Long Run Aggregate Supply

What determines the overall production of goods and services in the economy? How would an increase in immigration impact a country's long-run potential output? How has technology impacted the overall output produced in the U.S economy? You will be able to answer all these questions once you read our explanation in the Long-Run Aggregate Supply.

Long-Run Aggregate Supply Definition

Long-run aggregate supply definition refers to the total amount of production in an economy given that its full resources are employed.

The short-run aggregate supply curve depicts the number of goods and services produced in an economy at different price levels. This supply curve is only concerned with the number of goods and services produced during the short run. However, when we consider the long-run aggregate supply, we'd have to consider how production in an economy takes place during the long run. That is to say, we'd have to consider the factors that influence the production capacity of an economy in the long run.

In the long term, an economy's output of goods and services (its real GDP) relies on its supply of labor, capital, and natural resources and the available technologies utilized to transform these production elements into products and services. The reason for that is that the long-run aggregate supply assumes that the quantity of money does not impact technology or the quantity of labor, capital, and natural resources. That means that the price level and wages are flexible in the long run.

LRAS Curve

The LRAS curve or the long-run aggregate supply curve is vertical, as seen in Figure 1 below.

As the LRAS is vertical, there is no long-run trade-off between inflation and unemployment.

Fig. 1 - LRAS curve, StudySmarter

The overall amount of products and services provided is determined by the economy's labor, capital, natural resources, and technology over the long term. This quantity supplied is constant regardless of price.

Classical Long-Run Aggregate Supply

Modern aggregate models follow concepts in classic macroeconomic theory; read this deep dive below for more info on why the long-run aggregate supply is vertical.

Long-Run Aggregate Supply Curve Definition

The long-run aggregate supply curve illustrates the relationship between the aggregate price level in the economy and the aggregate output supplied that would take place if prices and nominal wages were flexible.

Fig. 2 - LRAS curve, StudySmarter

Figure 2 shows the long-run aggregate supply curve. Notice that the long-run aggregate supply is perfectly inelastic because it has no response to changes in price. That means that in the long run, regardless of the price level, the quantity of output would be fixed. The reason for that is that the price level does not impact the level of production in the economy in the long term.

Another important thing to consider is the long-run aggregate supply curve position along the horizontal axis. At the point where the LRAS intersects, the horizontal axis, which depicts the real GDP, provides the economy's potential output (Y1).

The LRAS curve is in line with the production possibilities curve (PPC), representing the maximum sustainable capacity. Maximum sustainable capacity refers to the total amount of production that can occur, given that all resources are fully employed.

The potential output is the real GDP that an economy would have if prices and wages were flexible. It is used to analyze economic fluctuations between potential output and real output. It is significantly hard to find periods in the economy where the actual output is the same as the potential output. You can usually find that the actual production is below or above the potential output. This helps economists analyze economic shocks that might have caused deviation from potential output. AD-AS model is one of the widely used models to analyze such fluctuations.

LRAS Shift

LRAS shift or shift in the long-run aggregate supply curve occurs when there are changes in factors that affect the potential output of an economy. Factors that cause a shift in LRAS include:

• labor
• capital
• natural resources
• technology changes.

Figure 3 shows shifts in LRAS. A rightward shift in the LRAS (from LRAS₁ to LRAS₂) will increase real GDP (from Y₁ to Y₃), and a leftward shift (from LRAS₁ to LRAS₂) will decrease real GDP (from Y₁ to Y₂). LRAS shows the number of products and services produced in the economy in the long term. The term "potential output" refers to the long-term level of production.

Fig. 3 - LRAS Shift, StudySmarter

Changes in labor

Consider a scenario in which an economy sees an increase in foreign workers. The number of products and services offered would rise due to increased employees. Consequently, the long-run aggregate supply curve would move to the right. Conversely, if enough employees left the economy to migrate overseas, the long-run aggregate-supply curve would shift to the left.

Also, the minimum wage has an impact on the long-run aggregate supply. That is because the potential output considers the natural unemployment rate. That means that the potential output considers all the workers employed at that level of economic production.

Changes in capital

When an economy experiences a rise in its capital stock, this enhances productivity, and as a result, more products and services can be delivered. As more products and services could be produced, the potential output in the economy would rise as well. This would cause the long-run aggregate supply to shift to the right.

On the other hand, a drop in the economy's capital stock affects productivity and the number of goods and services provided, pushing the long-run aggregate- supply curve to the left. This results in lower potential output.

Changes in natural resources

The natural resources of a country directly impact the production of the economy. Countries with rich natural resources have greater productivity and can produce more output than other countries. Discovering new materials and using new natural resources shift the long-run aggregate supply of a country to the right.

On the other hand, depleting natural resources will result in lower potential output shifting the LRAS to the left.

Technological advancements

The advancement of technology is perhaps one of the most important factors influencing the long-run aggregate supply curve. Consider labor productivity before computers and after. The number of goods and services produced through computers while using the same labor has increased significantly.

When an economy experiences technological advancement, it will cause a rightward shift in the long-run aggregate supply. That is because it directly improves productivity allowing for more goods and services to be produced using the same labor and capital.

The aggregate supply curve would be shifted to the left in the long term if new restrictions were passed by the government prohibiting companies from employing certain manufacturing techniques due to worker safety or environmental concerns.

Long-Run Aggregate Supply Examples

Let's consider a country that sees an increase in foreign workers as an example of the long-run aggregate supply.

Before the migration of foreign workers, the economy was producing a certain amount of goods and services, and for this amount of goods and services, there was a certain number of workers being hired. What happens when more people start coming to the economy?

Hence, the overall result will increase potential output (rightward shift in LRAS). This is because an increase in aggregate demand and labor supply allows supply and demand to increase in tandem, moving to a higher equilibrium.

Difference Between Short-Run and Long-Run Aggregate Supply

The aggregate supply curve behaves quite differently in the short term than in the long term. The main difference between short-run and long-run aggregate supply is that short-run aggregate supply depends on the price level, whereas long-run aggregate supply does not depend on the price levels.

The long-term aggregate-supply curve is vertical because, in the long run, the general level of prices and wages does not impact the economy's capacity to generate goods and services as they are flexible. Prices have a short-term impact on economic activity, though. Over a year or two, a rise in the overall level of prices in the economy tends to raise the number of goods and services provided, while a fall in the level of prices tends to lower the number of goods and services supplied. Consequently, the short-run aggregate supply curve is upward sloping.