LRAS - A fight between Keynesians (K) and neo-Classicals (NC)!

For Keynesian economists, in the short run where FoPs are more or less fixed, the economy has what's called "spare capacity" when some resources are not be used to their maximum potential.  This is represented by the perfectly elastic part of their LRAS curve.  Thus, when aggregate demand (AD) increases, say from AD1 to AD2 above, the national output (real GDP - Y) increases (Y1 to Y2) but the average price level (APL) doesn't increase (APL1).  As spare capacity is used up, there is inflationary (upward) pressure on all prices because firms have to start paying higher wages and more money to get scarcer FoPs.  In this "intermediate" section, both the output (Y2 to Y3) and the average price level are increasing (APL1 to APL3).  The final part of the Keynesian LRAS curve which is perfectly inelastic is just like the entire neo-Classical LRAS curve.  Here, the economy is at the full employment level of output (Yfe) and any increase in AD will merely increase the average price level (inflationary gap, slightly above APL3 to APL4).  There is no effect on real GDP (Yfe).  The distance between a level of output that is below full employment and full employment is called a deflationary gap.  Evaluative implications – to increase real output during a time of spare capacity, Keynesians would propose the government undertake expansionary fiscal and/or monetary policy. 

For neo-Classical economists, we are already at the full employment level of output.  If AD increases (here from AD1 to AD2), output increases beyond the full employment level of output (to Y2) which also increases the average price level (to APL2).  Because the price level includes all goods and services including the FoPs (especially labor), the costs of producing g/s increase and SRAS shifts in (SRAS1 to SRAS2) so the new equilibrium is simply an even higher price level (APL3) with no change in output (Yfe).  Conversely, if output falls below the full employment level of output, the price level also falls making production of all g/s cheaper and thus shifting SRAS out back to equilibrium at Yfe and an even lower APL (not shown).  This is why neo-Classicals don't promote government intervention in the macroeconomy per se.

Evaluation - Compare Keynesian and neo-Classical views of the economy?  How does this impact normative economics?

Video: AD & AS

Aggregate Demand (AD) / Aggregate Supply (AS) Model

Aggregate demand (AD) is the total demand for final goods and services in the economy at a given time and (average) price level (APL).  An aggregate demand curve is the sum of individual demand curves for different sectors of the economy : AD = C (consumption) + I (investment) + G (government) + (X-M) net exports.   Consumption is the total spending by consumers on domestic g/s, investment (I) is the addition of capital stock to the economy done by firms, government spending (G) is money (from taxpayers) spent on g/s and is altered by fiscal and monetary policy, and net exports (NX) are exports (domestic g/s bought by foreigners) minus imports (foreign g/s bought by domestic households, firms and/or government).  

Aggregate supply (AS) is the total supply of goods and services that firms are prepared to sell at a given time and (average) price level (APL).  In the short run, the SRAS is upward-sloping because as more output is produced, firms must pay higher production costs (i.e. pay more for overtime, bid higher prices for scarcer raw materials), and firms pass these higher prices off in the form of a higher average price level.   Short run macroequilibrium occurs at the price level APL* when all the output produced by the country’s firms is consumed (Y1).  Firms have no incentive to raise prices or increase output.