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Long run aggregate supply

In micro-economics, the long run refers to a situation when producers can increase the output of their goods and services without any short-run constraints in terms of fixed factors. In the long run all factors of production can be increased, including capital assets.

In terms of macro-economic analysis, the aggregate supply in the long run refers to how much real output - in terms of its monetary value - can be produced using all of the economy's scarce resources - labour, enterprise, capital, land and other natural resources.

In measuring aggregate supply in the long run it is assumed that the quantity and quality of output is not determined by the price level, but by other determinants including the quantity of factors, how efficiently they are used, the use of new technology and other factors that 'add value'.

The incentive to supply is driven by the pursuit of profits, and changes in the general price level are assumed to have no impact on profits in the long run.

The long run aggregate supply curve

The long run aggregate supply curve (or LRAS curve) is assumed to be a vertical curve at the economy’s current capacity (at YF).

The position of the LRAS curve is not determined by the price level, but by factors that affect the capacity of firms in the economy.

Determinants of LRAS

Application of technology

New technology increases the efficiency with which scarce resources are used and the productivity of the factors of production.

Economic incentives

The supply-side of an economy tends to work best when there are strong incentives to encourage existing factor owners to supply more, or improve their ability to supply. The ability to derive profits is a key incentive to the entrepreneur. Profits are also an incentive to encourage new entrepreneurs to develop new products. Lower business taxes can also act an incentive as firm's can retain more of their revenue.

Wage incentives are also significant, especially when they are connected to productivity improvements. However, linking wage increases to productivity may be resisted by trade unions who see such wage bargaining as simply a way to suppress wages.

Productivity

The productivity of labour [output per hour worked] is a very significant variable when considering a country's capacity to produce.

Productivity affects both the short and long run aggregate supply of a country. In the short run productivity improvements can reduce production costs and in the long run improvements in productivity increase capacity from existing factor inputs.

Mobility of factors and flexibility of labour

Labour mobility - both in terms of geographical and occupational mobility - has a significant bearing on an economy's productive capacity. If labour is occupationally mobile, there will be a better match between the skills supplied by labour and the skilled required by firms. Similarly, geographical mobility means that labour is used more effectively, with less likelihood of being unemployed or underemployed.

Flexibility of labour includes mobility, but also refers to whether workers are flexible in terms of the hours they work, and the skills they have. If workers are inflexible, it may mean that they do not participate in the labour market at all, and remain unemployed. The rise of part-time and flexi-work has meant more participation in the labour market, and hence there is more potential output from any given quantity of labour.

Supply of capital

The supply of capital provides the resources by which firms can expand. An effective capital market is very important for productive potential to be maintained and increased. This means an efficient stock exchange so that holder of shares can regain their liquidity by selling their shares, and are more likely to purchase shares in the first place, thereby encouraging a flow of funds into the capital market.

Effectiveness of the banking sector

Similarly, it is essential to have an effectively functioning banking sector, with both commercial and investment banks willing to lend to firms so that they can expand or simply to ensure liquidity in the system.

The transport and communications infrastructure

The total amount that an economy can produce in the long run is dependent on the ability to mobilise resources and distribute them to where they are needed. While infrastructure improvements take time to plan and build, there is little doubt that they have a considerable impact on supply.

Similarly, production and commerce requires an effective communications infrastructure. A country's ability to develop depends on an effective transport and communications network.

The LRAS curve

In the long run, and assuming normal levels of inflation – somewhere between 2 and 5% - the price level has little bearing on output.

However, the quantity and quality of factors, including 'human capital', the use of technology, and the productivity of factors, do have an influence on the capacity of the economy, and therefore on the position of the LRAS curve.

Although vertical, the LRAS can shift if productive potential changes, such as when education and training, or new technology, improves labour productivity.

Long run aggregate supply

It is assumed that the LRAS curve is influenced more by supply-side policy than fiscal or monetary policy.


Video on long run aggregate supply

Does money and monetary policy affect long run supply?

It has been a fairly long held belief that 'money is neutral' in its effect - the argument goes that changes in the money supply affect the price level, and because changes in the price level do not affect long run supply, then money and monetary policy have little bearing on the long run aggregate supply curve.

However, this position can be challenged - changes in monetary conditions can influence investment decisions, which can then increase an economy's capacity to produce. Research by Òscar et al 1 also indicates that monetary shocks can have long lasting effects on real national output.

Long run aggregate supply


Aggregate demand

Aggregate demand and the AD curve.

Aggregate demand
Fiscal policy

How can fiscal policy influence aggregate demand?

Fiscal policy
Monetary policy

How effective is supply-side policy?

Supply-side policy

1. Jordà, Òscar, Sanjay R. Singh, Alan M. Taylor. 2020. “The long-run effects of monetary policy,” Federal Reserve Bank of San Francisco Working Paper 2020-01; Viewed March 3 2021 https://doi.org/10.24148/wp2020-01