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Aggregate Demand/Aggregate Supply Model
Aggregate Supply
The Long-Run Aggregate Supply Curve
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We’ve almost completed our model of the macroeconomy. We’re almost ready to find the equilibrium price level and
output and see how changes in the environment can generate a business cycle and what policy can do to encourage
more output and growth. But what we need to add now is the long-run aggregate supply curve; a curve that answers
the question, What is the relationship between the aggregate price level and output in the economy in the long run
after all prices have completed the process of adjustment.
Recall that the process of adjustment may proceed in a jerky fashion. Good prices may be rising faster than labor
prices. Raw materials prices are rising at a different rate. But the long run is when all of those prices have completed
their adjustment and the general price level in the economy has risen, say by 10 percent. Once all prices have risen
by 10 percent, what would we expect businesses to do in response? Well, think about it. Businesses are out to make
a profit and profit is the difference between revenue and cost. Goods prices determine your revenue; materials and
labor prices determine your costs. And if all of those prices rise at the same rate, there’s been no change in the
relative prices of output and inputs. There is no new opportunity for profit. You're back where you started. So in the
long run after all prices have completed their adjustment, there’s no new opportunity for profit. Businesses are back in
the same position in which they started and we would imagine that they would choose the same output level that they
were choosing before.
So in the long run there’s no relationship between the aggregate price level and the level of output. The long-run
aggregate supply curve is a vertical line. So if we want to draw that vertical line in our diagram, the next question we
have is, Where does it go? Where should we put the long-run aggregate supply curve? Should it be over here close
to the axis or out here further away? The answer depends on how much output the economy can produce when all
resources are fully employed. We’re now going to define the concept of full employment output.
Full employment output is the output of the economy when all resources are employed, perhaps all employed in their
best uses. You see, now we’re starting to get into some fuzzy stuff because you can always work people harder,
right? You can always go try to find more materials. But there’s a notion of full employment output when everyone
who wants to work is working as hard as they want and all materials that are relatively inexpensive to get to have
been employed; that nothing is being wasted. That’s the idea. The output that we can produce when nothing is being
wasted. You can always push the economy harder and try to make more, but that means paying people who don’t
want to work to come get a job while climbing further up the mountain to cut down more trees. So the full employment
level of output can be thought of as a kind of speed limit to the economy. This is the amount of output that we can
produce when all resources are employed. If we go faster than the speed limit, then we run the risk of inflation that is
pushing up prices. And if we go below the speed limit, then we’ve got unemployment and the prices will tend to drop
over time. Over time wages will even tend to drop if there’s unemployment in the labor market.
So the speed limit of the economy, full employment output, depends on two things. First, the resource pool. How
much labor is there? How much raw materials do we have to work with in our economy? So if you combine labor and
raw materials, these two things together determine the resource base of the economy. Also another important
resource is capital. I could put a hammer in this picture and we’d have all of our resources represented.
The important component that determines full employment output is technology, that is our skill or ability to turn these
resources into output. The better our technology, the more output we can produce with a given quantity of resources.
So take your resources and take your technology, put them together and that determines full employment output; the
output that’s produced when all resources in the economy are fully employed. Think of that as a speed limit to the
economy. You can go faster, you can go slower, but if you do you're in a situation that’s unstable. Prices are going to
start to adjust and other changes are going to be set in motion.
So let’s go ahead then and draw our curve to represent the long-run aggregate supply curve. And here it is. It’s a
vertical curve and I'll label it LRAS for long-run aggregate supply and I'll call this 0 because this is my original one.
And the long-run aggregate supply curve then represents the output of the economy when all resources are fully
employed. In the long run, we’re going to wind up back on this green curve. I've colored it green to remind us that the
economy is constrained by the natural environment. All of our resources come from the natural environment and that
natural environment determines how much output we can produce given our technology.
