Short Run Vs Long Run Aggregate Supply

The aggregate supply (AS) curve is a cornerstone of macroeconomic analysis, representing the total quantity of goods and services that firms are willing to produce at various price levels. It is typically divided into two distinct time horizons: the short run and the long run. Understanding the differences between the short-run aggregate supply (SRAS) and the long-run aggregate supply (LRAS) is crucial for comprehending how the economy responds to various shocks and policy interventions.

Short-Run Aggregate Supply (SRAS)

The SRAS curve illustrates the relationship between the aggregate price level and the quantity of output supplied in an economy during a period when some input costs, such as wages and raw materials, remain fixed. This stickiness of input costs is a key characteristic of the short run.

Characteristics of SRAS

• Upward Sloping: The SRAS curve is upward sloping, indicating a positive relationship between the price level and output. As the price level rises, firms can increase their profits without immediately facing higher input costs. This incentivizes them to expand production.
• Fixed Input Costs: The primary assumption behind the SRAS curve is that some input costs are fixed or slow to adjust. These sticky input costs can include:
  • Wage Contracts: Labor contracts often stipulate wages for a specific period, preventing immediate adjustment to changes in the price level.
  • Raw Material Contracts: Similar to wage contracts, agreements for the purchase of raw materials might fix prices for a certain duration.
  • Menu Costs: Menu costs refer to the expenses firms incur when changing prices. These costs might deter firms from immediately adjusting prices in response to small changes in the overall price level.
• Temporary Disequilibrium: The SRAS curve represents a temporary disequilibrium situation. In the short run, the economy can operate above or below its potential output due to these rigidities.

Factors Shifting the SRAS Curve

The SRAS curve can shift due to changes in factors other than the price level. These factors are primarily related to changes in production costs:

• Changes in Input Prices:
  • Increase in Input Prices: An increase in input prices (e.g., oil prices, wages) shifts the SRAS curve to the left. Higher costs reduce firms' profitability at each price level, leading to a decrease in the quantity of output supplied.
  • Decrease in Input Prices: A decrease in input prices shifts the SRAS curve to the right. Lower costs increase firms' profitability, encouraging them to produce more at each price level.
• Changes in Productivity:
  • Increase in Productivity: An increase in productivity (e.g., technological advancements) shifts the SRAS curve to the right. Higher productivity allows firms to produce more output with the same amount of inputs, increasing supply at each price level.
  • Decrease in Productivity: A decrease in productivity (e.g., natural disasters) shifts the SRAS curve to the left. Lower productivity reduces the amount of output firms can produce with the same inputs, decreasing supply at each price level.
• Changes in Government Regulations and Taxes:
  • Increased Regulations or Taxes: More stringent regulations or higher taxes increase the cost of production, shifting the SRAS curve to the left.
  • Reduced Regulations or Taxes: Reduced regulations or lower taxes decrease the cost of production, shifting the SRAS curve to the right.
• Supply Shocks:
  • Adverse Supply Shock: An adverse supply shock (e.g., a sudden increase in oil prices or a natural disaster) shifts the SRAS curve to the left, as it disrupts production and increases costs.
  • Favorable Supply Shock: A favorable supply shock (e.g., the discovery of new resources) shifts the SRAS curve to the right, as it lowers production costs and increases supply.

Implications of SRAS

The SRAS curve helps to analyze short-term economic fluctuations and the impact of various policies. For example:

• Expansionary Monetary Policy: An expansionary monetary policy (e.g., lowering interest rates) increases aggregate demand (AD). The economy moves along the SRAS curve to a higher price level and a higher level of output. This can stimulate economic growth in the short run but also leads to inflation.
• Contractionary Fiscal Policy: A contractionary fiscal policy (e.g., increasing taxes or decreasing government spending) decreases aggregate demand. The economy moves along the SRAS curve to a lower price level and a lower level of output. This can help to control inflation but may lead to a recession.
• Supply-Side Policies: Policies aimed at shifting the SRAS curve to the right, such as deregulation or investment in infrastructure, can lead to increased output and lower prices.

Long-Run Aggregate Supply (LRAS)

The LRAS curve represents the relationship between the aggregate price level and the quantity of output supplied in an economy when all factors of production have fully adjusted to price changes. Unlike the SRAS, the LRAS is not affected by the price level and is determined by the economy's potential output.

Characteristics of LRAS

• Vertical: The LRAS curve is vertical at the economy's potential output level. This implies that in the long run, the quantity of output supplied is independent of the price level. Regardless of the price level, the economy will produce at its full capacity.
• Potential Output: The LRAS curve is located at the level of potential output, which is the level of output an economy can produce when all its resources are fully employed. This is also referred to as the full-employment level of output.
• Flexible Input Costs: In the long run, all input costs, including wages and raw material prices, are assumed to be fully flexible. This means that they can adjust to changes in the price level. If the price level rises, input costs will also rise proportionally, leaving firms' profitability unchanged. As a result, firms have no incentive to change their level of output in response to price level changes.
• Equilibrium: The LRAS curve represents the long-run equilibrium of the economy. In the long run, the economy will tend to gravitate towards this level of output, regardless of short-term fluctuations.

