Neo Classical versus Keynesian LRAS curves

Neo-classical and Keynesian are two different approaches/bodies of thinking to certain

macroeconomic principles and government policy. This is your first introduction to
differences in their opinion, and as you will see later, they differ in opinion with regards
to much economic theory.

Neo-classical LRAS curve

The neo-classical LRAS curve is shown on the left below. Neo-classical economists
believe that the LRAS curve is perfectly inelastic at the full employment level of output.
They believe that the potential output of the economy is dependent on the quantity and
quality of the factors of production and is independent of the price level. In the long run,
neo-classical economists believe that economies will operate at the natural rate of
unemployment (i.e. equilibrium unemployment).
LRAS LRAS
Price Level

Price Level

Neo-classical
Keynesian

Real GDP Real GDP

Keynesian LRAS curve

The Keynesian view is that even in the long-run there can be unemployment above the
natural rate. Their view of the LRAS curve is shown on the right above.

At low levels of output (Real GDP) the LRAS curve is horizontal or perfectly
elastic. This is because with a resulting high level of unemployment and a lot of
spare capacity in the economy, output can be increased without a rise in costs as
more workers can be recruited at the current wage rates and a rise in the demand
for raw materials and capital will not raise their price.
Then at higher levels of output the LRAS starts to slope up as firms begin to
experience rises in costs as they have to compete for increasingly scarce resources
(e.g. raw materials & labour). The price level will rise to compensate for the
higher costs.
At the full employment level (maximum potential output), there is no spare
capacity and the LRAS curve becomes perfectly inelastic.
 Long-run equilibrium output

The long run equilibrium level of output is where aggregate demand is equal to the long-
run aggregate supply.

Neo-classical long-run equilibrium output

Neo-classical economists believe an increase in aggregate demand, without an increase

in LRAS, will result solely in a rise in the general price level. This is shown below.

The figure below shows an initial situation of short run microeconomic equilibrium at
full employment. The AD1 curve and SRAS1 curve intersect at $500bn on the LRAS
curve. Assume that Aggregate Demand increases from AD1 to AD2 for whatever reason
e.g. a growth in exports, everything else held constant.
An increase in Aggregate Demand
200 LRAS

Price
Level 150
GDP SRAS2
Deflator SRAS1

100

50 AD2

AD1

0
100 200 300 400 500 600 700 800 900
Real GDP (billions of 1999 US$)

Aggregate demand increases from AD1 to AD2. The new AD2 curve intersects SRAS1
curve at an increased level of real output of $650bn and at a higher price level than
before. There now exists an ________________________- actual output is above is
above potential output. This can (and does) occur because it is possible for economies to
operate at a level of unemployment below the natural rate. (Remember that the natural
rate of unemployment occurs when the labour market is in equilibrium- so for an
economy to operate below the natural rate the amount of people that are unemployed due
to S_____, S______ and/or S________, must fall).

The increased demand has increased real output but also increased the price level. Prices
of goods and services have risen to cover the increased production costs of firms.

The owners of the factors of production will, as a result of the increase in the price level,
demand higher factor prices. For example, higher wage rates will be required in order to
attract even scarcer labour.
Now, if wage rates and other costs of production rise, how will this affect the SRAS
curve?

As the SRAS curve shifts upwards to the left, real output falls and the price level rises.
This process will continue as long as the macroeconomic equilibrium level is greater than
the full employment level of real output. The process will halt only when the SRAS2
curve cuts the AD2 curve at the LRAS curve. Real output will have fallen back to the
full employment level of real output at $500bn. So in the LONG RUN, there is no
increase in real output and unemployment is again at its natural rate. The effect of an
increase in aggregate demand is solely an increase in the general price level.

THIS SHORT RUN EQUILIBRIUM CANNOT REMAIN ABOVE FULL

EMPLOYMENT.

Note, a decrease in AD when the economy is at full employment equilibrium will also be
self correcting as factor prices will adjust accordingly. See below.

200 LRAS

Price
Level 150
GDP SRAS1
Deflator
SRAS2
100

AD1
50
AD2

0
100 200 300 400 500 600 700 800 900
Real GDP (billions of 1999 US$)

A decrease in Aggregate Demand

AD falls shifting AD1 to AD2. Actual output falls below potential output and
unemployment exists above the natural rate- there is a ________________ gap.

Firms will experience lower final prices but the same price of inputs (e.g. wage rate).
Therefore firms will renegotiate input costs at a lower level. As costs fall, SRAS curve
shifts to the right. As it moves real output increases and price level falls. It will halt
only when the SRAS curve cuts the AD2 curve at full employment level. Real output is
restored to its original level but at a lower price level.

Of course..some economists will argue that factor costs will not adjust as simply as that
suggested above because wages tend to be_______________, as workers are not
______________. These economists tend to take a more Keynesian view on the above.
 Keynesian long-run equilibrium

Keynesians argue that an increase in AD will have a different effect depending on where
the economy is operating on the Keynesian LRAS curve.
LRAS At a level of mass unemployment
Price Level

If there is an increase in aggregate demand at a low level of economic

activity and high unemployment rates, the effect will simply be to
cause an increase in real output with no increase in the price level.
This is because businesses can employ the unused factors of
production to increase output with no increase in costs. (e.g. wage
rates will remain the same).

AD1 AD2

Real GDP

LRAS At higher levels of output and employment

Price Level

If there is an increase in AD at a level below full employment where

shortages in resources are beginning to be experienced, both output
and the general price level will rise.

This is because businesses have to attract increasingly scarce

resources which are commanding higher prices (and wage rates).
The price level rises from P1 to P2 (not shown) to compensate
AD1 AD2 producers for their higher costs.

Real GDP

LRAS
Price Level

At full employment level

At this level (the vertical section of the LRAS) Keynesians and neo-
classicalists agree that an increase in AD will solely result in an
AD2 increase in the price level. An increase in AD from AD1 to AD2
results in no change in output as the economy cannot produce output
AD1 beyond the full employment level. The price level rises to allocate
the scarce resources among the competing components of AD-
consumers, businesses etc.
NOTE: further attention to Neo-classical versus Keynesian
views on unemployment will follow later.
Real GDP