Long-Run Aggregate Supply
What is Long-Run Aggregate Supply?
Long-run aggregate supply is the total supply of goods and services when all factors of production are fully employed.
In the long run, an economy's potential output is determined by its factors of production, such as labor, capital, and technology. Changes in the price level do not affect the quantity of goods and services supplied in the long run. The LRAS curve is vertical.
Long-Run Aggregate Supply: a worked example
Suppose potential output is $840 billion, the position of the vertical LRAS curve. The labor force then grows 2 percent while output per worker rises 1.5 percent, so potential output becomes $840 billion × 1.02 × 1.015 = about $870 billion. LRAS shifts right by roughly $30 billion and the full-employment level of production moves with it. Now test the vertical shape. Aggregate demand increases and the price level climbs from 100 to 108 while nothing changes about the labor force, capital stock or technology. Long-run output stays at $870 billion, so the entire increase in spending lands in prices. Short-run output can exceed $870 billion while wage contracts are stale, but once nominal wages catch up SRAS shifts left and output returns to the LRAS line.
The mistake students make with long-run aggregate supply
Seeing output above full employment, students shift LRAS right to make the graph fit. Potential output has not changed. The economy is temporarily overworking existing resources through overtime and extra shifts, which is a point to the right of an unchanged LRAS, and the correction comes through SRAS as nominal wages rise. A related error is treating LRAS as the curve for a long period of time. LRAS shows output once all input prices have fully adjusted, whether that adjustment takes months or years.
Long-Run Aggregate Supply questions
Why is the long-run aggregate supply curve vertical?
Potential output depends on resources, technology and institutions, not on the price level. In the long run every input price, including nominal wages, adjusts in proportion to output prices, so a doubling of the price level leaves real production costs and real profit unchanged and firms have no reason to produce more. The quantity supplied is identical at every price level, which draws a vertical line at full-employment output.
What shifts long-run aggregate supply?
Anything that changes productive capacity: growth in the labor force, more or better capital, new technology, newly available natural resources, or improvements in education and property rights. Changes in aggregate demand, the money supply or the price level leave LRAS where it is. Permanent destruction of capital from a disaster shifts it left, and so does a lasting decline in the labor force.
Does LRAS sit at zero unemployment?
No. LRAS sits at the full-employment level of output, where the unemployment rate equals the natural rate. Frictional unemployment from people between jobs and structural unemployment from skill mismatches persist even at potential output, so the natural rate might be 5 percent in a given economy. Cyclical unemployment is the component that equals zero when output sits exactly on LRAS.
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