Factors Shifting the LRAS Curve

The LRAS curve shifts due to changes in factors that affect the economy's potential output. These factors include:

• Changes in the Quantity of Labor:
  • Increase in Labor Force: An increase in the labor force (e.g., due to immigration or increased labor force participation) shifts the LRAS curve to the right. With more workers available, the economy can produce more at full employment.
  • Decrease in Labor Force: A decrease in the labor force (e.g., due to emigration or an aging population) shifts the LRAS curve to the left. With fewer workers available, the economy's potential output decreases.
• Changes in the Quantity of Capital:
  • Increase in Capital Stock: An increase in the capital stock (e.g., investment in new machinery and equipment) shifts the LRAS curve to the right. More capital allows workers to produce more output.
  • Decrease in Capital Stock: A decrease in the capital stock (e.g., due to depreciation or lack of investment) shifts the LRAS curve to the left.
• Changes in Technology:
  • Technological Advancements: Technological advancements (e.g., new inventions or improved production processes) shift the LRAS curve to the right. Technology allows more output to be produced with the same amount of inputs.
  • Technological Regression: Technological regression (e.g., due to loss of knowledge or infrastructure damage) shifts the LRAS curve to the left.
• Changes in Natural Resources:
  • Increase in Natural Resources: The discovery of new natural resources (e.g., oil, minerals) shifts the LRAS curve to the right. More available resources allow for more production.
  • Decrease in Natural Resources: The depletion of natural resources or restrictions on their availability shift the LRAS curve to the left.
• Changes in Human Capital:
  • Increase in Human Capital: Improvements in education, skills, and health of the workforce (i.e., increases in human capital) shift the LRAS curve to the right. A more skilled workforce can produce more output.
  • Decrease in Human Capital: Deterioration in education, skills, or health of the workforce shifts the LRAS curve to the left.

Implications of LRAS

The LRAS curve is crucial for understanding long-term economic growth and the determinants of potential output.

• Economic Growth: Long-term economic growth is represented by a rightward shift of the LRAS curve. Policies that promote investment in capital, education, technology, and efficient resource allocation are essential for achieving sustained economic growth.
• Inflation: In the long run, persistent inflation is primarily a monetary phenomenon. If the money supply grows faster than the economy's potential output, the price level will rise. The LRAS curve helps to illustrate that increasing aggregate demand without a corresponding increase in aggregate supply leads to inflation.
• Supply-Side Economics: Supply-side economics focuses on policies that shift the LRAS curve to the right. These policies aim to increase the economy's productive capacity and include measures such as tax cuts, deregulation, and investments in infrastructure and education.

SRAS vs. LRAS: Key Differences

Adjustment Process: From Short Run to Long Run

The economy's adjustment from the short run to the long run involves the gradual adjustment of input costs to changes in the price level.

• Initial Shock: Suppose there is an increase in aggregate demand (AD) due to expansionary monetary policy. In the short run, the economy moves along the SRAS curve to a higher price level and a higher level of output. This creates a temporary boom.
• Adjustment of Input Costs: As time passes, input costs begin to adjust to the higher price level. Workers demand higher wages to compensate for the increased cost of living. Suppliers of raw materials also increase their prices.
• Shift of SRAS: The increase in input costs shifts the SRAS curve to the left. The economy moves to a new equilibrium with a higher price level but a lower level of output than the initial short-run equilibrium.
• Long-Run Equilibrium: Eventually, the SRAS curve shifts far enough to the left that the economy returns to its potential output level. At this point, the economy is in long-run equilibrium. The price level is higher than the initial level, but the output is back at its full-employment level.

This adjustment process illustrates that in the long run, changes in aggregate demand primarily affect the price level, while output remains at its potential level. Policies that aim to stimulate demand can lead to temporary increases in output but will ultimately result in inflation if not accompanied by increases in aggregate supply.

Examples and Applications

• The Oil Crisis of the 1970s: The oil crisis of the 1970s provides a real-world example of a negative supply shock. The sudden increase in oil prices shifted the SRAS curve to the left, leading to both higher inflation and lower output (stagflation).
• Technological Boom of the 1990s: The technological boom of the 1990s, driven by the rise of the internet, led to increased productivity. This shifted both the SRAS and LRAS curves to the right, resulting in higher economic growth and lower inflation.
• The Great Recession of 2008-2009: The Great Recession was triggered by a financial crisis that led to a decrease in aggregate demand. In the short run, the economy experienced a sharp decline in output and employment. Over time, policymakers implemented both monetary and fiscal policies to stimulate demand and shift the AD curve back to the right.

Conclusion

The short-run aggregate supply (SRAS) and long-run aggregate supply (LRAS) curves are essential tools for understanding how the economy responds to various shocks and policy interventions. The SRAS curve captures the short-term relationship between the price level and output, while the LRAS curve represents the economy's potential output in the long run. Understanding the factors that shift these curves and the adjustment process from the short run to the long run is crucial for effective macroeconomic policymaking. Policymakers must consider both the short-term and long-term effects of their actions to promote stable economic growth and avoid inflationary pressures. While demand-side policies can provide temporary relief, supply-side policies that enhance the economy's productive capacity are essential for sustained prosperity.