- Explain aggregate supply in the income-expenditure model and how the income-expenditure model correlates to the AD-AS model
We observed earlier the income-expenditure model doesn’t explicitly discuss aggregate supply, but it’s straightforward to add that, if we think of the aggregate supply curve as answering the question: how do producers respond to a change in aggregate demand? Recall Figure 1 below from our earlier discussion of aggregate demand in the Keynesian model. Figure 1 shows the pure Keynesian AD-AS model. Let’s think about how this corresponds to the income-expenditure model.
Figure 2 (Interactive Graph). The Real Aggregate Supply (RAS) Curve.
This version of the Keynesian Cross works exactly like the original version for changes in aggregate expenditure. But it also allows for positive and negative supply shocks which show up as shifts in real aggregate supply due to changes in resource prices, productivity, etc.
Suppose there is a positive supply shock, for example, an increase in the labor supply. A larger labor supply means the economy can produce more output, so the level of potential GDP (Yp) shifts to the right. As a result, an increase in Ep doesn’t cause higher prices since the increased Yp provides room for the economy to grow. Thus, increased Ep leads to increased Y. Of course, if Ep increases enough, the economy would pass Yp and the increased spending would cause inflation, but no additional real GDP.