Source: Image of AD/AS graph created by Kate Eskra, Image of SRAS created by Kate Eskra, Image of LRAS created by Kate Eskra, Image of LRAS increasing created by Kate Eskra, Image of LRAS decreasing created by Kate Eskra
Hi. Welcome to Macroeconomics. This is Kate. This tutorial is called Long Run Versus Short Run. As always, my key terms are in red, and my examples are in green.
In this tutorial, you'll see what aggregate supply, both the short-run and long-run aggregate supply curves are, and you'll see what they look like on a graph. We'll talk about the difference between the short-run and long-run aggregate supply curves. And we'll discuss how long-run aggregate supply can actually move to change our country's production capabilities over time.
So this is the aggregate supply and aggregate demand model. In this tutorial, we're going to be focusing on the aggregate supply, which I have drawn here in red. But this is how the model will eventually come together.
So the x-axis in this model does represent quantity as the graph also does in microeconomics, but here it's more broad. We're talking about the overall quantity in our economy. And that's real GDP. I'll define that for you in a side.
The y-axis doesn't just represent the price of something specifically, like shoes, but the y-axis represents the price of everything. So it's the overall price level, not just one price of a specific item.
So this the most common graph that we use in macroeconomics to show overall macroeconomic activity. So that x-axis, the real GDP, or real gross domestic product, is the sum of the final value of goods and services produced over a specific time interval and within a country's national borders. And we calculate this across time periods using a constant price level. When we use a constant price level, that's where we get this word real here. It means we're adjusting for inflation and really looking to see whether we've been more or less productive as evidenced by our gross domestic product.
The y-axis is that price level. And this is defined as an aggregate index value that provides indication of the increase in prices from one period to another. And we use this to evaluate inflation across periods.
So the thing about aggregate supply is that we have to distinguish between them because we're looking at the relationship between these two axes, the relationship between the price level and real GDP. Well in the short run, you'll see that there is a relationship between prices and GDP. You can see that in the short run as prices go up producers will want and be able to produce more to take advantage of higher prices.
But in the long run, we'll talk about why there is not a relationship between the price level and real GDP, that no matter how high prices are there's actually a fixed amount that can actually be produced in a sustainable manner. So we need to distinguish between the short and long run.
Let's start with the short run though. So short-run aggregate supply is assumed to maintain this positive price and quantity correlation. And we can see that more can be produced through increased resource utilization, technological improvements, or other factors. So for those reasons, short-run aggregate supply is an upward sloping curve. So again, this is a positive relationship then between the overall price level and the total amount that producers can produce by real GDP.
So if prices go up in the short run, businesses can try to take advantage of that and produce more. They won't have to necessarily pay their workers more immediately because as prices go up it's not as if wages immediately adjust. They can use the inventories that they already have. So those are some things can do to take advantage of higher prices in the short run and why it's possible for aggregate supply to then slope upwards.
So one analogy that I sometimes use with my students, I say you can pull an all-nighter to cram for an exam, or for me, I know I just did this over the holidays to get my house ready to entertain the next day. So that way, if you stay up all night, you can really accomplish more than you normally would be able to do in a 24-hour period. But I want you think about whether this level of activity would be sustainable for you night after night indefinitely. I know at least for me, maybe I could do this two nights in a row but by day three I would crash and burn.
So if you think about it with employers, if employers want to take advantage of higher prices in the short run, certainly they can do that. They can hire workers to work overtime. They can draw down their inventories to try to produce more right now. But at some point there is a limit to the amount of resources, their land, labor, and capital.
So that's where we get this idea of long-run aggregate supply. And long-run aggregate supply is assumed to be constant in the long run as the long-run resources are assumed to be used optimally leaving no potential for increasing capacity. And so because there is a fixed amount that we can ultimately produce given our land, labor, and capital, the long-run aggregate supply curve then will be a vertical curve and will look like this.
So this represents our economy's full potential in terms of our production given our current resources. When we have no cyclical unemployment all, meaning that we only have those very normal types of unemployment like frictional and structural-- that's the subject of a different tutorial-- but when we only have those kinds and no cyclical unemployment due to the kind that we have during a recession, that means that all of our land, labor, and capital is being fully employed. And we have a very, very low unemployment rate in the economy. When we're doing those things, we are on this long-run aggregate supply curve.
So the idea is then our production capacity is actually fixed as you can see this. Certainly as prices go up, producers would like to produce more. And we talked about how in the short run, they certainly can. But at some point, it will just come back to the long run unless something actually changes to increase our ability to produce more into the long run.
So like I've already talked about a little bit, ramping up our production in the short run really can only get us so far. We have this limited amount of resources like materials and workers. And so the idea is that what we can actually sustain here is fixed in terms of our production capacity.
So the sustainability is one of your key terms. It's the idea that consumption and production isn't stressing or exceeding a threshold required for natural regeneration of depleted resources. So an example would be in the short run, if producers were using a whole lot of our resources, like timber for example, to try to produce more in the short run, that would be fine. But if they're producing it faster than those things are being replaced, that rate of growth is unsustainable. You cannot sustain that into the long run.
So then how is it that our economy grows over time? Because we know that it does. If we're saying that this is where we can only go using all of our land, labor, and capital, how is it that we grow from year to year and from decade to decade? Well the long-run aggregate supply curve can actually move. So it is possible for the economy to grow.
The idea is that we need to find more land, labor, or capital. So we can see this with population changes, like if we have a greater amount of people in the workforce. As we discover new resources, that can certainly help. And as we advance our technology, that allows us to utilize what we have much more efficiently.
So here you can see that if any of these things would happen, it would actually shift our long-run aggregate supply curve to the right, giving us the ability to produce more then into the long run.
So real GDP growth here is now what we're talking about. This shows the measure of the percentage change in real GDP from one period to another where price levels held constant and the growth provides insight to the increase in the production of final goods and services over the interval evaluated.
Unfortunately, the long-run aggregate supply curve could also shift to the left. So that would happen if something reduces our amount of land, labor, and capital that we have. Examples of those are natural disasters or wars unfortunately. And that would be shown by movement to the left of our long-run aggregate supply curve.
So in this tutorial, we looked at aggregate supply. You saw what it looks like and what it's all about. We talked about the difference between short-run and long-run aggregate supply.
Remember the short-run aggregate supply curve does have a positive relationship between the price level and the real GDP, or the amount that producers are able to produce. But in the long run, that quantity, that real GDP is actually fixed given our current land, labor, and capital. And so the long-run aggregate supply curve is a vertical curve.
Finally we talked about, and I showed you some shifts of the long-run aggregate supply curve, how that can actually move to change our country's potential for production.
Thanks so much for listening. Have a great day.
An aggregate index value that provides an indication of the increase in prices from one period to another; used to evaluate inflation across periods.
Real Gross Domestic Product: Gross Domestic Product (the sum of the final value of goods and services produced over a specific time interval and within a country’s national borders.) calculated across time periods using a constant price level.
The measure of the percentage change in RGDP from one period to another where price level is held constant and the growth provides insight to the increase in the production of final goods and services over the interval evaluated.
Consumption and production that does not stress or exceed the threshold required for natural regeneration of depleted resources.
Long-run aggregate supply is assumed to be constant in the long-run as in the long-run resources are assumed to be used optimally, leaving no potential for increasing capacity. LRAS is a vertical curve.
Short-run aggregate supply is assumed to maintain the positive price and quantity correlation; more can be produced through increased resource utilization, technological improvements or other factors. SRAS is an upward sloping curve.