Why Is Long Run Aggregate Supply Vertical

In the realm of macroeconomics, understanding the long-run aggregate supply (LRAS) curve is crucial for grasping the potential output of an economy and the factors influencing long-term economic growth. A key characteristic of the LRAS curve is that it is vertical, a representation that often sparks questions and requires a thorough explanation. This article delves into the reasons behind the verticality of the LRAS curve, exploring the underlying economic principles and assumptions.

Defining Aggregate Supply

Before diving into the long run, let's clarify what aggregate supply (AS) represents. Aggregate supply is the total quantity of goods and services that firms are willing to produce and sell at a given price level in an economy. It's a critical component of the aggregate demand-aggregate supply (AD-AS) model, which economists use to analyze macroeconomic conditions.

The Short-Run Aggregate Supply (SRAS)

In the short run, the aggregate supply curve (SRAS) is upward sloping. This slope implies that as the overall price level in the economy rises, firms are incentivized to increase their output. Several factors contribute to this relationship:

• Sticky Wages and Prices: Many wages and prices are "sticky" in the short run, meaning they don't adjust immediately to changes in economic conditions. For instance, labor contracts may fix wages for a certain period, preventing them from falling instantly when demand decreases. Similarly, businesses might hesitate to change prices rapidly due to menu costs (the costs associated with changing prices) or fear of losing customers.
• Misperceptions Theory: This theory posits that suppliers may misinterpret changes in the overall price level as changes in the relative price of their specific product. If a firm sees its product's price rise, it might assume demand for its product has increased, leading it to increase production.

Transitioning to the Long Run

The long run in macroeconomics is a time horizon long enough for all prices and wages to adjust fully to changes in the economy. It's a period where all resources can be adjusted, contracts can be renegotiated, and firms have time to adapt to economic conditions. This flexibility is what distinguishes the LRAS from the SRAS.

Why is the Long-Run Aggregate Supply (LRAS) Vertical?

The LRAS curve is vertical because, in the long run, the aggregate supply of goods and services is determined solely by the economy's potential output, which is independent of the price level. Several key factors and assumptions underpin this assertion:

• Full Adjustment of Wages and Prices: In the long run, wages and prices are fully flexible. This means that they can adjust to any changes in the economy. If the price level rises, wages will also rise to compensate workers for the increased cost of living. Similarly, the prices of other inputs will adjust. As a result, firms' real costs of production (costs adjusted for inflation) remain unchanged, and they have no incentive to change their output.
• Potential Output: The LRAS curve represents the potential output of the economy, which is the level of output an economy can produce when all its resources (labor, capital, natural resources, and technology) are fully employed. Potential output is determined by the supply-side factors of the economy, not the overall price level.
• Classical Dichotomy and Neutrality of Money: The classical dichotomy is the idea that real and nominal variables are determined separately in the long run. Nominal variables, such as the price level and the money supply, affect only nominal aspects of the economy (like prices) and have no impact on real variables (like output and employment). This concept is closely related to the neutrality of money, which states that changes in the money supply affect only nominal variables and have no long-run effect on real variables.
• No Money Illusion: In the long run, people are assumed to be free from money illusion, the tendency to think of money in nominal rather than real terms. In other words, people understand the difference between a change in their nominal income (e.g., their salary) and their real income (their purchasing power). As such, a general increase in the price level will not fool people into thinking they are wealthier, so it will not affect their behavior or the economy's output.

Factors that Shift the LRAS Curve

Since the LRAS curve represents potential output, shifts in the curve are caused by changes in the factors that determine potential output:

• Changes in the Labor Force: An increase in the size or quality of the labor force (e.g., through immigration or education) will increase potential output and shift the LRAS curve to the right.
• Changes in Capital Stock: An increase in the amount of physical capital (e.g., factories, machines) or human capital (e.g., skills and knowledge of the workforce) will increase potential output.
• Changes in Natural Resources: The discovery of new natural resources or improvements in the ability to extract and use them will increase potential output.
• Technological Advancements: Technological progress allows the economy to produce more output with the same amount of resources, leading to an increase in potential output.

