1. Aggregate demand and aggregate supply
SBC Economics
Aggregate demand and aggregate supply
Learning outcome W
Define aggregate demand and understand its components
Explain what causes AD to shift
Define aggregate supply
Define the different versions of LRAS
Explain what causes AS to shift
Explain the interaction of AD and AS in the determination of equilibrium output
Draw AD/AS curves to illustrate the shifts in the economy
Reading: Units 33 & 34

2. Aggregate supply
Aggregate means total, aggregate supply therefore means the total of all the supply in the economy

3. Aggregate supply
Aggregate supply can be shown as a curve showing the relationship between the price level and the level of real expenditure in the economy
Price level is the average prices in the economy, an increase in the price level is known as inflation
Real output is equal to real expenditure and real income (O=E=Y)

4. The aggregate supply curve
Price
level
SRAS P2 P1 O Y1 Y2
Real output

5. What causes the AS curve to shift?
A change in costs would cause the aggregate supply curve to shift
An increase in costs would cause the AS curve to shift upwards (SRAS1 to SRAS2)
A decrease in costs would cause the AS curve to shift downwards (SRAS1 to SRAS3)
Factors that could affect costs include:
Wage rates
Cost of raw materials
Taxation

6. The aggregate supply curve
Price
level
SRAS2
SRAS1 P2
SRAS3 P1 P3 O Y
Real output

7. Classical view of long run aggregate supply
In the long run there is a limit as to how much firms can increase their supply
Firms face limits on the amount of labour that can be hired, labour productivity is maximised and capital equipment is fixed in supply
It is argued that in the long run aggregate supply is fixed at a given level of output, whatever the price level
This means the LRAS curve is drawn as a vertical line

8. Classical view of long run aggregate supply
LRAS
Price
level O Y
Real output

9. What causes the classical LRAS curve to shift?
An economy operating on the LRAS curve is at its’ maximum potential output i.e. on the edge on the production possibility frontier
Economic growth therefore will increase the potential output of the economy and the LRAS curve will shift to the right (outwards) LRAS1 to LRAS2
A fall in potential output however would cause the LRAS curve to shift to the left (inwards) LRAS1 to LRAS3

10. Shifts in the classical LRAS curve
Price
level O Y3 Y1 Y2
Real output

11. Keynesian view of the long run aggregate supply curve
Keynesian economists disagree with the classical view that in the labour market will clear
They argue that even if there is unemployment there will be not be a fall in real wages
When there is mass unemployment the LRAS curve will be horizontal because output can be increased without experiencing an increase in costs (O to A)
When the economy nears full employment the LRAS curve will be upward sloping as workers will be able to negotiate higher pay and therefore increase costs to the firm (A to B)
At full employment firms will not be able to take on more labour whatever they pay, therefore the LRAS curve is vertical (B)

12. Keynesian view of long run aggregate supply
LRAS
Price
level
Mass unemployment
Full employment O A B
Real output