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Friday, 5 August 2011

Production Possibility Frontier and Long Run Aggregate Supply

The PPF shows the combination of capital and consumer goods that can be produced within the economy. The PPF shows what the economy can produce. If the economy is producing inside the PPF, point X, it is in a recession. Unemployment is high and the economy is not producing at it’s full productive capacity.

When the economy is producing on the PPF, point Y, it IS producing at its full productive capacity. It is also producing on the LRAS curve, point V on the supply/demand diagram. Real national output is YFE and the price level is P1. Full employment of resources has been achieved, which means that the labour force is fully employed, see Word of the Day. The only way to increase output is by increasing investment in capital goods (which increases consumer goods) thereby increasing LRAS. If this happens, economic growth is occurring in the long run. See Word of the Day. LRAS1 moves rightward to LRAS2 and thus SRAS1 shifts rightward to SRAS2. Real national output in the economy has increased from YFE to YFE2. Assuming AD remains unchanged, the price level falls from P1 to P2.

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