Long Run Aggregate Supply

EdExcel AS Economics 2.3.3

• Changes in a nation’s potential GDP are brought about by:• Changes in labour supply available for production (i.e.

more people joining the labour force)• Changes in the stock of capital inputs – affected by the

level of gross capital investment• Changes in the efficiency of allocation of factor inputs

e.g. shifting resources from rural to urban areas• Improvements in the quality of factor inputs /

productivity of inputs• Advances in the state of technology• Improvements in institutions such as the banking

system• An outward shift of LRAS signifies an increase in long-run

potential output and employment• A higher level of LRAS signifies real economic growth

Increasing LRAS – Lifting Productive Potential

Components of Trend Growth for the UK Economy

Data for 2015 and 2016 are forecasts published at time of July 2015 budget

Annual growth rate (per cent)

Potential

productivity (output per

hour)

Potential average hours

Potential employment rate for those

aged 16+

Potential population

growth

Overall Potential Output for the UK Economy

2015 1.4 0.0 0.0 0.6 2.12016 1.8 -0.1 -0.1 0.6 2.22017 2.0 -0.2 -0.1 0.6 2.32018 2.1 -0.2 -0.1 0.5 2.3

Trend growth is the estimated rate of growth of a nation’s productive potential. The table shows data for the UK and finds that productivity growth is the main driver of potential output over the long run. The main measure of productivity used is output per person-hour.

Key Factors affecting Long-Run Aggregate Supply

Higher Productivity of

Labour and Capital

I.e. a rise in output per person

employed or increased

efficiency of technology

Increased Labour Market

Participation i.e. A growing

labour supply and a rise in the

number of people in paid work

Gains from Innovation and

EnterpriseThese are two key

factors that determine

competitiveness especially in international

markets

Capital Investment

Including capital spending by

businesses, inward investment from

overseas (FDI) and the Public Sector

(Government)

Productivity

Productivity measures the efficiency of the production process

• In the long run, productivity is a major determinant of economic growth and of inflation.

• A fall in labour productivity leads to a rise in firms’ (unit) costs of production (assuming that the level of wages remains the same)

• Higher productivity allows businesses to pay higher wages and achieve increased profits at the same time.

Factor Inputs (land,

labour and capital)

Factor Productivity(efficiency)

Output

Impact of improved productivity on the UK Economy

All other things being equal, an improvement in labour productivity is most likely to …..

Macroeconomic Objective Comment on the Effect

Inflation Lower – unit costs will be falling

Economic growth Higher – gains in aggregate supply

Unemployment Lower in long run as growth rises

Balance of trade in goods & services Improved – more competitive exports

Spare capacity in the economy Rise from extra capacity in short run

Business investment Higher – profits will have increased

Government fiscal balance Productivity gains in government will help to reduce state spending

Explaining the non-linear AS curve

• When spare capacity is high then SRAS will be elastic• A rise in AD can be met easily by increased output• There is little threat of rising prices (inflation)

• The elasticity of SRAS curve falls as output increases• The amount of spare capacity declines• Possibility of diminishing returns in production• Bottlenecks in supply of inputs and components• Resource shortages as the economy approaches full

employment e.g. Skilled labour becomes more scarce• When SRAS becomes perfectly inelastic the economy is at

full capacity (equivalent to being on the PPF boundary)• Further increases in AD at this point are purely

inflationary in the short run with little extra real output

Keynesian Non-Linear Aggregate Supply Curve

General Price Level

Real GDP

AS

AD1 AD2AD3

AD4

AD5

Non-inflationary growthAn outward shift in AD from AD1 to AD2 can be met without an increase in the price level because short run aggregate supply is highly elastic

GPL1

Y1Y2

Keynesian Non-Linear Aggregate Supply Curve

General Price Level

Real GDP

AS

AD1 AD2AD3

AD4

AD5

Inflationary pressuresAn outward shift in AD from AD3 to AD4 causes a sharp rise in the general price level because AS is inelastic (i.e. output is close to full-capacity levels)

GPL4

Y3 Y4

GPL5

Keynesian Non-Linear Aggregate Supply Curve

General Price Level

Real GDP

AS

AD

When the AS curve become vertical, the economy has reached full-employment of factor resources.

Full employment is defined as a state of the labour market in which everyone who is willing and able to work at the current wage rate is in employment, excluding those who are frictionally unemployed

YFE

GPL

Keynesian AS Curve and Negative Output Gap

General Price Level

Real GDP

AS

AD

YFE is full employment and at Y1, the economy is operating below full employment so it is experiencing a negative output gap

YFE

GPL

AD1

Y1

Long Run Aggregate Supply

EdExcel AS Economics 2.3.3