Keynesian and neoclassical views of long-run aggregate supply

Overview

Horizontal section of the Keynesian long-run aggregate supply curve flat and point on which the Keynesian and neoclassical views agree.

What you need to know

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Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Describe the shape of the long-run aggregate supply curve as drawn by neoclassical economists and explain the reasoning behind it.

   Model answer

   It is a vertical line on a diagram with the general price level on the vertical axis and real national output on the horizontal axis, positioned at the economy's full-employment level of output. The reasoning is that in the long run all prices, including wages, are fully flexible and adjust to any change in the general price level, so real costs return to their original level and firms have no reason to produce more or less. Output in the long run therefore depends only on the quantity and productivity of the factors of production.

2. 2

   Describe the shape of the long-run aggregate supply curve as drawn by Keynesian economists.

   Model answer

   It has three sections on a diagram with the general price level on the vertical axis and real national output on the horizontal axis. At low levels of output it is horizontal, because with mass unemployment and idle capacity firms can expand output without any rise in costs or prices. As output rises further it slopes upwards, because shortages of particular skills, materials and machinery begin to bid up costs. At full capacity it becomes vertical, because no more output is physically possible whatever the price level.

3. 3

   Why is the horizontal section of the Keynesian long-run aggregate supply curve flat?

   Model answer

   In deep recession there is a large pool of unemployed labour and unused machinery, so firms can hire and produce more without competing resources away from anyone else and without bidding up wages or input prices. Costs per unit are therefore roughly constant, and firms are willing to supply more output at the existing price level. It is also assumed that money wages do not fall in this range, which prevents costs and prices from dropping.

4. 4

   Why does the Keynesian long-run aggregate supply curve become vertical at high levels of output?

   Model answer

   At that point every available worker is employed and every machine is running, so the physical limit of what the economy can produce has been reached. Extra spending cannot call forth more goods, because there are no unused resources for firms to bring into production. Any increase in aggregate demand at that point can only raise the general price level.

5. 5

   Analyse the effect of a rightward shift of aggregate demand on the Keynesian long-run aggregate supply curve when the economy is in deep recession.

   Model answer

   The economy is on the horizontal section, so the aggregate demand curve intersects a flat aggregate supply curve. With the general price level on the vertical axis and real national output on the horizontal axis, the new equilibrium lies directly to the right of the old one: real national output rises substantially and the general price level is essentially unchanged. Demand management is highly effective in this range, delivering extra output and employment at no inflationary cost.

6. 6

   Analyse the effect of a rightward shift of aggregate demand on the vertical section of a Keynesian long-run aggregate supply curve.

   Model answer

   The economy is at full capacity, so the aggregate demand curve intersects a vertical aggregate supply curve. The new equilibrium lies directly above the old one: the general price level rises while real national output is completely unchanged. Any extra spending simply bids up the prices of a fixed quantity of goods, so demand expansion in this range is purely inflationary. The Keynesian and neoclassical views agree entirely once this point is reached.

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