This concededly short paper outlines the varying justifications and policy implications of the Classical and Keynesian models of aggregate supply. Recall that AS represents the production-side accounting of national economic activity, i.e. the total supply of goods and services.
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In the most basic formulations, AS is held to be influenced primarily by the price at which total domestic production is consumed.
In the classical view, the AS curve is purely vertical (see Figure 1). This holds in the long run because both (selling prices) and wage rates accelerate in response to increased production, i.e. a rising pace of activity for the economy as a whole.
In effect, the above demonstrates the concept of the “production possibility frontier” and the equilibrium point for a closed economy when inflows from exports or ‘leakage’ due to imports are not accounted for. Hence, the justification of this model lies in taking the supply of labour into account.
The Keynesian Model
Conceptually, it is easier to grasp the Keynesian view of production rising rapidly in the short run because manufacturers are able to maximise gross revenue by producing more in a time horizon where prices for the factors of production remain inelastic. Another way of conceiving this is that total planned output can be raised in response to greater demand and there is no extraneous factor like technology that can provide either a lower-cost substitute or a more attractive way of satisfying the same demand.
Since rising AS is a function of increased demand for the good, short-run AS shifts to the right and upward to match rising price levels. The slope is a function of how much spare production capacity there is in the closed economy.
A more steeply-sloping short-run AS (Figure 3 below) in the Keynesian view is possible. This is justified by more attractive prices for finished goods shifting aggregate demand for labour to such an extent as to outstrip aggregate supply of workers. A classic case of this is the ongoing cost-cutting of outsourced services in America and the UK. The “production facilities” are shifted overseas to low-income but English-speaking countries like Ireland, India and the Philippines. Since the supply of such educated workers with tolerable accents is finite, a sudden rush of outsourcing call centre work would send short-run AS rising from one price level to another, albeit in the form of inducements given experienced agents to transfer.