Question

Explain why the short-run aggregate supply curve might be vertical in the neoclassical zone of the SRAS curve. How might we tell if we are in the neoclassical zone of the AS?

Short answer

In the neoclassical zone of the SRAS curve, the curve is vertical because the economy is producing at or near its potential output with fully utilized resources. An increase in the price level does not lead to an increase in output. We can identify the neoclassical zone by observing macroeconomic indicators such as the unemployment rate, inflation, output gap, and capacity utilization.

Step-by-step solution

Define Short-run Aggregate Supply Curve

The short-run aggregate supply (SRAS) curve represents the relationship between the quantity of goods and services produced in an economy and the price level in the short run. It shows how much output firms are willing to produce and sell at various price levels, holding all other factors constant.

Define Neoclassical Zone of the SRAS Curve

The SRAS curve can be divided into three zones: the Keynesian zone, the intermediate zone, and the neoclassical zone. The neoclassical zone represents a situation where the economy is operating at or near its potential output or full employment level. In this zone, output is determined by the long-run aggregate supply (LRAS) curve, which is vertical because of the classical assumption that wages and prices are fully flexible in the long run.

Explain Vertical SRAS Curve in the Neoclassical Zone

The SRAS curve becomes vertical in the neoclassical zone because the economy is producing at or near its potential output. At this point, firms have already utilized all their available resources, including labor and capital, and moving beyond this point would result in higher production costs, which would be reflected in higher prices. Therefore, an increase in the price level does not lead to an increase in output, implying that the SRAS curve is vertical in the neoclassical zone.

Identifying the Neoclassical Zone of the AS

To identify if we are in the neoclassical zone of the SRAS curve, we can observe several macroeconomic indicators, including: 1. Unemployment rate: If the unemployment rate is near the natural rate, it suggests that the economy is operating at full employment, which corresponds to the neoclassical zone. 2. Inflation: Persistent inflation or even hyperinflation may indicate that the economy is in the neoclassical zone. In this situation, any attempt to increase output would only lead to higher prices. 3. Output gap: If the output gap (the difference between actual output and potential output) is close to zero, the economy could be in the neoclassical zone. 4. Capacity utilization: High capacity utilization signifies that firms are operating at or near their full capacity, indicating the possibility of being in the neoclassical zone. In conclusion, when the economy is in the neoclassical zone, the SRAS curve is vertical, as firms are already producing at or near their potential output. Increases in the price level do not result in additional output. To identify if we are in the neoclassical zone, we can observe macroeconomic indicators such as the unemployment rate, inflation, output gap, and capacity utilization.