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 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 Enterprise These 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 ObjectiveComment on the Effect InflationLower – unit costs will be falling Economic growthHigher – gains in aggregate supply UnemploymentLower in long run as growth rises Balance of trade in goods & servicesImproved – more competitive exports Spare capacity in the economyRise from extra capacity in short run Business investmentHigher – 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 AD2 AD3 AD4 AD5 Non-inflationary growth An 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 AD2 AD3 AD4 AD5 Inflationary pressures An 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 Y3Y4 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