The King Edmund School Business Department

1. The King Edmund School Business Department Aggregate Supply

2. Aggregate Supply • Aggregate Supply (AS) is the total of all the output in the whole economy. So it could also be described as: • GDP or GNP (depending on which measure you use) • National income or Y (which means the same thing) • National output • It is also equivalent to the production possibility curve (macro model)

3. Aggregate Supply Aggregate Supply can be increased or decreased by changing the factors of production. • Land • Labour • Capital • Enterprise

4. Increasing Factors of Production

5. What does AS look like? Price Level (inflation) AS National Income or Output (Y)

6. Upward sloping AS • Economists agree that in the short term the AS curve will be upward sloping. (This is because it is the sum of all the industry supply curves in the economy.) • Companies will tend to supply more products at higher prices because they anticipate higher profits will follow. • The more output companies produce, the higher their costs of production will be and this will eventually result in higher prices.

7. The Short Run The short run in economics is a period of time when the behaviour of individuals, companies and consumers is unlikely to change dramatically. In the short run firms can increase supply without necessarily increasing the size of the workforce or increasing wages drastically (although overtime might start to be paid.) Companies in the short run are more likely to absorb increases in cost and reduce profit rather than raise prices. The short run AS curve is therefore relatively elastic. In the short run we assume that at least one factor of production is fixed. The Short Run AS Curve (SRAS) Price Level SRAS National Income or Output (Y)

8. Short run shifts • Just like in microeconomics, the AS curve will shift left or right. • In the short run, the main reasons why this happens are: • Wage rate changes • Raw material costs • Taxation changes (business taxes like VAT) • Productivity changes (factors of production perform better)

9. Short run shifts in AS Price Level SRAS2 LEFT (Y FALLS) SRAS1 SRAS3 RIGHT (Y RISES) National Output (Y)

10. Left or right? Left (bad for production) • Higher wages • Staff shortages • Industrial unrest • High import costs • Increases in VAT • Costly legislation Right (good for production) • Productivity improvements • Wages fall • Costs fall • Taxes fall • Subsidies/grants given Output FALLS; Prices RISE Output RISES; Prices FALL (Shortages lead to scarcity)

11. John Maynard Keynes • British economist • 1883-1946 • Economic theories shaped the post war world (not just in the UK) • Credited with guiding the US out of the 1930s depression HW: Find out more about Keynes!

12. The Keynesian AS Curve AS Price Level P4 P3 P2 P1 AD5 AD4 AD3 AD1 AD2 National Income or Output (Y) Y1 Y2 Y3 Y4

13. Explanation • Imagine the economy is in recession at Y1. Output is low and inflation is low at P1. • The AS curve is perfectly elastic. Firms can easily respond to an increase in demand; they simply switch on the machines they stopped using and use up excess stock. They can increase Y easily to Y2 without prices needing to go up at all from P1. • There comes a point however when they will have to employ extra workers or buy more raw materials. This will lead to a slight increase in prices to P2 as output moves to Y3 and subsequently higher prices P3 as national output moves to Y4. • Eventually all companies reach full capacity. All the machines are being used and workers are on 24 hour shifts. Firms cannot increase supply and so all they can do is raise prices. (The other options, for example moving to a bigger premises are only available in the long run.)

14. A critique of the Keynesian Model AS2 Price Level AS1 C P3 B P2 P1 A AD2 AD1 National Income or Output (Y) Y1 Y2

15. A critique of the Keynesian Model • The economy starts in equilibrium where AD1=AS1. The price level is P1 and output is Y1. • Assume there is an increase in Aggregate Demand. The AD curve shifts to AD2 and there is a new equilibrium at Y2 P2. For a bit of extra output the economy must accept a higher level of inflation. Keynes argued it was worth it in terms of jobs that would be created. • Critics however argue that as soon as the inflation rate goes up to P2, workers will start to bargain for higher wages. As firms’ costs of production go up, there will be a leftward shift of the AS curve to AS2. The new equilibrium is now Y1 and P3. • The economy is worse off than it was before because there is the same level of Y, but much higher inflation. • Any further attempts to increase AD will cause higher and higher inflation. • In the long run, the AS curve is vertical.

16. What does the Long Run look like? Price Level LRAS National Income or Output (Y)

17. What happens when you increase AD? Price Level INFLATION LRAS P2 P1 AD2 AD1 National Income or Output (Y) Y1

18. What happens if you increase LRAS? Price Level LRAS1 LRAS2 P1 P2 AD1 National Income or Output (Y) Y1 Y2

19. Supply-Side EconomicsSo how do you increase AS? All these policies aim to increase factors of production (land, labour, capital, enterprise) or make them work more effectively (productivity). Land/Capital • Boost investment, R&D and innovation • Improve infrastructure (e.g. roads, transport, national grid, broadband) Labour • Improve education and training, e.g. apprenticeships, improving employability of young people, retraining older people • Improve job centres and availability of job information • Improve incentives to work and employ people such as reductions in income tax, employer national insurance contributions or subsidies to take people on. • Improve work ethic by making it harder to claim benefits • Reduce restrictions in the labour market, e.g. Minimum wage or trade unions Enterprise • Encourage business start ups and enterprise; this can be through subsidies and grants, but also through regulation or deregulation. • Remove the factors that inhibit business – i.e. unnecessary red tape/laws/restrictions or reduce corporation or business taxes.

20. Possible problems (1) There are negative side effects: • Cutting benefits affects income distribution and may increase poverty (it depends on whether people on benefits are lazy or in genuine need) • Tax cuts can result in reduced income for government (although it depends on how people react to changes) • Subsidies can be expensive and long term lead to inefficiency (it depends on whether companies come to rely on grants) • Reducing red tape and changing laws may increase monopoly power or damage the environment or cause a deterioration of working conditions. • Reducing union activity or reducing the minimum wage affects working conditions and worker welfare. Will strikes be inevitable?

21. Possible problems (2) • Most supply side measures take a long time to work • Education and training changes take time to work through; • Infrastructure takes time to build • Requires culture change or a change in people’s thinking or mind set or work ethic – can take a generation • Requires government intervention and often money (e.g. grants) • Political change often scuppers long term projects e.g. Labour’s educational policy which took 10 years to develop is now being reversed!

22. Conclusion In the long run, supply side policies can increase growth and employment without causing inflation But • They take a long time and can have negative side effects in the short run. Therefore • most governments agree that in the short term some demand management (i.e. increasing AD is also important especially in times of recession.