Macroeconomics Revision Notes
Classical economists view supply-side of the macro economy as existing in two
forms rather than as a single entity that Keynesian economics believe. They are
convinced that:
• There is a short-run element that is affected by costs.
• There is a long-run element that is affected by productivity.
Short Run Aggregate Supply (SRAS)
This tells us how much output will be produced in
an economy at a given time, given the available
resources, based on the current price level e.g., at
PL1 the economy will produce Y1, at PL2 it will
produce Y2.
The SRAS is based on the costs incurred in production (workers, raw materials,
land).
In the short run, the cost of resources is said to be fixed and is not influenced by
scarcity, e.g. workers do not require higher wages as there are fewer available, land
does not become scarce, and firms compete which raises its price, which explains
why the curve is drawn as a straight line.
The curve is relatively elastic as supply can be increased quite easily as resources
are currently available and thus do not take time to invest in them
The SRAS slopes upwards from left to right, meaning that the price level will
increase as output increases. This is explained by three key reasons:
1: Higher price levels means higher profits. As the price level increases, firms look to
produce more output in order to make greater profits.
2: In order to produce more, firms will need to spend more e.g. hiring more workers,
buying new machinery. The higher price level helps cover these extra costs.
3: Existing factors of production tend become less productive as output increases,
e.g. machines become less effective the more they are used, workers get tired the
longer they work, so the average cost of production tends to rise as output does so
the firm charges more to produce more.
,Shifts of the SRAS
Changes in PL move us to a new output level. A change in costs causes a shift, like
so:
• Any change in the firm’s costs will cause
the SRAS to shift, as was the case with
the microeconomic supply curve.
• An increase in costs will shift it upwards,
leading to a higher PL at the same output level
(SRAS2).
• A fall in costs will shift it downwards,
leading to a lower price level at each output level
(SRAS3).
The common reasons for shifts include:
Wage Rates:
A higher wage rate would shift the curve upwards by increasing a firms’ costs. In
the short run, the firm is unlikely to reduce the size of its workforce to reduce its
costs as workers are expensive to be made redundant, and it would inevitably lead
to a reduction in output. The SRAS curve shifts upwards and the price level at each
given level of output rises. Falling wage rates are unlikely.
Raw Material Prices:
The price of raw materials fluctuates on a regular basis and are the most irregular
cost a firm faces. Any raw material that falls in price will reduce a firms’ costs and
shift the SRAS curve downwards – this could be due to good weather leading to a
rise in the amount of a particular crop, or perhaps a fall in demand from other
sources making the product less scarce – leading to a general fall in the price level.
An increase in the price of raw materials would have the opposite effect.
As many raw materials are imported, the value of the pound has a significant impact
on the price at which the raw materials are bought. With a traditionally strong and
stable pound, the exchange rate has ensured that UK firms generally pay a low price
for their raw materials – usually in the region of £1 = 1.2 Euros. However, the value
of the pound has gradually fallen in value over the past 5 years and reached an all-
time low of £1=1 EURO in immediate response to the UK’s decision to leave the UK.
,Taxation:
Any change in taxes faced by a firm will affect their costs; a higher tax will raise
them; a lower tax will cause them to fall. In a heavily polluting industry, there is
likely to be an indirect tax in place to punish the polluting firm.
Key taxes that firms face are VAT which are usually paid when firms buy materials
or part-finished products, corporation tax (19% of all profits are paid to the
government) and import duties, which are taxes on imported goods.
Subsidies:
Subsidies are given to firms to help them cope with the burden of production,
perhaps in response to a rise in other costs. The introduction of a subsidy, or rise of
an existing one, will lower a firm’s costs and shift the SRAS downwards. In contrast,
the removal or reduction of a subsidy will shift the SRAS upwards.
Interest Rates:
Interest rates refer to the cost of borrowing. If interest rates on loans fall, then firms
can borrow more money at a reduced rate, leading to a reduction in their monthly
repayments and a fall in their costs, shifting the SRAS downwards. A rise in the rate
of interest will have the opposite effect. Many firms operate with long-term variable
loans that have changing interest rates, so any rise/fall in rates will affect them in the
same way.
Supply-Side Shocks
These are sudden events that lead to large changes in one of the factors that affect
the SRAS and cause it to shift upwards suddenly. Theoretically a supply-side shock
is most likely to be caused by:
1. A decline in currency value, raising the price of imports. This is typically
triggered by economic uncertainty, whereby people are reluctant to hold onto their
sterling reserves for fear of it dropping. Recent events such as Theresa May’s
resignation and the Brexit vote caused the pound to fall by more than 5%.
2. A rise in the price of oil, leading to a rise in transport and haulage costs. In
the 1970s the price of oil trebled, causing inflation of over 16%, and rose sharply
again in 2008.
3. Extreme weather, affecting the supply of food in a country. Hurricanes and
droughts will typically have the effect of a short-term rise in food prices.
4. Worker shortages, as witnessed in the UK recently due to COVID, triggered
quire rapid inflation in the UK towards the end of 2021 due to product shortages
e.g., delivery drivers.
, Long Run Aggregate Supply (LRAS)
The LRAS curve tells us the normal (maximum) amount of output the economy is
capable of producing, given the available resources. It is based upon the amount
and productivity of the resources at the country’s disposal. This curve effectively
marks the point at which the Keynesian curve becomes vertical e.g., the point of full
employment.
• Represents the full productive potential (capacity)
of an economy.
• ‘Full employment’ – all available resources (land,
labour, capital, enterprise) are being used to their full
(sustainable) potential.
• Fixed at a specific point, given the current
level/quality of resources – hence it is vertical (per-
fectly inelastic).
Shifts of the LRAS
• If there were a change in either the amount
OR the productivity of these resources, then the
level of Yf would change.
• Any increase in either the amount or
productivity of resources would shift the LRAS to
the right – there is a rise in maximum potential
output.
• Any decrease would shift the LRAS to the
left – there is a fall in maximum potential output.
• The shifts are for the same reasons to explain the shift of the Keynesian curve.
The LRAS curve shifts due to:
• An increase in productivity or amount will shift the curve to the right.
• A decrease in productivity or amount will shift the curve to the left.
