Monetarist/New Classical View of the Long-run Aggregate Supply (LRAS) Curve
- Classical and Keynesian economists have different views on the long-run aggregate supply
- Classical economists believe that the LRAS is perfectly inelastic (vertical) at a point of full employment (YFE) of all available resources
- This point corresponds to the maximum possible output on a production possibilities curve (PPC)
- This point corresponds to the maximum possible output on a production possibilities curve (PPC)
- The classical view believes that in the long-run an economy will always return to this full employment level of output (YFE), and all that will change in the long run will be the average price level
- During extreme periods of economic growth there can be an inflationary gap that develops
- In the long run this will self-correct and return to the long-run level of output, but at a higher average price level
- During slowdowns or recessions there can be a recessionary gap that develops
- In the long-run this will self-correct and return to the long-run level of output, but at a lower average price level
- During extreme periods of economic growth there can be an inflationary gap that develops
The Classical View of long-run aggregate supply (LRAS) with a vertical aggregate supply curve at the full employment level of output (YFE)
Diagram Analysis
- Using all available factors of production, the long-term output of this economy (LRAS) occurs at YFE
- The economy is initially in equilibrium at the intersection of AD1 and LRAS (P1, YFE)
- A slowdown reduces output from AD1→AD2 and creates a short term recessionary gap
- This self corrects in the long term and returns the economy to the long-run equilibrium at the intersection of AD2 and LRAS (P2, YFE) - a lower price and back to the full employment level of output