In this lesson summary review and remind yourself of the key terms and graphs related to the long-run aggregate supply curve and its relationship to the stock of resources, technology, and the natural rate of unemployment.
How much an economy is able to produce ultimately depends on that country’s resources. In the lesson on short-run aggregate supply, we learned that producers respond to changes in the price level in the short-run, which is why we have the SRAS curve.
But the SRAS curve is based on the idea that prices can’t adjust easily. In the short-run prices may have a hard time adjusting, but that might not be true in the long run. While in the short run some input prices are fixed, in the long run all prices and wages are fully flexible. Because of this flexibility, there isn’t a long-run trade-off between inflation and output.
Rather, in the long-run, the output an economy can produce depends only on the resources and technology that the country has available. This is the idea embodied in the long-run aggregate supply curve (LRAS), which is vertical at the economy’s potential output. Once prices have had enough time to adjust, output should return to the economy’s potential output.
|long-run||a sufficient period of time for nominal wages and other input prices to change in response to a change in the price level; the long-run is not any fixed period of time. Instead, this refers to the time it takes for all prices to fully adjust|
|long-run aggregate supply (LRAS)||a curve that shows the relationship between price level and real GDP that would be supplied if all prices, including nominal wages, were fully flexible; price can change along the LRAS, but output cannot because that output reflects the full employment output.|
|full employment output||(also called potential output) the amount of real GDP that an economy would produce if it is using all of its factors of production efficiently|
|The classical assumption||the belief that it is possible for all prices to fully adjust; prior to the Great Depression, economists generally assumed that prices weren’t stuck, which meant that the “old school” way of thinking about aggregate supply was that it was a vertical line like the LRAS.|
Long-run vs. short-run
Macroeconomics and microeconomics have slightly different definitions of what the long run means. But they have an important idea in common: long run means long enough for pretty much anything to change. But in macroeconomics specifically, the long run means long enough for all prices to fully adjust to any kind of change.
For example, suppose the price of gas goes up so much it takes a really big chunk of money out of your budget. But it’s Monday morning, and you still have to get to school, so you wince and fill up your tank. It might mean you have to give up something else today to fill your tank. But, if the price stays high and you know it will stay that high forever, eventually you can find a way to change something. Maybe you organize a carpool to spread costs, or start taking the bus, or find a more fuel efficient car. The short run is how you react when you see the higher price on Monday morning. The long run is however long it takes for you to adapt to that price shock.
The LRAS is vertical at a value of real GDP that represents a point on the PPC
The LRAS represents a point on a country’s PPC, translated into the AD-AS model. Every point on the PPC represents the maximum sustainable capacity for production in an economy. This value of real GDP represents the economy’s maximum sustainable capacity given its current stock of resources.
Why is the LRAS vertical?
The LRAS is vertical because, in the long-run, the potential output an economy can produce isn’t related to the price level. There are only two things that matter for potential output: 1) the quantity and the quality of a country’s resources, and 2) how it can combine those resources to produce aggregate output. When an economy is producing exactly its full employment output, the rate of unemployment is equal to the natural rate of unemployment.
The LRAS curve is also vertical at the full-employment level of output because this is the amount that would be produced once prices are fully able to adjust. In the short-run, some prices are sticky. This means that producers might respond to changes in the price level by changing their output. However, in the long-run, those prices get “unstuck,” and once they have fully adjusted the economy will produce the efficient, full employment output.
Economists tended to assume that prices were fully flexible before the Great Depression. In times of high unemployment, they believed, wages will go down and restore full employment. There was just a slight problem: that didn't happen during the Great Depression! High unemployment and low output persisted for a long time. The logical conclusion is that wages (and other prices) are temporarily rigid.
In the long-run there is no tradeoff between inflation and unemployment
In a previous lesson, we learned that there was a short-run tradeoff between inflation and unemployment. That might be true in the short-run, but not the long-run. Of course, inflation can temporarily impact employment. But once prices have a chance to adjust, inflation no longer impacts employment. The LRAS illustrates this well. Output is tied to employment on the LRAS, so if output doesn’t change in response to the price level, neither will employment.
