Short-run vs Long-run Aggregate Supply

Introduction

Key Concepts

Aggregate Supply

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 period. It is a fundamental component of macroeconomic models, interacting with Aggregate Demand (AD) to determine economic equilibrium. AS encompasses the production capabilities of an economy, influenced by factors such as resource availability, technology, and institutional frameworks.

Short-run Aggregate Supply (SRAS)

Short-run Aggregate Supply refers to the relationship between the price level and the quantity of goods and services that firms are willing to produce, holding certain input prices constant. In the short run, some production costs, particularly wages and raw material prices, are sticky or fixed due to contracts and adjustment delays. As a result, an increase in the price level can lead to higher profits, encouraging firms to increase output, thereby making SRAS upward sloping.

The SRAS curve is influenced by factors such as:

• Resource Prices: Changes in wages or raw material costs can shift the SRAS curve. An increase in resource prices shifts SRAS leftward, indicating a decrease in aggregate supply.
• Productivity: Higher productivity improves production efficiency, shifting SRAS rightward.
• Supply Shocks: Events like natural disasters or technological breakthroughs can abruptly alter SRAS. Negative shocks decrease aggregate supply, while positive shocks enhance it.

Long-run Aggregate Supply (LRAS)

Long-run Aggregate Supply represents the total output an economy can sustainably produce when all input prices, including wages, are flexible and have fully adjusted to changes in the economy. Unlike SRAS, LRAS is typically vertical, reflecting the economy's maximum sustainable output, also known as potential GDP. This position illustrates that, in the long run, aggregate supply is determined by factors such as resources, technology, and institutional structures, rather than the price level.

Key determinants of LRAS include:

• Capital Stock: Investments in physical capital increase an economy's productive capacity, shifting LRAS rightward.
• Labor Force: Growth in the labor force, through population growth or increased labor force participation, enhances LRAS.
• Technological Advancements: Innovations and improvements in technology boost productivity, facilitating a rightward shift in LRAS.
• Natural Resources: Availability and efficient utilization of natural resources contribute to the economy’s long-term supply capacity.

Determinants of Short-run and Long-run Aggregate Supply

While both SRAS and LRAS influence the overall supply within an economy, their determinants differ significantly. In the short run, AS is primarily affected by nominal rigidities and temporary factors, such as:

• Wage Contracts: Pre-established wage agreements can prevent immediate adjustments to labor costs, affecting SRAS.
• Price Expectations: If firms anticipate future price changes, they may adjust production levels accordingly in the short run.

Conversely, in the long run, aggregate supply is dictated by real factors that determine the economy's capacity to produce, including:

• Human Capital: Education and training enhance worker productivity, influencing LRAS.
• Infrastructure: Development of infrastructure facilitates efficient production and distribution processes.
• Institutional Framework: Stable political and economic institutions provide an environment conducive to long-term growth.

Equilibrium in the Short-run and Long-run

Economic equilibrium occurs where Aggregate Demand intersects with Aggregate Supply. In the short run, the intersection with SRAS determines the equilibrium price level and output. However, this equilibrium may not correspond to the economy’s potential output, leading to situations like inflationary gaps or recessions.

In the long run, prices and wages fully adjust, ensuring that Aggregate Demand intersects with LRAS. This long-term equilibrium aligns actual output with potential output, promoting sustainable economic growth and stability. The adjustment process from short-run to long-run equilibrium often involves shifts in SRAS due to changes in price expectations and input costs.

Factors Affecting Short-run and Long-run Aggregate Supply

Various factors influence both short-run and long-run aggregate supply, though their impacts differ based on the time frame:

• Input Prices: Sudden increases in input prices (e.g., oil shocks) can reduce SRAS, leading to higher price levels and lower output in the short run. In the long run, the economy adjusts, and LRAS remains unaffected if the shock is temporary.
• Productivity Growth: Improvements in productivity shift SRAS to the right in the short run and LRAS in the long run, enhancing overall economic capacity.
• Government Policies: Fiscal and monetary policies can influence short-run aggregate supply by affecting production costs. However, long-term policies targeting education, infrastructure, and technology primarily impact LRAS.
• Technological Innovations: Technological advancements can immediately boost SRAS by making production more efficient and permanently increase LRAS by expanding the economy's productive capacity.

Understanding these factors is essential for policymakers aiming to stabilize the economy and foster sustainable growth. For instance, addressing supply-side constraints can mitigate inflationary pressures and enhance long-term productivity.

Comparison Table

Summary and Key Takeaways