MODULE 18 LONG-RUN AGGREGATE SUPPLY By J.A.Sacco Aggregate Supply • Knowing the position and shape of AD does not tell us anything about how the total dollar value of spending will be divided between output (real goods/services) and prices. • To determine this and thus the equilibrium level of real GDP must also look at aggregate supply. • Aggregate Supply- shows the relationship between planned rates of total production for the entire economy at various prices Two Types of Aggregate Supply Curves LRAS- Long Run SRAS- Short Run An Old Friend Revisited • What does the PPC have in common with the LRAS? The PPC and the Long-Run Aggregate Supply Curve LRAS 1 Price Level Capital Goods Over time, the production possibilities curve shifts outward. Consumption Goods LRAS 2 This same principle can be shown by shifting the LRAS curve to the right. 0 1 2 3 4 5 6 7 8 Real GDP per Year ($ trillions) 9 10 The Long Run Aggregate Supply Curve • A vertical line representing real output of goods and services based on full information and after full adjustments has occurred • Represents the real output of the economy under conditions of full employment • Shows the potential level of output when resources are fully employed LRAS is vertical because all resources fully employed, output can not be increased at present time Nothing changes ! What doesn’t change that makes the LRAS vertical? Why the LRAS is Vertical Key is Inputs do not change!!! • Technology does not Change- No change in technology, no change in output. Why the LRAS is Vertical • Endowments of Resources Fixed- Amount/Quality of resources does not change. If these resources were being fully used then output will be maximum in the long run. Why the LRAS is Vertical • Labor Productivity- No change in productivity means no change in output Why the LRAS is Vertical • Population is Constant- No growth in population means no increase in the labor force/ no change in output. Why the LRAS is Vertical • Full Adjustment to Price Level Changes- The price level has no effect on real GDP. If the price level for GDP rises, there will be comparable rise in input prices. Therefore suppliers have no incentive to increase output. Cost of Inputs = Money received from Output There is no profit . No incentive to produce anymore. Input prices and output receipts all part of the same price level. An implication of all of this is that aggregate demand has no effect on LRAS and output. LRAS- Review • Therefore the LRAS illustrates full information and full adjustment level of real output (inflation adjusted) of goods/services. • The LRAS is the level of real output that will continue being produced year after year, forever, if nothing changes. • Full employment level of real GDP. When economy reaches full employment, no further adjustments will occur unless a fundamental change occurs Shifts in the LRAS • The LRAS shifts outward when one of the non-price level determinants change in the following way 1. Population increase 2. Resources increase 3. Technology improves Permanent Changes! Aggregate Demand and Long-Run Aggregate Supply • Because the LRAS is vertical, AD in the long run has no bearing on the level of output of real goods and services • If there is a shift of AD in the long run, the only thing that level (inflation). ? changes is the price ___________ Shift of AD in long run only leads to inflation!!! Aggregate Demand and Long-Run Aggregate Supply GDP Deflator LRAS Changes in AD have no impact on LRAS--only on the price level 120 90 AD2 AD1 0 1 2 3 4 5 Real GDP per Year ($ trillions) 6 7 Aggregate Demand and Long-Run Aggregate Supply • In the long run, output of real goods/services is supply-side determined. Only shifts in LRAS will change long run levels of output not a shift of AD.