In this video we will take a look at an alternative perspective to the long run aggregate supply
curve.
We’ll examine the Keynesian perspective and consider the key differences between Keynes’
and the classical economists.
Let’s go…
In response to the classical views of his time, Keynes questions the long run view by
stating
‘But this long run is a misleading guide to current affairs.
In the long run we are all dead.
Economists set themselves too easy, too useless a task, if in tempestuous seasons they can
only tell us, that when the storm is past, the ocean is flat again.’
In this quote Keynes is challenging the classical economists acceptance that society can afford
to wait for the market to clear and return to normal in the long run.
His focus is influenced by the human difficulties that occur while waiting for the market to
settle.
He held a specific view on depressions and deep recessions that underpinned his views
on economic intervention and demand management.
He believed that government intervention was necessary to emerge from such bleak economic
times as the market would struggle to correct itself — and impose significant harm on
society as it awaited a return to ‘long run equilibrium’.
The Keynesian long run aggregate supply curve has three portions, which we will describe
in detail.
The flat portion at low levels of real GDP, an intermediate range with an upward slope
and finally a vertical portion at full employment.
Let’s start with the horizontal portion.
So we’ll get rid of the vertical portion at full employment, then the intermediate
range where real GDP and the price level are increasing and focus solely on the flat section.
Keynes believed that at low levels of real GDP the aggregate supply curve was elastic.
With firms having high levels of spare capacity and the economy suffering from high unemployment,
firms had abundant access to resources to increase production.
They could increase production with no impact on the price level as resources were abundant
and had a lot of unused capacity to fill.
It is unlikely at these levels of GDP that competition for the demand for labour and
resources is high at all.
Keynes also held that prices were sticky downwards, which meant that it was difficult to adjust
prices downwards in tough economic times.
The logic behind this is that some forces will prevent wages from falling.
These could include minimum wage laws, trade union agreements and also labour contracts.
Without the flexibility to fall further, the cost of production could not fall as we expect
in the Classical model.
It’s for this reason that Keynes advocates government intervention at such low levels
of output.
Referencing the quote earlier, he was influenced by human suffering that could persist if governments
do not intervene and allow for the classical view of thought to prevail.
Sure, we could just wait for the market to return to equilibrium in the long run, but
at what cost - in the long run, we’re all dead.
Next up, the intermediate range…
In the intermediate range of the curve, real GDP is continuing to rise and we are much
closer to full employment.
The economy is approaching its potential level of output and resources are becoming more
and more scarce.
For this reason the price level is rising.
As we move along this portion of the aggregate supply curve, there is a tradeoff between
growth and inflation.
This is in contrast to the horizontal portion, where the economy could achieve growth with
no change in the price level.
And finally, the vertical portion of the curve, where we’ve reached full employment.
At this point, further increases in aggregate demand will drive up the price level and not
change our level of output.
This is because resources are fully employed and increasing demand will result in greater
competition for those resources.
I use the example of the overworked employee to illustrate.
There is only so far an economy can push its resources and this level of output is where
they will reach their limits.
We’ll see how an economy can increase its productive potential in a later video.
Now we bring it all together.
We’ve seen the different ranges of each part of the Keynesian aggregate supply curve
and we’ve also examined the characteristics of each.
I planned this video a little differently to try some techniques that make it easier
for you to remember the logic behind this curve.
Which brings us to the end of this video on Keynesian long run aggregate supply.
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If you’d like a copy of this presentation just follow the link in the video notes.
That’s us done and I will see you in the next one!