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Aggregate Demand and Aggregate Supply

Long-Run Aggregate Supply

What Is Long-Run Aggregate Supply?

The long-run aggregate supply (LRAS) curve is a description of the relationship between the price level and the quantity of output produced in an economy over the long run.

The aggregate supply curve shows the relationship between price level and output. In the short run, this curve reflects the view that firms will respond to an increase in price by increasing their output. However, this action relies on the premise that the price at which consumers are buying is increasing while the input costs for production are remaining the same. While this may be true in the short run, this assumption does not hold in the long run. Over time, the input costs also increase, making it no longer advantageous to increase output in response to an increase in price. As a result, the long-run aggregate supply curve (LRAS) shows that output does not depend on price level, and the linear expression of output versus price is a vertical line, determined only by production costs. The main rationale is that there is potential output based on capacity and that the economy always returns to this level of potential output. Potential output or GDP occurs when the economy is at the natural rate of unemployment, the amount of unemployment that occurs when the economy is producing at potential output. Any remaining unemployment is considered to be frictional, structural, or voluntary. It is also assumed that all the material and capital resources in an economy are fully available to be utilized for the production of goods and services.

At full employment of all resources, the LRAS is a vertical line that intersects the aggregate demand (AD) curve, determining an equilibrium price level. The economy may shift away from this equilibrium point in the short run, but in the long run it will always come back to the same vertical LRAS, even though it may return at a different price level. For example, if there is an increase in AD, both price level and output increase in the short term, and the economy will move to the right along the SRAS. Over time, the economy will adjust and output will come back down. However, the price increase will remain, and the economy will return to a higher point on the LRAS corresponding to an increase in price level. Similarly, if AD decreases, both price level and output decrease, and the economy will move to a lower point on the LRAS.
Over the long run, GDP will remain at the same point (YY^{\ast}) at varying price levels, resulting in a long-run aggregate supply curve (LRAS) that is a vertical line.
The LRAS is described by Y=YY=Y^\ast where YY^{\ast} is the natural level of output. This value is not affected by price levels.

Shifts in the Long-Run Aggregate Supply Curve

The long-run aggregate supply curve can shift when the productive potential of an economy changes because of factors such as increased resources or technological development, but not because of changes in price level.

The long-run aggregate supply (LRAS) curve is a vertical line on a graph of output versus price level, indicating that in the long run, there is a potential level of output from an economy that is independent of price. The LRAS curve can be compared to the production possibilities frontier (PPF) model. The PPF model indicates various combinations of two products that an economy can produce in the most efficient manner, given a fixed supply of resources and a given state of technology. Points along the PPF represent the efficient use of the economy's resources to produce various combinations of the two goods. A change in resources used to produce one or both of the goods represented in the model or a change in the state of technology will shift the PPF. The LRAS curve explains very much the same idea. An improvement in the level of labor, capital, technology, or natural resources will cause the LRAS curve to shift. A shift in the LRAS curve indicates that this natural level of output has either increased or decreased, so the productive potential of the economy has changed. A shift in the PPF also illustrates changes in the economy's output potential. A shift of the LRAS curve to the left indicates a reduction in productive potential, and a shift to the right indicates an increase in productive potential.

In order to change the productive potential of an economy, something fundamental needs to alter its potential level of output, such as changing the quality and quantity of available resources. Resources could refer to labor, capital, technology, or natural resources. If, for instance, there is a growth in population that increases the amount of available labor in an economy, the economy's potential level of output level will increase and the LRAS curve will shift to the right. On the other hand, if there is less available labor, output will decrease and the LRAS curve will shift to the left. Technological development, such as better machinery, is another key factor for increasing production because it can enable labor to be more productive or increase the ability to make use of natural resources. During the Industrial Revolution (the development of mechanized industry over the 18th and 19th centuries), inventions such as the sewing machine and cotton gin increased production greatly. These technologies increased output and shifted the LRAS curve to the right.
As potential output increases (from Y1 to Y2),the long-run aggregate supply curve (LRAS) shifts to the right.
If governments want to increase or decrease their output to shift the LRAS curve, they can implement certain policies. The supply of labor can be controlled through work incentives and regulating immigration and migration. Infrastructure investments can also affect labor availability by improving workers' mobility. Additionally, innovation and technological development can be promoted through capital investment and favorable tax policies for businesses, enabling the natural output of the economy to increase.