From the short run to the long run

Overview

Long-run aggregate supply curve related to the production possibility frontier.

What you need to know

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Questions from this subtopic

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1. 1

   Describe the long-run aggregate supply curve in the neoclassical view and explain what determines its position.

   Model answer

   It is drawn as a vertical line on a diagram with the general price level on the vertical axis and real national output on the horizontal axis, positioned at the economy's potential output. Its position is determined entirely by supply-side factors: the quantity and quality of labour, capital, land and enterprise, and the state of technology. Because it is vertical, the general price level has no influence on output in the long run.

2. 2

   Explain the process by which an economy producing above its potential output returns to the long-run aggregate supply curve.

   Model answer

   Producing above potential means labour and other resources are stretched beyond their sustainable use, so shortages appear and workers bargain for higher pay while suppliers raise prices. As money wages and input prices rise, firms' costs increase, so the short-run aggregate supply curve shifts upwards and to the left. With the general price level on the vertical axis and real national output on the horizontal axis, the equilibrium moves up and to the left along the aggregate demand curve until output has fallen back to the level of the long-run aggregate supply curve, at a permanently higher price level.

3. 3

   Explain the process by which an economy producing below its potential output is supposed to return to the long-run aggregate supply curve.

   Model answer

   With output below potential there is unemployed labour and idle capacity, so competition for jobs restrains pay demands and firms find inputs cheaper. Falling money wages and input prices reduce costs, so the short-run aggregate supply curve shifts downwards and to the right. The equilibrium slides down the aggregate demand curve until real national output has risen back to the long-run aggregate supply level, at a lower general price level. Whether this happens quickly, or at all, is one of the central disagreements in macroeconomics.

4. 4

   Analyse how the speed of wage adjustment affects the relationship between short-run and long-run aggregate supply.

   Model answer

   The gap between the short run and the long run exists only because money wages have not yet adjusted to the general price level. Where pay is settled frequently, contracts are short and pay is linked to inflation, wages catch up quickly, the short-run aggregate supply curve shifts back rapidly and the economy returns to its long-run position after only a brief change in output. Where pay is set by long agreements and is difficult to cut, adjustment is slow and output can stay away from potential for years. The speed of wage adjustment therefore determines how long a demand stimulus raises real output before it is fully absorbed by prices.

5. 5

   Analyse the role of inflation expectations in the relationship between short-run and long-run aggregate supply.

   Model answer

   Workers bargain over real pay, so their wage claims embody what they expect prices to do. If they expect inflation to be high, they demand large money wage increases now, costs rise immediately and the short-run aggregate supply curve shifts left quickly, so a demand expansion raises the price level with little gain in real output. If expectations are firmly anchored by a credible inflation target, wage claims stay moderate, the short-run curve shifts back only slowly and output can remain above potential for longer. Expectations therefore determine how fast the short run turns into the long run.

6. 6

   Why does the downward rigidity of money wages make the return to long-run equilibrium asymmetric?

   Model answer

   Money wages rise readily when labour is scarce but are very hard to cut, because workers resist nominal pay cuts, contracts and minimum wage rules prevent them, and firms fear losing their best staff. An economy above potential therefore corrects itself quickly as wages are bid up and the short-run aggregate supply curve shifts left. An economy below potential corrects only slowly, if at all, because the fall in wages needed to shift the curve right does not readily occur, so output can remain depressed and unemployment persist. Adjustment upwards is fast and adjustment downwards is slow.

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