Short-run vs Long-run Aggregate Supply

Introduction

Key Concepts

Aggregate Supply: An Overview

Aggregate Supply (AS) represents the total quantity of goods and services that producers in an economy are willing and able to supply at a given overall price level, within a specific time frame. It is a fundamental concept in macroeconomics, influencing economic growth, inflation, and unemployment rates. AS is typically analyzed in two distinct time horizons: the short run and the long run.

Short-run Aggregate Supply (SRAS)

In the short run, certain factors of production are considered fixed, such as capital and technology. Firms respond to changes in the price level by adjusting the quantity of goods and services they produce, primarily through variations in labor and raw materials. The Short-run Aggregate Supply curve is upward sloping, indicating that as the price level increases, the quantity of aggregate output supplied also increases, assuming nominal wages and other input prices remain sticky.

Factors influencing SRAS include:

• Resource Prices: Changes in wages, raw material costs, and energy prices can shift the SRAS curve. An increase in resource prices typically decreases SRAS.
• Supply Shocks: Events like natural disasters or geopolitical tensions can disrupt production, affecting SRAS.
• Expectations: If producers expect future price increases, they may increase current production, shifting SRAS rightward.

The SRAS can be represented by the following equation:

Where:

• Y: Actual output
• Y_potential: Potential output
• α: A positive coefficient indicating the responsiveness of output to price level changes
• P: Actual price level
• P_expected: Expected price level

Long-run Aggregate Supply (LRAS)

In the long run, all factors of production are variable, and the economy is assumed to operate at full employment. The Long-run Aggregate Supply curve is vertical at the potential output level, indicating that in the long run, the aggregate supply is not influenced by the price level. This reflects the economy’s capacity determined by factors such as technology, resources, and institutional structures.

Key determinants of LRAS include:

• Technology: Advances in technology enhance productivity, shifting LRAS rightward.
• Resource Availability: An increase in the quantity or quality of factors of production (labor, capital, land) shifts LRAS rightward.
• Institutional Factors: Improvements in governance, property rights, and economic policies can positively impact LRAS.

The LRAS can be expressed as:

Where:

• Y_long-run: Long-run aggregate output
• A: Total factor productivity
• F(K, L): Production function dependent on capital (K) and labor (L)

Factors Differentiating SRAS and LRAS

The distinction between SRAS and LRAS lies in the flexibility of input prices and the time frame considered. In the short run, input prices like wages are sticky due to contracts and other rigidities, making SRAS responsive to price level changes. Conversely, in the long run, input prices adjust fully to changes in the price level, rendering LRAS independent of such fluctuations.

Aggregate Demand and Supply Interaction

The interaction between Aggregate Demand (AD), SRAS, and LRAS determines the equilibrium price level and output. Short-run equilibrium occurs where AD intersects SRAS, which may differ from the long-run equilibrium where AD intersects LRAS. Shifts in AD or shifts between SRAS and LRAS influence economic outcomes such as inflation and output gaps.

Impact of Fiscal and Monetary Policies

Fiscal and monetary policies primarily influence Aggregate Demand but can have indirect effects on Aggregate Supply. For instance, expansionary fiscal policy may increase AD in the short run, impacting SRAS by altering resource prices and expectations. In the long run, policies that enhance productivity or resource availability can shift LRAS, promoting sustainable economic growth.

Graphical Representation

The following diagram illustrates the distinction between SRAS and LRAS:

In the graph, the vertical LRAS curve intersects the SRAS and AD curves at the long-run equilibrium, indicating full employment. Deviations from this equilibrium in the short run can lead to economic fluctuations.

Real-world Examples

Consider the oil price shocks of the 1970s. An increase in oil prices raised production costs, shifting the SRAS curve leftward, leading to stagflation—characterized by high inflation and unemployment. In the long run, economies adjusted through technological advancements and resource reallocations, restoring equilibrium at a different price level with potential output unchanged.

Advanced Concepts

Theoretical Foundations of Aggregate Supply

The concept of Aggregate Supply is rooted in classical and Keynesian economic theories. While classical economics emphasizes the self-regulating nature of markets leading to full employment in the long run, Keynesian economics highlights the potential for short-run deviations due to price and wage stickiness.

In the short run, Keynesian models propose that prices and wages do not adjust immediately to changes in economic conditions, allowing for fluctuations in output and employment. This is encapsulated in the upward-sloping SRAS curve, where increased demand leads to higher output and prices without necessarily moving the economy towards its long-run potential.

Conversely, in the long run, classical models assume flexibility in prices and wages, ensuring that the economy self-adjusts to achieve full employment. The vertical LRAS curve signifies that, regardless of price level changes, the economy’s output is determined by structural factors like technology and resource endowments.

Mathematical Derivation of SRAS and LRAS

To delve deeper, consider the Phillips Curve relationship, which connects inflation and unemployment. In the short run, an increase in aggregate demand can reduce unemployment below the natural rate, leading to higher inflation. This relationship can be modeled as:

Where:

• π: Actual inflation rate
• π^e: Expected inflation rate
• β: Positive coefficient
• u: Actual unemployment rate
• u_n: Natural unemployment rate

Rearranging, the SRAS can be expressed as:

This equation illustrates that actual output deviates from potential output based on the difference between actual and expected inflation, reinforcing the upward slope of the SRAS.

Advanced Problem-Solving: Multiplier Effects and AS Shifts

Consider an economy experiencing a demand shock, leading to an initial increase in AD. Using the Keynesian multiplier, the total change in output (\ΔY) can be expressed as:

Where:

• MPC: Marginal propensity to consume
• ΔG: Change in government spending

If the initial AD increase shifts SRAS leftward due to rising production costs, the net effect on equilibrium output and price level requires integrating both AD and SRAS shifts. This scenario demands multi-step reasoning to assess the compounded impacts on macroeconomic stability.

Interdisciplinary Connections: AS in Financial Markets

Aggregate Supply dynamics influence and are influenced by financial markets. For instance, expectations of future economic policies or technological innovations can affect investment decisions, altering capital stock and productivity (factors of LRAS). Additionally, inflation expectations shaped by financial markets can influence wage negotiations, impacting SRAS.

Moreover, monetary policies targeting interest rates can indirectly affect AS by influencing investment and costs of borrowing for firms, thereby affecting production levels in the short run.

Policy Implications and AS Analysis

Policymakers utilize AS analysis to design strategies that promote economic stability and growth. Understanding the differences between SRAS and LRAS is essential for formulating effective fiscal and monetary policies. For instance, supply-side policies aimed at shifting LRAS—such as investing in education and infrastructure—can enhance long-term economic potential. In contrast, demand-side policies may be more appropriate for addressing short-term economic fluctuations.

Empirical Evidence and Case Studies

Empirical studies provide insights into the reliability of AS models. For example, during the COVID-19 pandemic, many economies faced negative supply shocks due to disruptions in production and supply chains, shifting SRAS leftward. Simultaneously, policy responses aimed at supporting businesses and workers sought to mitigate these supply-side impacts, highlighting the practical relevance of AS analysis in crisis management.

Criticisms and Limitations of AS Models

While AS models offer valuable frameworks, they are not without criticisms. Critics argue that the assumption of price and wage rigidity in SRAS does not hold in all economic contexts, potentially oversimplifying real-world complexities. Additionally, the vertical LRAS assumes full employment, neglecting issues like underemployment and labor market frictions. These limitations underscore the necessity of integrating AS analysis with other economic theories for comprehensive policymaking.

Comparison Table

Summary and Key Takeaways