IB DP Economics - Unit 3 - Alternative views of aggregate supply (AS)-Study Notes - New Syllabus

Alternative Views of Aggregate Supply (AS)

Economists have different views about how the economy behaves in the short run and long run. These differences lead to different interpretations of the aggregate supply (AS) curve.

The two main approaches are:

• Monetarist/New Classical view
• Keynesian view

These views differ mainly in how they explain:

• The flexibility of wages and prices
• The ability of markets to self-correct
• The role of government intervention
• The causes of unemployment and inflation

Monetarist/New Classical View of the Long-Run Aggregate Supply (LRAS) Curve

The Monetarist/New Classical view argues that, in the long run, the economy naturally moves toward full employment equilibrium.

According to this view:

• Wages and prices are flexible.
• Markets adjust efficiently.
• Government intervention is usually unnecessary.

The Long-Run Aggregate Supply (LRAS) Curve

In the Monetarist/New Classical model, the LRAS curve is drawn as a vertical line.

Reason:

• Long-run output depends only on the economy’s productive capacity.
• Changes in the price level do not affect real output in the long run.
• The economy eventually operates at its potential output.

\( \mathrm{LRAS} \) is vertical at full employment output

Determinants of LRAS

The position of the LRAS curve depends on factors affecting productive capacity.

• Quantity and quality of labour
• Capital stock
• Technology
• Productivity
• Natural resources

These are supply-side factors.

Implications of the Monetarist/New Classical View

• Increases in aggregate demand only cause inflation in the long run.
• Unemployment above the natural rate is temporary.
• The economy self-corrects through wage and price adjustments.
• Government demand-management policies have limited long-run effects.

Keynesian View of the Aggregate Supply Curve

The Keynesian view argues that wages and prices may be inflexible, especially downward.

As a result:

• The economy may remain below full employment for long periods.
• Markets may not automatically self-correct.
• Government intervention may be necessary to stabilize the economy.

Shape of the Keynesian AS Curve

The Keynesian AS curve has three sections.

1. Horizontal Section

Occurs at very low levels of output during deep recession.

• Large amounts of unemployed resources exist.
• Firms can increase output without increasing prices.
• AS is highly elastic.

Key Idea:

• Increase in AD mainly increases output and employment.

2. Upward-Sloping Section

Occurs when the economy is approaching full employment.

• Some resources become scarce.
• Costs of production begin to rise.
• Both output and price level increase.

3. Vertical Section

Occurs at full employment output.

• All resources are fully employed.
• Output cannot increase further in the short run.
• Any increase in AD causes only inflation.

Comparison Between Monetarist and Keynesian Views

Inflationary Gap

An inflationary gap occurs when actual output exceeds the economy’s potential output.

This means: 

• Aggregate demand is greater than full employment output.
• The economy is operating beyond sustainable capacity.
• Strong inflationary pressure develops.

Actual output > Potential output

Effects of an Inflationary Gap:

• Demand-pull inflation
• Labour shortages
• Rising wages and production costs
• Overheating economy

Deflationary/Recessionary Gap

A deflationary gap or recessionary gap occurs when actual output is below potential output.

This means:

• Aggregate demand is insufficient.
• Resources are underutilized.
• High unemployment exists.

Actual output < Potential output

Effects of a Deflationary/Recessionary Gap:

• Cyclical unemployment
• Lower income and output
• Weak economic growth
• Possible deflationary pressure

Importance of Inflationary and Recessionary Gaps

• Help governments identify macroeconomic problems.
• Used to design fiscal and monetary policies.
• Important for understanding inflation and unemployment.

Summary Table

Key Ideas:

• Different economic schools have different views about AS.
• Monetarists emphasize self-correcting markets.
• Keynesians emphasize market instability and government intervention.
• Inflationary and recessionary gaps explain macroeconomic instability.