In this video we’ll take a look at the classical long run aggregate supply curve.
In A-level economics you’ll have a choice of which aggregate supply curve you use to
illustrate the long run.
I’ll introduce this curve here, but in future analysis will refer back to the Keynesian
aggregate supply curve which we’ll visit next.
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leave them below, email me at enhancetuition@gmail.com or tweet me @enhancetuition.
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of the way, let’s begin.
The classical model of aggregate supply holds that prices are flexible and any change in
aggregate demand will result in either an increasing or decreasing price level, with
no long run changes in output.
Prices and wages are considered to be completely flexible which means they are decided by market
forces.
Workers also do not have money illusion.
Price changes are matched by wage changes so that any increase in the price of goods
and services is met by an increase in the wage rate.
Real, not nominal values, underpin this behaviour.
Say’s law states that supply creates its own demand.
That means the equilibrium output will be determined by the supply side, not demand.
By producing goods and services, workers generate the income that they will use to purchase
this goods and services.
In the case of the classical model, increases in aggregate demand result only in increases
the price level in the long run.
In addition, decreases result in a lowering of the price level.
Both increases and decreases in aggregate demand result only in changes in the price
level, but not change the level of real GDP.
The underlying theory is that the economy will always move towards the full employment
level of output in the long run.
The economy will self correct and needs no intervention from the government to do so.
To show you why economists holding the classical view believe that changes in aggregate demand
only impact the price level in the long run, we have to understand the rational of their
view.
Let’s move step by step and see what happens in the short-run as we progress back towards
the long-run at a higher price level.
Our starting point is with a short-run and long-run macroeconomic equilibrium at Yfe
and PL*.
When aggregate demand increases from AD to AD1, producers are incentivised to increase
production.
There’s an extension of supply and our output level exceeds the full-employment level.
The difference between Yfe and Y1 is our positive output gap.
This is also known as an inflationary gap.
After some time, at a higher price level, workers will ask for higher wages and drive
up the cost of labour, which returns us to our full-employment level of output in the
long run, Yfe.
Increases in the costs of inputs can also be part of the rise in production costs.
Given enough time, workers will request wage increases and sellers of key resources will
eventually raise prices.
Let’s move step by step and see what happens in the short-run as we progress back towards
the long-run at a lower price level.
Our starting point is with a short-run and long-run macroeconomic equilibrium at Yfe
and PL*.
When aggregate demand decrease from AD to AD1, producers are have less incentive to
produce.
There’s a contraction of supply and the output level falls below the full-employment
level.
The difference between Yfe and Y1 is our negative output gap.
It is also known as a deflationary or recessionary gap.
In the case of a recessionary gap, real GDP is below the potential level and unemployment
is greater than the natural rate.
The argument is put forth that over time, as workers are out of work for longer periods
of time, they are willing to accept lower wages in order to return to work.
When they do this, the cost of production falls and the economy returns to its long-run
macroeconomic equilibrium.
We started off this video with a simple look at the classical long run model and have now
examined it further to understand the logic behind it.
You should be a little bit more comfortable with this topic by now and you shouldn't worry
if you’re not 100% confident just yet.
As you examine macroeconomic changes you’ll be applying this or the Keynesian model to
illustrate changes.
As always, leave any messages below or contact me directly.
I’ll see you in the next one.