Up to now the model has been agreed. Here it splits. Two schools of economists look at the same economy and draw the long-run supply curve differently, and because the diagram differs, so does everything that follows: whether recessions fix themselves, and whether governments should do anything about them.
📘 What you need to know
The monetarist / new classical view: LRAS is perfectly inelastic (vertical) at the full employment level of output, YFE.
In that view the economy always returns to YFE in the long run, and all that changes is the average price level.
YFE corresponds to maximum output on the PPC, and to the natural rate of unemployment.
The Keynesian view: the AS curve is L-shaped, with three sections.
Section 1 is elastic (spare capacity), section 2 is upward sloping (capacity tightening), section 3 is vertical (full employment).
Keynesians argue the economy can get stuck below full employment for a long time, because wages are sticky downwards.
That disagreement leads to a policy disagreement: supply-side only, or an active role for government.
The classical view: a vertical LRAS
Classical economists start from a simple claim: in the long run, all prices are flexible, and that includes wages. If output falls and workers become unemployed, they will eventually accept lower wages to get back into work. Lower wages reduce firms’ costs, so firms expand output again.
The conclusion is that the economy always finds its way back to YFE, the level of output at which all available resources are being used. That level is fixed by the quantity and quality of the factors of production, and nothing on the demand side can change it. So the long-run supply curve is vertical.
Aggregate demand has fallen substantially, and in the long run output has not changed at all. Only the average price level is lower.
The implications are serious:
Any deviation from YFE is temporary. Recessions happen, but they cure themselves.
Demand-side policy cannot raise output in the long run. Boosting AD just raises the price level.
Only supply-side policy generates growth, because only supply-side policy moves the vertical line.
Unemployment at YFE is the natural rate, and there is no unemployment for policy to remove beyond it.
The Keynesian view: an L-shaped AS
Keynes did not dispute that a vertical section exists. He disputed that the economy reliably gets there, and he argued that how the economy behaves depends entirely on how much spare capacity it has.
The same curve behaves completely differently depending on where the economy is sitting on it, which is the heart of the Keynesian argument.
Section
What the economy looks like
What happens if AD rises
1. Elastic (flat)
Deep recession. Idle factories, unemployed workers, firms desperate for orders.
Output rises with almost no rise in prices. Struggling firms take the work at existing prices.
2. Upward sloping
Recovery. Spare capacity is running down and firms begin competing for the same workers and materials.
Output rises and prices rise, and the closer to full employment, the more of the effect goes into prices.
3. Vertical
Full employment. Every available resource is in use.
Output cannot rise at all. The entire effect is inflation.
This is the most useful diagram in the whole topic, because it lets you give a conditional answer. Asked whether a stimulus will be inflationary, you can say: it depends where the economy is. In a deep recession, hardly at all. Near full capacity, almost entirely. That single sentence lifts an answer out of the middle bands.
Why wages are sticky downwards
The Keynesian case rests on a specific claim: wages can rise easily but resist falling. The reasons are practical rather than theoretical:
Minimum wage laws put a legal floor under pay.
Trade unions negotiate collectively and resist pay cuts hard.
Long-term employment contracts fix wages for a period regardless of conditions.
Workers simply refuse. Below a certain point people would rather stay unemployed than accept the offered pay.
If wages will not fall, the classical correction mechanism stalls. Costs do not come down, SRAS does not shift right, and the economy sits below full employment with high unemployment for as long as it takes. Keynes pointed at the Great Depression as the obvious example.
Animal spirits. Keynes used this phrase for the emotions driving decisions under uncertainty. In a slump, gloom is self-reinforcing: firms will not invest because they expect weak demand, and demand stays weak because nobody is investing or hiring. He argued only government spending was big enough to break that loop and restart confidence.
Assumptions and implications side by side
Classical / monetarist
Keynesian
Wages and prices are flexible in both directions
Wages are sticky downwards and often will not fall at all
Any deviation from YFE is temporary and self-correcting
The economy can be in equilibrium at any level of output, including well below YFE
No need for government intervention in the long run
Government must intervene, because waiting is very costly
Growth comes from supply-side policy that raises productive capacity
Demand-side policy works, and works best when there is spare capacity
Unemployment at YFE is the natural rate
Mass unemployment can persist for years, so it is not natural at all
Keynes’s famous objection to the classical model was not that it was wrong but that it took too long. Saying the economy self-corrects in the long run is no comfort to someone unemployed for five years. That is the point behind his line about all of us being dead in the long run, and it is a legitimate evaluation point rather than a joke.
WORKED EXAMPLE
A government increases spending by 3% of GDP. Using the Keynesian AS curve, explain why the effect on inflation depends on the state of the economy. [4]
Step 1: what the policy doesG rises, so AD shifts rightStep 2: if the economy is in the elastic sectionThere is plenty of spare capacity, so firms can raise output without bidding up wages or materials. Real GDP rises and the price level barely moves.Step 3: if the economy is in the vertical sectionno spare resources, so output cannot rise and the whole effect is inflationStep 4: judgementThe same policy is expansionary in a recession and purely inflationary at full employmentAnswer the question with a condition, not a flat prediction.
WORKED EXAMPLE
Explain why a classical economist would oppose using demand-side policy to reduce unemployment in the long run. [4]
Step 1: the shape of LRAS
LRAS is vertical at YFE, so long-run output is fixed by the quantity and quality of the factors of production.
Step 2: what a demand boost doesAD shifts right, output rises briefly, then wages rise in responseStep 3: the long-run resultHigher wages raise costs, SRAS shifts back left, and output returns to YFE at a higher price level.The policy delivers inflation, not lasting employmentStep 4: what they would do instead
Supply-side policy, such as training or infrastructure, which moves the vertical curve right and genuinely raises YFE.
💡 Exam tip
You may be told which model to use. If not, choosing one and justifying the choice is itself an evaluation point.
Number the three sections on your Keynesian diagram. It makes the explanation far quicker to write.
Always mark YFE. Without it neither diagram means anything.
Use “it depends on spare capacity” as your default evaluation line for any demand-side policy question.
Explain wage stickiness with real reasons: contracts, unions, minimum wage laws.
Do not caricature either school. Both have a vertical section. They disagree about whether the economy reliably gets there.
⚠️ Common mix-up
Drawing the Keynesian curve with no vertical section. There is a limit to output in both models.
Confusing SRAS with LRAS on the classical diagram. SRAS still slopes up; LRAS is the vertical line.
Saying classical economists think unemployment is impossible. They accept the natural rate, and short-run unemployment during adjustment.
Thinking Keynesians ignore inflation. Their model has a vertical section precisely because they take it seriously near full employment.
Assuming one model is simply right. The exam rewards using both and explaining which fits the situation.
Forgetting to link the diagram to policy. The shape of the curve is only interesting because of what it implies governments should do.
Up next: What Shifts Long-Run Aggregate Supply, the factors that genuinely raise what an economy is capable of producing.
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