Introduction

In the last article we discussed aggregate supply (“AS”) in general, the factors of production, the difference between the short-run and long-run, and what causes the AS curve to shift.

We also mentioned that economists disagree about the shape of the AS curve in the long-run (“LRAS”). Two famous schools of economics that disagree about the shape of the LRAS curve are the classical school, and the Keynesian school.

The shape of the LRAS curve impacts whether increases in aggregate demand (“AD”) will cause an increase in gross domestic product (“GDP”), or merely in price. This in turn impacts what policies governments and central banks should be using to grow GDP and control inflation (we discuss this in later articles).

In this article we discuss:

1. The broad differences between the classical and Keynesian school of economics;
2. The interaction between the SRAS curve and AD; and
3. The classical concept of LRAS and its interaction with AD.

In the next article, we discuss the Keynesian concept of LRAS, following which we discuss other factors that may impact AS.

Broad differences between the classical and Keynesian schools of economics

The differences between the classical and Keynesian schools of economics are too many to describe in detail in this article and would vary depending on what point in time you made the comparisons. However, some of the key differences between the two schools in relation to AS are as follows:

1. Classical economists consider that the free market works to equate supply and demand in all markets, which results in an efficient and sustainable use of resources. Where there is a change in supply or demand, the markets will adjust to a new equilibrium at which resources are used efficiently and sustainably i.e. the markets would clear;
2. Connected to this, classical economists believe that a free market will result in full employment – all those who are willing to work would be in work, except for those in between jobs (see our article on Unemployment for more detail);
3. Due to the belief that free markets work to equate supply and demand in all markets, classical economists argue for a laisse-faire (let it be) approach to government – they think that governments should not interfere in markets and, by interfering with the market and competition, governments only make things worse;
4. As will be explained in more detail below, classical economists believe that, in the long-run, an increase in AD will only result in price increases and not in GDP growth. They consider that only an increase in AS will result in GDP growth in the long-run;
5. On the other hand, Keynesian economists reject the assumption that all markets clear – there may indeed be disequilibrium between supply and demand;
6. In particular, Keynesian economists think that disequilibrium can occur within labour markets. This is because of social and political forces which make it difficult for wages to fall fast enough for the market to clear where there is a fall in demand for labour (see article on Keynesian Aggregate Supply);
7. This idea results in the concept of spare capacity and a different view on the shape of the LRAS curve – we will discuss this in further detail in our next article.

Short-run aggregate supply – classical theory

As explained in our last article, the AS curve shows the total amount of supply of goods within an economy at given price levels for those goods.

The short-run is a period over which the price of at least one factor of production is fixed – usually the price of labour (i.e. wages). Further, when constructing a single SRAS curve, we assume that the quantity of factors of production at given price levels, and their quality, are constant. A change to these results in a shift in the SRAS curve.

The long-run is a period over which the prices of all factors of production are variable.

The SRAS curve is upward sloping and therefore, in the short-run, classical economists consider that changes in AD may have an impact on GDP and not just price.

If AD increases, the price level within the economy will increase and so will GDP (AD1 to AD2). If AD decreases, so does the price level and GDP (AD1 to AD3). Where GDP decreases, in general terms this is known as a recession – a demand deficient recession here, because it is caused by a fall in the levels of AD (although the official definition of a recession is a fall in GDP in two successive quarters).

Where there is a recession due to a fall in AD, in the short-run this could also lead to unemployment as fewer workers will be required to produce the fewer goods demanded (see article on Unemployment).

In the long-run, classical economists believe that shifts in AD also have an impact on SRAS, which we discuss below.

Long-run aggregate supply curve and interaction with aggregate demand

Whilst classical economists acknowledge that shifts in AD can affect GDP in the short-run, in the long-run they consider the AS curve (LRAS) to be vertical.

Accordingly, in the long-run, a shift in AD will not have any impact on GDP, only on price levels within an economy – causing inflation or deflation. See figure 2.

Classical economists believe that there can only be sustainable GDP growth in the long-run through an increase in AS (see the prior article in which we discuss what causes the AS curve to shift - in summary, changes to price / quantity or quality of the factors of production).