Implications of a Vertical LRAS Curve

The verticality of the LRAS curve has several important implications for macroeconomic policy and analysis:

• Monetary Policy and Inflation: In the long run, changes in the money supply primarily affect the price level. If the money supply grows faster than the economy's potential output, inflation will occur. Monetary policy is therefore effective in controlling inflation in the long run but cannot permanently increase output.
• Fiscal Policy and Economic Growth: Fiscal policy (government spending and taxation) can affect the composition of output (e.g., more government spending and less private investment) but has no long-run effect on the overall level of output. Instead, long-run economic growth is driven by supply-side factors that shift the LRAS curve to the right.
• Supply-Side Economics: Policies aimed at increasing potential output, such as tax cuts to incentivize investment, deregulation to reduce business costs, and education reforms to improve the quality of the labor force, are seen as crucial for long-run economic growth.

Graphical Representation

To visualize the LRAS curve, consider a graph with the price level on the vertical axis and real GDP (output) on the horizontal axis. The LRAS curve is a vertical line at the level of potential output (Y*).

• An increase in aggregate demand (AD) will shift the AD curve to the right. In the short run, this will lead to an increase in both the price level and output. However, in the long run, as wages and prices adjust, the economy will return to potential output, but at a higher price level.
• A shift in the LRAS curve to the right, caused by an increase in potential output, will lead to an increase in long-run economic growth. This allows the economy to produce more goods and services at any given price level.

Real-World Examples

While the LRAS curve is a theoretical concept, it has real-world implications. Consider the following examples:

• Technological Boom: The dot-com boom of the late 1990s and early 2000s was driven by rapid technological advancements, particularly in the field of the internet. This led to an increase in potential output, shifting the LRAS curve to the right and allowing for sustained economic growth.
• Oil Price Shocks: A sudden increase in oil prices can negatively affect potential output, particularly in economies heavily reliant on oil. This can shift the SRAS curve to the left, leading to stagflation (a combination of high inflation and low economic growth). However, the LRAS curve is not directly affected unless the oil price shock leads to a permanent reduction in the economy's productive capacity.
• Education and Human Capital: Investments in education and human capital development can lead to a more skilled and productive workforce, increasing potential output and shifting the LRAS curve to the right.

Criticisms and Alternative Views

While the vertical LRAS curve is a cornerstone of classical and neoclassical economics, it has faced criticisms and alternative views:

• Keynesian Economics: Keynesian economists argue that the long run may not be as flexible as assumed by classical economists. They believe that wages and prices can be sticky even in the long run, particularly in the face of deep recessions. This implies that the LRAS curve may not be perfectly vertical and that aggregate demand can have a lasting impact on output.
• Hysteresis: The concept of hysteresis suggests that short-run economic events can have long-lasting effects on potential output. For example, a prolonged recession can lead to a decline in investment, a loss of skills among the unemployed, and a permanent reduction in the economy's productive capacity. This challenges the idea that the economy always returns to its original potential output in the long run.
• New Keynesian Economics: New Keynesian economists incorporate elements of both classical and Keynesian economics. They acknowledge that wages and prices are sticky in the short run but also recognize that they eventually adjust in the long run. They propose that the LRAS curve may be upward sloping rather than perfectly vertical, reflecting the possibility that aggregate demand can have some long-run effects on output.

Conclusion

The vertical long-run aggregate supply (LRAS) curve is a fundamental concept in macroeconomics, reflecting the idea that, in the long run, an economy's output is determined by its productive capacity and is independent of the price level. This verticality is based on the full adjustment of wages and prices, the neutrality of money, and the absence of money illusion. Understanding the LRAS curve is crucial for analyzing long-run economic growth, the effects of monetary and fiscal policy, and the role of supply-side factors in shaping an economy's potential. While the vertical LRAS curve is a simplification of complex economic realities and has faced criticisms, it remains a valuable tool for macroeconomic analysis and policymaking. By recognizing the factors that shift the LRAS curve, policymakers can implement strategies to foster long-run economic growth and improve living standards.