive for their workers to continue working. Another key feature of the classical model is that the economy will always be at full employment in the long run and therefore there will be no output gap. The functions of the classical model can be explained using the diagram below.
This diagram depicts the theory of the classical model in a time of a recession. A decrease in either: consumption, investment, government spending or net trade causes AD to decrease from AD1 to AD2. Firms can either accept this new level of output, or decrease their costs of production in order to stay at full employment. Although firms may want to continue at their current output levels in order to maintain their workforce (e.g. due to staff being already trained), they cannot. This is due to the fact that wages are fixed in the short run and meaning they have no way of reducing wages and therefore reducing costs of production. As a result of this, firms accept their new level of output. This causes real GDP to fall from YFE (full employment) to Y2 and the price level to fall from P1 to P2 (demand pull). The difference between YFE and Y2 is known as a recessionary gap and shows the fall in employment that takes place. This fall takes place due to the fact that the demand for labour is derived from the demand for goods/services. Therefore, if the demand for goods/services within an economy (AD) decreases (AD1 to AD2) then unemployment increases (YFE-Y2). The increase in unemployment that occurs causes workers to revise down their wage expectations. In an attempt to get a job, workers are willing to get paid less than they did previously. This allows firms decrease their workers’ wages, which are now variable (caused by the lower wage expectations), thus reducing costs of production and therefore increasing SRAS (SRAS1 to SRAS2). This increases real GDP, taking the economy back to a level of full employment (Y2 to YFE), as well as reducing cost push inflation in the economy (P2 to P3). As a result of this, classical economists believe that government intervention is not required in a recession as workers will eventually revise down their wages, taking the economy back to a level of full employment. The classical model can also be explained in the scenario of an economic boom/overheating economy as shown from the diagram below:
An increase in either: consumption, investment, government spending or net trade will result in an increase in aggregate demand (AD1 to AD2). This will cause an increase in real GDP (YFE to Y2) and an increase in the price level from P1 to P2 (demand pull). The economy is able to operate past the full employment level (YFE) as the full employment level represents around 5% unemployment rather than 0% meaning that output can go past the point of full employment, however this output is unsustainable. For example, firms could pay their staff overtime in the short term which is unsustainable. At the equilibrium of AD2=SRAS1, wages are still fixed. This is due to the fact that it takes a long time before workers realise that they are working harder (YFE-Y2), but receiving the same wage. In addition to this, the higher price level (P1 to P2) gives them more bargaining power as their wages have been reduced in real terms. Therefore, in the long term workers revise up their wage expectations. This causes workers’ wages to increase and therefore costs of production to increase also. As a result of this, SRAS decreases from SRAS1 to SRAS2 causing the economy to operate at the full employment level once again. However, this time the price level is higher (P2 to P3) (cost push inflation), (overall increase in price level – P1 to P3). This is why the classical economists say that the only way to grow sustainably when the economy is operating at full employment is through supply side policies.
B) Factors influencing long-run AS:
Anything that causes a change in the quantity/quality of factors of production within an economy will affect long-run Aggregate supply.