How do classical economists conclude that the LRAS curve is vertical in the long-run? Generally speaking, this comes from the belief that the free market works to equate supply and demand in all markets i.e. markets clear.

We can analyse this by looking at multiple interactions between the SRAS curve and AD – see figure 3.

Increase in aggregate demand

Our starting point is where AD1 and SRAS1/LRAS1 intersect to give the price level of P1, and output/GDP level O1. This is the point of natural production in an economy, where all resources are being used efficiently and sustainably.

In the short-run, if there is an increase in AD – AD1 to AD2 – this would result in increased GDP of O2, and an increased price level of P2. Accordingly, there would be growth in GDP in the short-run.

However, wages can fluctuate in the long-run. Classical economists argue that the increased demand for labour to produce the additional goods demanded would push wages higher. Alternatively, workers would notice that there had been an increase in price levels within the economy (inflation) following the increase in AD, meaning workers’ real spending power would be reduced; they would not be able to buy as much with their wages. To compensate for the reduction in real spending power, classical economists argue that workers would demand higher wages, causing wages (the price of labour, a factor of production) to increase. We have seen this during the cost-of-living crisis, where employees have asked for bigger wage increases due to high inflation.

Regardless of the mechanism for wage increases, this would result in an inward shift in the SRAS curve (SRAS 1 to SRAS2), with SRAS 2 intersecting AD2 at the point of natural production/output in the economy – P2 would move to P3, and O2 would move back to O1.

In this scenario, in the long-run an increase in AD would not have had any impact on the levels of GDP in the economy, only on price.

Decrease in aggregate demand

Something similar happens if there is a decrease, rather than increase, in AD – see figure 4.

Our starting point again is where AD1 and SRAS1/LRAS1 intersect to give the price level of P1, and GDP level O1. This is the point of natural production in an economy, where all resources are being used efficiently and sustainably.

If there was a decrease in AD – AD1 to AD2 – this would result in decreased GDP of O2, and a lower price level of P2. A decrease in AD would, in the short-run, cause an increase in unemployment as fewer workers would be required by firms to produce the fewer goods demanded, and firms would let people go.

In the long-run, classical economists argue that the increase in supply of labour following the reduction in AD (more people unemployed due to demand deficient recession) would cause real wages (the price of labour, a factor of production) to fall.

The SRAS curve would therefore shift outward, SRAS1 to SRAS2, intersecting AD2 at the point of natural production/output in the economy - P2 would move to P3, and O2 would move back to O1.

In this scenario, in the long-run a decrease in AD would not have had any impact on the levels of GDP in the economy, only on price.

Increasing aggregate supply in the long-run and growing GDP

As shown above, classical economists believe that, in the long-run, changes in AD have no impact on GDP at all, only on the prices within an economy.

To sustainably grow GDP in the long-run, classical economists argue that there must be an increase in AS – there must be outward shifts in the LRAS curve.

We discussed the causes of shifts in the LRAS curve in our last article. In summary, changes to the quantities / prices or quality of the factors of production will cause shifts in the LRAS curve.

Classical economists therefore believe that governments should focus on supply-side policies to grow GDP, which we discuss in later articles.

Conclusion

You should now understand the classical concept of AS, the interaction between AS and AD to determine GDP, and the impact of shifts in AD and AS on GDP in both the long-run and short-run from a classical perspective.

In summary:

• The interaction between AD and AS determines the level of GDP of an economy;
• The short-run is defined as a period in which the price of at least one of the factors of production is fixed (usually the price of labour). The long-run is a period in which the prices of all factors of production are variable;
• Classical economists argue that the SRAS curve is upwards sloping, and a shift in AD can have an impact on both GDP and price. However, they consider the LRAS curve to be vertical, and shifts in AD will only have an impact on price, not GDP;
• Accordingly, to grow GDP in the long-run, classical economists argue that there must be an increase in AS.

However, this is only one side of the story, and you will benefit further from reading the next article on the Keynesian concept of AS and how shifts in AD can affect GDP in the long-run.

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