The LRAS curve
The LRAS curve represents the potential output () that an economy can produce
LRAS and the PPC
Remember the PPC? In that model, an economy was using all of its resources efficiently if it was operating at a point on the PPC, as shown in Figure 3.
This economy is producing the combination of capital and consumption goods . Why did we label it ? Because this combination of output represents full employment output. You can think of the LRAS curve as taking that dot (which represents a certain amount of capital goods and a certain amount of consumption goods), figuring out the real value of that output, and then graphing the real value of that output in a new model. Imagine you can take that single dot on the PPC and then stretch it out into a vertical line . . . that is the LRAS!
What determines the placement of the LRAS?
The PPC tells us what an economy can produce if that economy is using all of its resources efficiently. That means this amount of production ultimately depends on what resources an economy has, and the value of the output that can be produced with those resources. For example, if an economy can produce million in real GDP by using all of its resources efficiently, then the LRAS will be vertical at a real GDP of million.
- How long is the long-run? Long enough! That might seem a little vague, but that is kind of the point. The long-run isn’t actually a specific time frame. It’s just “long enough” for prices to fully adjust. If prices haven’t fully adjusted, then it’s not the long-run yet.
- It might be helpful to think of the full employment output as a hypothetical and ideal quantity of real GDP. What if it was a perfect world where there was no excess unemployment, and what if all prices have adjusted perfectly? Then full employment output is how much would be produced. Not too little. Not too much. But just right!
- Remember that the SRAS was related to another model in the short run called the Short Run Phillips Curve? Well, the LRAS has a buddy in that model too: the Long-Run Phillips Curve (LRPC), which you’ll learn about in more depth later in this course (spoiler alert!). In that model, the LRPC curve shows that, just like in the LRAS, there is no relationship between inflation and the unemployment rate in the long run.
- Given the PPC below, construct an LRAS curve that contains all pertinent information given.
- What are the reasons that the aggregate supply curve is vertical in the long-run but not in the short-run?
- If an economy is producing its potential output, is the current rate of unemployment less than, greater than, or equal to the natural rate of unemployment? Explain.
Want to join the conversation?
- a shift to the left of the LRAS curve represents what(9 votes)
- Causes for shifting to the left of the LRAS maybe, destuction of production capabilities, for ex due to war factories were destroyed. It shifts LRAS to the left because your maximum output was decreased(3 votes)
- What factors causes both LRAS and SRAS to shift together?
Does a natural disaster cause both to shift to the left, since factor of production is destroyed?(2 votes)
- Yes, something like a natural disaster could shift both the LRAS and SRAS to the left together.
If there was a tsunami, houses, factories, would all be destroyed. Land would be devastated. This would drastically impact one of the factors of production, and move the LRAS to the left. In the short run, no one can get to work, as the area has been destroyed. So there will also be a large short run drawback.(1 vote)
- But WHICH point on the PPC does it represent?? They're all supposed to be efficient, right? And they're all based on what resources the country possesses?(1 vote)
- So a PPC represents the maximum possible combinations of two types of goods an economy can produce when it is at full employment, meaning that it is fully employing all of its resources and technology. The LRAS curve tells us that the economy is producing its resources fully and efficiently with the amount of technology it has access too. In order for an economy to be on the LRAS curve, it has to be fully employing all of its resources and be at a point on its PPC curve. All points on the PPC curve are supposed to be efficient, meaning that the country is utilizing all of it's possible resources to produce that certain combination of goods.
Remember that on the PPC curve, any point on the curve is efficient. It doesn't matter if they are producing more capital goods than consumer, near the y-axis or the x-axis, or right in the middle. Just as long as the country is on the PPC curve, then it is producing their maximum possible output when fully using their resources.
Taking that all into consideration, the LRAS curve can represent any point on the PPC so as that point is on the curve (fully employing resources with the given technology). It does not represent a point outside of the curve, or inside of it.(3 votes)
- Is there a real world example that shows that an economy is bounded by a Long Run Aggregate Supply Curve?(1 vote)