Aggregate Demand/Aggregate Supply Model
Aggregate Supply
The Long-Run Aggregate Supply Curve
Page 2 of 3
So now what we’re ready to do is we’re ready to put the short-run aggregate supply curve and the long-run aggregate
supply curve together and find out what would cause them to shift. Before I put the short-run supply curve in this
diagram, let’s think about what would shift the long-run aggregate supply curve. What would change the speed limit of
the economy? What would allow us to produce more output at any given price level? And the answer here is a
change in our resource base or a change in technology. If we get more resources, say there is immigration of labor,
more labor comes and joins our economy, now we can produce more output than we could before. Or if we get more
raw materials in the economy, that’s going to be an increase in our resource base. An increase in the resource base
for a given technology shifts the long-run aggregate supply curve outwards. That is it shifts here over to the right. If
there should be a reduction in the resource base due to a war, then the long-run aggregate supply curve shifts
inwards. Now let’s put the long run and short-run aggregate supply curve together in one picture and see what
happens. So let me go ahead and draw my short-run aggregate supply curve and remember the slope of the shortrun aggregate supply curve reflects the impact that the price level has on output in the short run when people are
confused and when there are fixed wages and sticky prices, we get this short-run aggregate supply curve. So in the
short run, we always have to be on the blue curve. If the price level is to increase, then in the short run we’re going to
get an increase in output because people aren’t sure whether it’s just their sector or inflation across the economy.
Also because wages are fixed so businesses see a profit opportunity. Also because of sticky prices there’s going to
be an increase in output as some people keep their prices low relative to the overall rising price level because of the
cost of adjustment. So you're always going to be on the blue curve, but in the long run you've got to be on the green
curve as well.
We’ll see how we get there when we talk about the process of adjustment after we put demand and supply together
and sound equilibrium. But we’ve got one more thing that we need to address and that is what causes these curves
to shift?
Suppose there’s an increase in resources in our economy due to immigration? What’s going to happen then is the
long-run aggregate supply curve is going to shift outwards like we talked about before. And we’re going to have a
new long-run aggregate supply curve and I can label that long-run aggregate supply curve one. The level of full
employment output in that case is increased. We’ve increased from YF0 to YF1. The new higher level of full
employment output is due to an increase in the resource base. You’d get the same result if you had an improvement
in technology. If technology were to improve, we would get an outward shift in the long-run aggregate supply curve.
Notice that any time you shift the long-run aggregate supply curve, it pulls the short-run aggregate supply curve with it.
So the short-run aggregate supply curve shifts as well. So I can label this SRAS1. If the long-run aggregate supply
curve were to shift inwards due to a war, it would also pull the short-run curve with it. So anything that shifts the longrun aggregate supply curve shifts the short-run aggregate supply curve along with it. It’s as if they’re attached right
here at this point.
Now there’s one more thing to consider and that is that the short-run aggregate supply curve can change on its own
power. That is if we were to go back to our original set of curves, that is the long-run aggregate supply curve here and
the short-run aggregate supply curve, then the short-run aggregate supply curve can change due to a change in
expectations. This is the factor that can shift the short-run aggregate supply curve on its own. Suppose everyone,
due to some change in the environment, decides that prices are actually falling. They expect a lower price level.
What’s going to start to happen is that workers in order to remain competitive will be willing to accept smaller wage
increases. What happens also is that my business trying to stay ahead of your business is going to try to lower its
prices first. Everybody, if they think that prices are falling, is going to move quickly to lower prices ahead of everyone
else. What happens then when people expect lower prices is they build those expectations into their decisions, into
their negotiations, into their wage contract and so forth. So if the short-run aggregate supply curve shifts downwards
so that you can get a given level of output now at a lower price level. This is the one thing that shifts the short-run
aggregate supply curve independently of the long-run aggregate supply curve; people’s expectations about the price
level. Once we start talking about the adjustment process, we’ll see that the short-run aggregate supply curve
frequently moves independently of the green curve, especially if you’ve created inflation by trying to go faster than the
speed limit. But in the meantime, we can keep in mind the summary that says that anything that shifts the long-run
aggregate supply curve, pulls the short-run aggregate supply curve with it. And the factor that shifts the short-run
aggregate supply curve independently of the long-run aggregate supply curve is people’s expectation about the price
Aggregate Demand/Aggregate Supply Model
Aggregate Supply
The Long-Run Aggregate Supply Curve
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level. Prices going down, the price expected, the SRAS shifts down. If people are expecting inflation soon they
preempt it by pushing prices up now shifting the SRAS up.
So now we know what these curves mean, why they slope the way they do and what can cause them to shift. We’re
ready now to introduce the aggregate demand curve and calculate an equilibrium. So we’ll be doing that next.