IB Economics Revision Notes on Aggregate Supply & Macroeconomic

Equilibrium

1. Aggregate Supply

Aggregate Supply – the total value of goods and services produced in an economy over a given
period of time

Short Run Aggregate Supply (SRAS)

The short run in economics isn't defined by a specific timeframe, but rather by the flexibility (or
lack thereof) of certain factors of production. Here, capital and technology are held constant, but
other inputs can be varied.

● Positive Relationship: In the short run, there's a direct relationship between the
aggregate price level and the quantity of goods and services supplied. As prices rise,
output tends to increase since it becomes more lucrative for producers.
● Sticky Wages: Wages often resist immediate change, even when prices move rapidly. If
prices jump, and wages lag behind, it becomes temporarily more profitable for firms to
produce, hence boosting the output.
● Costs of Production: If there's a sudden increase in the costs of raw materials or other
inputs, firms might reduce production, leading to a leftward shift of the SRAS curve.
Understanding the non-price determinants of supply is crucial in this context.
● Infrastructural Constraints: All firms have production limits. Once these are reached, no
matter how much prices rise, the output can't increase in the short run. It's important for
students to understand this constraint when studying the short run dynamics.

The SRAS curve is upward sloping, showing the direct relationship between the price level and
output in the short run.
Long Run Aggregate Supply (LRAS)

In the long run, all factors of production become flexible. This means firms can adjust their
capital stock, adopt new technologies, hire or fire workers, and source different raw materials.

● Potential Output: Represents the maximum sustainable amount the economy can
produce, given its resources and technology. It's an important concept as it indicates the
full capacity of an economy.
● No Relationship with Price Level: In the long run, price changes don't affect the quantity
supplied. This is because all the variable costs, including wages and input prices, adjust
accordingly over time. This self-adjustment mechanism ensures that production is based
solely on an economy's capacity and not on price incentives. The interplay between
aggregate demand and aggregate supply further illustrates this dynamic.

The LRAS curve is a vertical line. It remains stationary at the potential output of the economy,
demonstrating that in the long run, production is unaffected by price changes.
Shift Factors

The aggregate supply curve, both in the short and long run, can shift due to various reasons:

Short Run Shift Factors:

● Commodity Prices: If there's a sudden spike in oil prices, this can increase costs for
many firms, leading to a decrease in SRAS.
● Supply Shocks: These are unexpected events – for instance, a natural disaster might
disrupt production lines, causing the SRAS curve to shift to the left. Conversely, a boon
in production technology might lead to a rightward shift.
● Government Action: Policies such as subsidies or taxes can affect production costs. For
instance, a new tax on production will increase costs, leading to a decrease in SRAS.
The impact of government policies on fiscal policy limitations and monetary policy
limitations should also be considered.

Long Run Shift Factors

● Technological Advancements: Over time, as firms adopt new technologies, they can
produce more with the same amount of resources. This boosts potential output and
shifts LRAS to the right.
● Education and Training: A well-trained workforce can enhance production efficiency.
When workers are better educated or undergo beneficial training, they can produce
more or higher quality goods, increasing potential output.
● Demographic Changes: An increasing population or a rise in the working-age population
can lead to a rightward shift in LRAS as there are more workers available for production.
● Government Policies: Investment in infrastructure, R&D subsidies, and favourable
business policies can all increase potential output. It's vital to understand how negative
externalities of production can shift the LRAS curve by affecting the productive capacity
of an economy.

2. Macroeconomic Equilibrium

Short-run Equilibrium in the Monetarist/New Classical Model

Real national output equilibrium occurs where aggregate demand (AD) intersects with short-run
aggregate supply (SRAS)
A diagram showing the Classical short-run equilibrium in an economy resulting in an equilibrium
price of AP1 and real output of Y1

● According to classical theory, this economy is in short run equilibrium at AP1Y1

● Any changes to the components of AD will cause the AD curve to shift left or right
creating a new short-run equilibrium
● Any changes to the non-price determinants of SRAS will shift the SRAS curve left or
right creating a new short-run equilibrium

Long-run Equilibrium in the Monetarist/New Classical Model

● Classical and Keynesian economists have different views on the long-run equilibrium of
real national output
● Classical economists believe that the economy will always return to its full potential level
of output and all that will change in the long-run, is the average price level
● YFE is considered to be equal to the natural rate of unemployment in an economy
A diagram that shows the Classical view of long-run equilibrium which occurs at the intersection
of long-run aggregate supply (LRAS), short-run aggregate supply (SRAS) and aggregate
demand (AD)

● The LRAS curve demonstrates the maximum possible output of an economy using all of
its scarce resources
● The SRAS intersects with AD at the LRAS curve
● This economy is producing at the full employment level of output (YFE)
● The average price level at YFE is AP1

The Classical Adjustment Process (Self-correcting)

Classical economists believe that in the long run the economy will always return to its full
potential level of output and all that will change is the average price level
● This is the also referred to as the self-correcting mechanism

Automatic adjustment from a deflationary output gap

● A deflationary (recessionary) output gap occurs when the real GDP is less than the
potential real GDP

Aggregate demand (AD) has shifted left causing a deflationary gap, which in the long-run will
self-correct to YFE but at a lower average price level (AP2)

Correction Process:
1. Initial long-run equilibrium is at AP YFE
2. AD shifts left from AD → AD1, possibly due to the onset of a recession
3. Output falls from YFE → Y1 and price levels fall from AP → AP1
4. Due to the fall in output, firms lay off workers
 5. Unemployed workers are now willing to work for lower wages and this reduces the costs
of production which causes the SRAS curve to shift right from SRAS1 → SRAS2
6. A new long-run equilibrium is formed at AP2 YFE
7. The economy is back to the full employment level of output (YFE), but at a lower average
price

Automatic adjustment from an inflationary output gap

● An inflationary output gap occurs when real GDP is greater than the potential real GDP

Aggregate demand (AD) has shifted right causing an inflationary gap, which in the long-run will
self-correct to YFE but at a higher average price level (AP2)

Correction Process:
1. Initial long-run equilibrium is at AP YFE
2. AD shifts right from AD1 → AD2, possibly due to raid expansion of the money supply
3. Output rises from YFE → Y1 and price levels rise from AP → AP1
4. Due to the increase in average prices (inflation), workers demand higher wages
5. Higher wages increase the costs of production which causes the SRAS curve to shift left
from SRAS1 → SRAS2
6. A new long-run equilibrium is formed at AP2 YFE
7. The economy is back to the full employment level of output (YFE), but at a higher average
price

Equilibrium in the Keynesian Model

● Keynesian economists believe that the economy can be in long term equilibrium at any
level of output
 ● 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 aggregate supply (AS) with a vertical aggregate
supply curve at the full employment level of output (YFE) becoming more elastic at lower levels of
output

● Using all available factors of production, the long-term output of this economy occurs at
YFE
● The economy is initially in equilibrium at the intersection of AD1 and AS (AP1YFE)
● A slowdown reduces aggregate demand from AD1 → AD2 and creates a recessionary
gap equal to YFE – Y1
● The economy may reach a point where average prices stop falling (AP2), but output
continues to fall
○ Prices may be blocked from falling further due to minimum wage laws, the
existence of trade unions, or long-term employment contracts preventing wage
decreases
● 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