• Long run aggregate supply (LRAS)?is influenced by a change in the?productive capacity?of the economy
  • Productive capacity is changed by changes to the?quantity or quality?of the?factors of production
• Economists have?two opposing views?on how?LRAS?works in an economy
  • The?original view?is called the?classical view
  • The insights developed by?John Meynard Keynes?in 1936 are called the?Keynesian view

?The Classical LRAS View

• The classical view believes that the?LRAS is perfectly inelastic?(vertical) at a point of?full employment?of all available?resources
  • This point corresponds to the maximum possible output on a?production possibilities frontier (PPF)
• The classical view believes that?in the long-run?an economy will always return to this?full employment level of output
• There may be?short-run output gaps?in the economy
  • During extreme periods of?economic growth?there can be an?inflationary gap?that develops
    • In the?long run?this will?self-correct?and return to the long-run level of output, but at a?higher average price level
  • During slowdowns or?recessions?there can be a?recessionary gap?that develops
    • In the?long-run?this will?self-correct?and return to the long-run level of output, but at a lower average price level

A diagram that shows the Classical View of long-run aggregate supply (LRAS) with a vertical aggregate supply curve at the full employment level of output (YFE)

Diagram Analysis

• Using?all available?factors of production, the long-term output of this economy?(LRAS) occurs at YFE
• The economy is initially in?equilibrium?at the intersection of?AD1?and LRAS (P1, YFE)
• A?slowdown?reduces output from?AD1→AD2?and creates a short term?recessionary gap
• This?self corrects?in the?long term?and returns the economy to the?long-run equilibrium?at the intersection of?AD2?and LRAS (P2, YFE)

?The Keynesian LRAS View

• Keynes believed that the?long-run aggregate supply curve (LRAS)?was more?L shaped
  • Supply is elastic?at lower levels of output as there is a lot of?spare production capacity?in the economy
    • Struggling firms?will increase output?without raising prices
  • Supply?is perfectly inelastic?(vertical) at a point of?full employment (YFE)?of all available?resources
    • The closer the economy gets to this point the more?price inflation?will occur as?firms compete for scarce resources
• The?Keynesian view?believes that an economy?will not?always self-correct and?return to the full employment level of output (YFE)
  • It can?get stuck?at an equilibrium well?below the full employment level?of output e.g. Great Depression
• The?Keynesian view?believes that there is?role for the government?to increase its expenditure?so as to?shift aggregate demand?and change the negative?'animal spirits'?in the economy

A diagram that shows the Keynesian View of long-run aggregate supply (LRAS) with a vertical aggregate supply curve at the full employment level of output (YFE) becoming more elastic at lower levels of output

Diagram Analysis

• Using?all available?factors of production, the long-term output of this economy?(LRAS) occurs at YFE
• The economy is initially in?equilibrium?at the intersection of?AD1?and LRAS (P1, YFE)
• A?slowdown?reduces output from?AD1→AD2?and creates a?recessionary gap?Y1-YFE
  • The economy may reach a point where?average?prices stop falling (P2), but output continues to fall
  • This economy?may not self-correct to YFE?for years
  • The?low output?leads to?high unemployment?and?low confidence?in the economy
    • This stops further?investment?and further?reduces consumption
• Keynes argued that this was where?governments needed to intervene?with significant?expenditure?e.g. Roosevelt's New Deal; response to financial crisis of 2008

• Any factor that changes the quantity or quality of a?factor of production?will impact the?long-run aggregate supply (LRAS)?of an economy:
  • This corresponds to an?outward or inward shift?of the potential output of an economy on the?production possibilities frontier
• The following factors will shift the entire LRAS curve outwards and increase the potential output of the economy:

1. Technological advances: these often improve the quality of the factors of production e.g. development of metal alloys
2. Changes in relative?productivity: process innovation often results in?productivity improvement?e.g. moving from labour intensive car production to automated car production
3. Changes in education and skills:?over time this increases the?quality of labour in an economy
4. Changes in government regulations:?these can improve the?quantity of the factors of production. e.g. deregulation of fracking (extracting oil from shale deposits) increased oil reserves
5. Demographic changes and migration:?a positive?net birth rate?or positive?net migration rate?will increase the quantity of labour available
6. Competition policy:?regulating industries so as to?prevent monopoly power?results in more firms supplying goods/services in an economy and this?increases the potential output?of an economy