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Aggregate Demand and Aggregate Supply

Long-Run versus Short-Run Macroeconomic Analysis​

Long-Run versus Short-Run Macroeconomic Analysis

Macroeconomic analysis is divided into long-run and short-run analysis. The crucial difference is the role played by expected price level in affecting short-run aggregate supply curves.

Macroeconomic analysis is divided into long-run and short-run analysis. This division arose out of the Great Depression of the 1930s, which necessitated an analysis of macroeconomic behavior that allowed policymakers to interpret and address short-run trends. The Great Depression was a time of severe economic downturn that lasted from 1929 to 1939. Prior to the Depression, most macroeconomic theories had been based on the behavior of economies over long periods of time.

The distinction between the short run and the long run in macroeconomics relates to time periods over which resources and their corresponding prices are either inflexible or can be adjusted. The short run is generally defined as the time horizon over which wages and the prices of other inputs to production are sticky, or inflexible, and the long run is defined as the period of time over which these input prices have time to adjust. Theoretically, the distinction between the short run and the long run is that the short run considers the circumstances in which resources are allocated and production decisions are made. Short-run decisions are made with regard to production in accordance with pressures from price, supply, cost, and revenue. In the short run, price levels, wages, and perceptions do not necessarily adjust to prevailing economic circumstances. In the long run, expectations are assumed to adjust to meet actual economic activity.

In macroeconomic analysis, wages and certain other prices are not responsive in the short run to changes in the marketplace. These slow-to-respond prices are called sticky prices. Because of this stickiness, it is possible for short-run equilibrium to not be consistent with long-run equilibrium. Shortages and surpluses result from slowness to respond to prevailing conditions and employment will, therefore, not reach its natural level. The overall output of the economy is unlikely to reach its full potential. In the long run, however, prices and wages are considered to be flexible, and as a result, employment will rise or fall until it reaches its natural level. In other words, the level of real wages (wages expressed in terms of the actual amount of goods and services that they can purchase, or wages adjusted for inflation) will adjust until the supply of labor is equal to the demand for labor.

In the long run, price levels in the macroeconomy are assumed to be responsive to shifts in aggregate supply and aggregate demand. Furthermore, labor and capital move freely within the economy and between nations. The long run is also the period in which most businesses conduct planning for their future activities. This includes decisions on whether to enter or withdraw from a market, acquiring plants and tools for production, or shifting to a business model that relies on an emerging technology. Businesses can use a combination of long-run and short-run analysis to predict what is best for the company, often seeking positive long-run solutions while also considering the short-run impacts.