Eco 104:

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Introduction to
Macroeconomics
Lecture 10 (Chapter 8)
Parisa Shakur
Long-run Aggregate Supply
• Reasons for SRAS to be upward sloping do not hold anymore

• Level of Real GDP or Real output changes in the economy to

full-employment Real GDP or Natural Real GDP

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• The supply curve that identifies what economy produces in
the long run is the Long-Run Aggregate Supply (LRAS) curve

• In the long run, changes in price level has no effect on the

quantity of aggregate output supplied

• Long run output level is one where there is only natural rate of
unemployment and all prices are fully flexible
 LRAS curve

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Classical Economics
• Widely regarded as the first modern school of economic
thought with works dating from the 1750s to early 1900s.
Their ideas are still employed by some modern-day
economists.
• Major developers include Adam Smith, John Staurt Mill, Jean

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Baptiste Say, Thomas Malthus, David Ricardo
• Fundamental principle: The economy is self-regulating.
Classical economists maintain that the economy is always
capable of achieving the natural level of real GDP or output.
• The classical doctrine is based on two firm beliefs
1.Say’s Law
2.Prices, wages and interest rates are flexible
Say’s Law

• Named after French economist, Jean-Baptist Say (1767-1832),

this law states that SUPPLY CREATES ITS OWN DEMAND. Thus

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there can be no over-production or under-production

• All economists agree that this holds in a barter economy

• But according to Classical economists, this also holds in a

money economy through interest rate flexibility
Say’s law and savings
• What happens when an economy saves?

According to the expenditure approach,

AD/Total expenditure= C+ I+ G+ NX
Consumption (C)= Disposable income- Saving

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If C=3000, I=600, G=1200 and NX=200
Then, TE=5000
Let’s also assume that Aggregate supply=5000
Then, AD=AS and Say’s Law is valid

But what if the economy saves 100?

Say’s Law continued
According to Classical Economists, any fall in consumption (C)
will be matched by an equal increase in investment (I)

Savings have no effect on Aggregate Demand (AD) as AD is

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affected by TE and savings does no change TE

So what is true for barter economy is also true for money

economy

AND SAVINGS EQUAL INVESTMENT THROUGH INTEREST RATE

FLEXIBILITY
 Flexible interest rates

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Flexible wages and prices
Classical economists believe that what is true for the credit
market is true for all markets

In the labour market, shortage or surplus of labour is adjusted

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through flexible wage rates

In the market for goods and services, shortages and surpluses e

quickly adjusted through flexible prices

THUS ACCORDING TO THE CLASSICAL DOCTRINE ECONOMY IS

ALWAYS CAPABLE OF OPERATING AT NATURAL REAL OUTPUT
LEVEL THROUGH FLEXIBLE INTEREST RATES, PRICES AND WAGES
The three states of an economy
1. Real GDP is less than Natural Real GDP (Recessionary Gap)

2. Real GDP is greater than Natural Real GDP (Inflationary Gap)

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3. Real GDP is equal to Natural Real GDP (Long-run
Equilibrium)
Recessionary gap: Real GDP is less
than the Natural Real GDP

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Inflationary Gap: Real GDP is greater
than the Natural Real GDP

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Long-run equilibrium: : Real GDP is
Equal to Natural Real GDP

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The three states of the labour
market
1. Recessionary gap and the Labour market: The
unemployment rate is higher than the natural
unemployment rate, and a surplus exists in the labour
market

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2. Inflationary gap and the Labour market: The unemployment
rate is less than the natural unemployment rate, and a
shortage exists in the labour market

3. Long-run equilibrium and the labour market: The

unemployment equals the natural unemployment rate, and
equilibrium exists in the labour market
Physical and Institutional PPF
• Given these two PPFs, the
Institutional PPF has
institutional constraints:
anything that prevents
economic agents from

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producing the maximum Real
GDP physically possible.
• An economy can never
operate beyond its physical
PPF, but it is possible for it to
operate beyond it’s
institutional PPF.
• The economy is operating at
it’s lowest unemployment
rate at the institutional PPF
The Self-regulating economy
and Policy implication
• To believe that the economy is self-regulating is to
believe that if the economy is not operating at full
employment/natural unemployment or natural Real
output level, it can move itself to that position without

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any interference
• Flexible wages (and other resource prices) play a critical
role in the story of the self-regulating economy.
• Laissez-faire: A public policy of not interfering with
market activities in the economy.
• In the view of some economists, the government does
not have an economic management role to play.
 Recessionary gap and the
economy
We know,
• It is producing at a Real GDP level that is less than Natural
Real GDP
• The unemployment rate is greater than the natural rate of

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unemployment
• A surplus exists in the labour market
This implies that,
• unemployment is relatively high and that as old wage
contracts expire, business firms will negotiate contracts that
pay workers lower wage rates
• SRAS curve shifts to the right
• Economy moves to long run equilibrium
Recessionary gap and the economy

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Inflationary gap and the
economy
We know,
• It is producing at a Real GDP level that is greater than
Natural Real GDP
• The unemployment rate is less than the natural rate of

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unemployment
• A shortages exists in the labour market
This implies that,
• unemployment is relatively low and that as old wage
contracts expire, business firms will negotiate contracts
that pay workers higher wage rates
• SRAS curve shifts to the left
• Economy moves to long run equilibrium
Inflationary gap and the
economy

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Short run and long run changes in
the economy: When AD increases
• If the economy is self regulating, an increase in aggregate demand
can raise the price level and Real GDP in the short run, but in the
long run the only effect of an increase in aggregate demand is an
increase in price level

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Short run and long run changes in
the economy: When AD decreases
• If the economy is self-regulating, a decrease in aggregate demand
can lower the price level and Real GDP in the short run, but in the
long run the only effect of a decrease in aggregate demand is a
lower price level

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Shift of AD and the long and
short run
Change in AD In the Short Run In the Long run

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AD shifts to the right Price level increases Price level increases
Real GDP increases Real GDP does not
change

AD shifts to the left Price level decreases Price level decreases

Real GDP decreases Real GDP does not
change
Questions to practice
• For short questions
Practice questions 1-12 from page 193

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• For MCQ type questions
Practice questions 1-3 from page 194