Why is the natural rate of output crucial for AS?

The natural rate of output is crucial for Aggregate Supply (AS) as it represents the economy's potential output.

The natural rate of output, also known as potential output or full-employment output, is the level of real GDP that the economy would produce if its resources were fully employed. In other words, it's the maximum amount of goods and services an economy can produce when it is operating at its full capacity, without causing inflation or unemployment to rise.

Aggregate Supply (AS) refers to the total quantity of goods and services that firms in an economy are willing and able to sell at a given level of prices. It is influenced by the natural rate of output because the natural rate represents the economy's productive capacity. If the actual output is less than the natural rate, there is a negative output gap, indicating that the economy is underperforming and there is spare capacity. This will cause the AS curve to shift to the right, indicating an increase in supply. Conversely, if the actual output is greater than the natural rate, there is a positive output gap, indicating that the economy is overheating and resources are being over-utilised. This will cause the AS curve to shift to the left, indicating a decrease in supply.

Moreover, the natural rate of output is also crucial for AS because it helps determine the shape of the AS curve. In the short run, the AS curve is upward sloping, indicating that firms will produce more as prices rise. However, in the long run, the AS curve is vertical at the natural rate of output, indicating that in the long run, output is determined by the economy's productive capacity, not by the price level.

Therefore, understanding the natural rate of output is crucial for understanding the behaviour of AS and the overall performance of the economy. It helps policymakers to formulate appropriate policies to manage the economy, such as fiscal and monetary policies, to ensure that the economy operates at its full potential and achieves sustainable growth.