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IB DP Economics — Unit 3: Macroeconomics | SL | 3.2 Variations in Economic Activity — Aggregate Demand and Aggregate Supply
📋 What You Will Learn
- Define long-run aggregate supply (LRAS) and explain what determines it
- Distinguish between the Monetarist/New Classical model of LRAS and the Keynesian model of LRAS
- Analyse how each model depicts the relationship between the price level and real output in the long run
- Apply both models to evaluate the effectiveness of demand-side and supply-side policies
- Evaluate the policy implications of each model for governments facing unemployment and inflation
🔍 Guiding Question Does the economy automatically return to full employment in the long run, or does it require active government intervention — and does the answer change everything about how we think about macroeconomic policy?
🌍 Why This Matters In 2023, the United States Federal Reserve raised interest rates to their highest level in 22 years to combat inflation, betting that the economy would return to its natural rate of output without a severe recession. Meanwhile, Japan's government continued decades of fiscal stimulus, unconvinced that the economy would self-correct. Two of the world's largest economies, guided by fundamentally different theories of long-run aggregate supply.
What Is Long-Run Aggregate Supply?
Short-run aggregate supply (SRAS) slopes upward because input prices — particularly wages — are sticky in the short run. Firms can expand output by paying existing workers overtime or hiring at current wages. But in the long run, all input prices adjust fully to changes in the price level. The question is: what does this mean for the economy's capacity to produce?
📖 Definition — Long-Run Aggregate Supply (LRAS) Long-run aggregate supply (LRAS) represents the total real output that an economy can produce when all factor markets — particularly labour — have fully adjusted to changes in the price level. It reflects the economy's productive capacity, determined by the quantity and quality of factors of production, not by the price level.
The key insight is that in the long run, the price level does not determine real output — only real factors do. What those real factors are, and whether the economy automatically reaches its long-run potential, is precisely where the Monetarist and Keynesian models diverge.
📖 Definition — Potential Output (Full Employment Output) Potential output (also called full employment output or Yf) is the level of real GDP an economy can sustain when all resources are fully and efficiently employed, consistent with a stable rate of inflation. It corresponds to the natural rate of unemployment — where only frictional and structural unemployment exist.
The Monetarist / New Classical Model of LRAS
The Monetarist (also called New Classical) model holds that the economy has a well-defined, stable long-run equilibrium at full employment output. Any deviation from this equilibrium is temporary — the economy contains automatic self-correcting mechanisms that restore it to potential output without government intervention.
Core Assumptions of the Monetarist Model
- Flexible wages and prices: in the long run, wages and all input prices adjust fully to changes in the price level, eliminating any excess supply or demand in factor markets
- Natural rate of unemployment: the economy gravitates toward a natural rate of unemployment (NRU) determined by