Introduction

In the last two articles, we discussed the classical and Keynesian concepts of aggregate supply (“AS”).

Classical economists think that the long-run AS (“LRAS”) curve is vertical, whereas Keynesian economists think that its shape is horizontal when there is spare capacity, and vertical when an economy reaches full capacity.

The economic theory behind AS has moved on since the pure classical and Keynesian theories, and many economists think that the shape of the LRAS may differ depending on various factors.

Different economists stress the importance of different factors in constructing AS curves, and may therefore obtain different outcomes from their models. The effectiveness of a model is how accurately it can predict and explain economic phenomena, and so economists are likely to continually recalibrate their models as new data becomes available.

In the last two articles, we discussed spare capacity and diminishing returns on the shape of the LRAS curve. The LRAS curve is flatter where there is more spare capacity (which could occur following a reduction in aggregate demand (“AD”) and wages being sticky downwards and steeper as an economy nears full capacity and reaches the point of diminishing returns.

In this article, we discuss the impact of investment within an economy and the expectation of firms on the shape of the LRAS curve. Finally, we summarise the learnings from all our articles on AD and AS.

Investment

Firms may decide how much to spend on investment based upon their forecasts of AD, and what impact they think this will have on their business i.e. what do firms expect to happen? Investment in this context means the acquisition of goods / services which will be used in production i.e. the factors of production – land, labour, capital and entrepreneurship.

For example, if firms forecast a rise in AD (which will cause a rise in demand for their goods / services) and are optimistic about further growth in the economy, they may be more willing to invest in their operations (e.g. further machinery, more workers, new premises etc).

On aggregate, this will result in an increase in the quality or quantity of the factors of production within an economy, thereby pushing the SRAS curve outward and making the LRAS curve flatter in the long-run. The more firms invest, the flatter the LRAS curve will be.

However, the inverse also applies. If AD falls and the demand for firms’ goods / services also falls, there may be reduced investment due to a short-run loss of profits. Further, firms may think that the fall in AD will give rise to a recession, causing them to invest less because there may not be sufficient demand for their goods or services in future.

This may cause an inward shift in the SRAS curve, which would make the LRAS curve steeper in the long-run. The less firms invest, the steeper the LRAS curve will be.

Conclusion

Over the last few articles, we have developed an understanding of the concept of AD and AS, and how they interact to determine an economy’s GDP (output).

In summary:

• GDP is used as a measure of a country’s wealth, and a country’s wealth is often used as a measure of how well-off its citizens are (although there are some pitfalls with this measure, which we discuss in our article on GDP);
• Generally speaking, governments want what is best for their citizens, and seek to grow GDP;
• An economy’s GDP (output) is determined by the interaction between AD and AS and the shape and positioning of those curves – in particular the shape of the LRAS curve, on which economists disagree;
• AD is the total demand for goods and services at given price levels within an economy. The formula for AD is “consumer spending, plus investment (spending by firms on capital goods), plus government spending, plus exports minus imports” – AD = C+I+G+(X-M). A change in any of these factors will cause the AD curve to shift. At the given price level within an economy (i.e. where AD intersects AS), this is also the formula for GDP;
• AS is the total supply of goods and services at given price levels within an economy. AS is an amalgamation of the factors of production – land (including natural resources), labour, capital (physical capital, which are human made assets used in production, and also financial capital which can be used to acquire other factors of production), and entrepreneurship;
• Economists disagree about the shape of the LRAS curve. The long-run is a period over which the prices of the factors of production are variable. The short-run is a period over which the price of at least one factor of production is fixed (usually the price of labour);
• Classical economists think that the LRAS curve is vertical, and shifts in the AD curve do not have an impact on output (GDP) in the long-run, only price;
• However, Keynesian and more modern economists think the shape of the LRAS may curve vary depending on a range of factors, including (without limitation):
  • Spare capacity – the LRAS curve is flatter where there is more spare capacity, and steeper where there is less spare capacity. Spare capacity may result following a demand deficient recession, and wages being sticky downwards i.e. they cannot fall to true equilibrium point due to legal or social constraints. Further, if labour is not being used to fully capacity, other resources (such as machinery) could also be operating at below full capacity;
  • Diminishing returns – as firms ramp up production to near full capacity, it may cost more to produce each additional unit of good / service. Accordingly, prices increase at this point, and the LRAS curve is steeper. Further, at a certain point, there will be bottlenecks in the factors of production and an economy will not be able to produce any more;
  • Investment – the more firms invest, the flatter the LRAS curve is. The less firms invest, the steeper the LRAS curve is;
• Shifts in AD may have different impacts on price and output depending on the shape of the LRAS curve and point of intersection:
  • If AD intersects the LRAS curve where it is flatter, an increase in AD will have a proportionately larger increase in output (GDP) than price; overall, citizens will be better-off (assuming equal distribution);
  • If AD intersects the LRAS curve where it is steeper, an increase in AD will have a proportionately larger increase in price compared to output (GDP); overall, citizens will be worse-off (assuming equal distribution);
• Considering the above, governments and central banks within an economy may use a combination of demand and supply-side policies to grow GDP. Governments and central banks will track various data to make these decisions – such as unemployment and inflation. For example:
  • ‍If unemployment is high and inflation is low, this might indicate that the economy has a lot of spare capacity (AD intersects LRAS where it is flatter) and an economy can grow GDP through increasing AD;‍
  • Alternatively, if unemployment is low and inflation is high, this could indicate that an economy is operating at close to full capacity and growing AD will only increase price levels. In this scenario, an increase in AS would be needed to grow the economy.

In the next few articles, we discuss:

• Business cycles;
• Unemployment;
• Inflation; and
• Demand and supply side policies.