Supply-side policies in the AD-AS model

Overview

Diagram showing a successful supply-side policy and successful supply-side policy affect the output gap.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   In the AD-AS model, what does the long-run aggregate supply curve represent, and why is it usually drawn vertical?

   Model answer

   Drawn against the general price level on the vertical axis and real national output on the horizontal axis, it represents the economy’s productive potential, the level of real output that can be sustained given the quantity and quality of the factors of production and the current state of technology. It is drawn vertical because in the long run that capacity does not depend on the general price level: if all prices and wages doubled, the number of workers, machines and hours available would be unchanged. Its position can only be moved by changes in the resources themselves or in how efficiently they are used, which is precisely what supply-side policies attempt.

2. 2

   Describe the diagram showing a successful supply-side policy.

   Model answer

   Put the general price level on the vertical axis and real national output on the horizontal, with a downward-sloping aggregate demand curve, an upward-sloping short-run aggregate supply curve and a vertical long-run aggregate supply curve, intersecting at price level P1 and output Y1. A successful supply-side policy raises capacity, so long-run aggregate supply shifts right from LRAS1 to LRAS2 and, where costs also fall, short-run aggregate supply shifts right from SRAS1 to SRAS2. With aggregate demand unchanged the new equilibrium is at a higher real output Y2 and a lower general price level P2, which is the combination of faster growth and lower inflation that makes such policies attractive.

3. 3

   Distinguish a shift in short-run aggregate supply from a shift in long-run aggregate supply.

   Model answer

   Short-run aggregate supply shifts when the costs firms face change at a given level of capacity, for example because wages, energy prices, indirect taxes or imported input prices have changed, and the shift alters how much firms are willing to supply at each price level without altering what the economy is capable of producing. Long-run aggregate supply shifts only when capacity itself changes, through more or better labour, more or better capital, better technology or more efficient use of resources. A cut in an indirect tax moves the short-run curve; a permanent improvement in the skills of the workforce moves the long-run curve.

4. 4

   Which supply-side measures shift short-run aggregate supply, and which shift long-run aggregate supply?

   Model answer

   Measures that lower firms' immediate costs shift short-run aggregate supply right, such as cutting employers' social security contributions, reducing regulatory compliance costs, or lowering indirect taxes on inputs. Measures that add to the quantity or quality of resources shift long-run aggregate supply right, such as education and training, infrastructure investment, research support and reforms that raise participation in the labour force. Many policies do both, because a measure that lowers costs today also raises the return to investment and so adds to capacity tomorrow.

5. 5

   Show, using AD-AS, how a supply-side policy combined with growing aggregate demand can produce growth with stable prices.

   Model answer

   With the general price level on the vertical axis and real national output on the horizontal axis, begin with aggregate demand and short-run aggregate supply intersecting at price level P1 and output Y1, with long-run aggregate supply just to the right. If aggregate demand shifts right from AD1 to AD2 while a successful supply-side programme simultaneously shifts short-run and long-run aggregate supply right by a similar amount, the new intersection lies well to the right at Y2 but at a price level close to P1. Real output and employment have risen without inflationary pressure, because the extra spending has been matched by extra capacity rather than pressing against a fixed ceiling.

6. 6

   Use AD-AS to explain why supply-side policies alone may fail to raise output in an economy in deep recession.

   Model answer

   On a diagram with the general price level on the vertical axis and real national output on the horizontal axis, in a deep recession aggregate demand intersects the short-run aggregate supply curve far to the left of the vertical long-run aggregate supply curve, so there is already a large amount of unused capacity. Shifting long-run aggregate supply further right adds capacity that nobody is buying, so the intersection of aggregate demand with the flat section of short-run aggregate supply barely moves and real output is almost unchanged. The binding constraint is demand, not capacity, so what is needed first is a rightward shift of aggregate demand, with supply-side measures raising the ceiling for when the recovery arrives.

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