Core Concepts & Learning Goals
This chapter introduces the crucial distinction between the short run and the long run in macroeconomics. The central concept is the Long-Run Aggregate Supply (LRAS) curve, which represents an economy's potential output when all prices and wages are fully flexible. Understanding the LRAS is fundamental to analyzing how an economy behaves over time and returns to its full-employment capacity after economic shocks.
After completing this section, you will be able to define the short run and the long run and use a graph to explain the shape and position of the long-run aggregate supply curve.
Key Concepts Breakdown
1. The Short Run vs. The Long Run
In macroeconomics, the distinction between the short run and the long run is not about a specific length of time (e.g., six months or five years). Instead, it is defined by the flexibility of wages and other input prices.
Short Run: A period in which some input prices, particularly nominal wages, are "sticky" or fixed. This stickiness is often due to labor contracts or social norms that prevent wages from adjusting immediately to changes in economic conditions.
Long Run: A period in which all prices and wages are fully flexible. In the long run, enough time has passed for all contracts to be renegotiated and for input prices to adjust completely to changes in the overall price level.
A key consequence of this distinction relates to the relationship between inflation and unemployment. Because wages are flexible in the long run, there is no long-run trade-off between inflation and unemployment. The economy will naturally return to its full-employment level of output regardless of the rate of inflation.
The table below summarizes the key differences between these two time horizons.
| Feature | Short Run | Long Run |
|---|---|---|
| Input Prices (Wages) | Fixed or "sticky" | Fully flexible |
| Effect of Price Level | A change in the price level can change real output | A change in the price level does not change real output |
| Economy's Output | Can be above, below, or at potential output | Returns to potential (full-employment) output |
2. The Long-Run Aggregate Supply (LRAS) Curve
The Long-Run Aggregate Supply (LRAS) curve illustrates the relationship between the aggregate price level and the quantity of aggregate output supplied in the long run.
The defining characteristic of the LRAS curve is that it is vertical. This shape reflects the core idea of the long run: that an economy's total output is determined by its resources (labor, capital, technology), not by the overall price level.
The reason for its vertical shape is the full flexibility of wages and prices. Consider what happens if the overall price level in the economy doubles. In the long run, nominal wages and all other input prices will also double.
A firm's revenue from selling its products will double.
A firm's costs (like wages) will also double.
Because both revenues and costs have changed proportionally, the firm's real profit incentive has not changed.
Therefore, the firm has no reason to change its level of production. This logic applies to the entire economy, meaning that real output remains independent of the price level in the long run.
3. LRAS and Maximum Sustainable Capacity
The vertical LRAS curve is positioned at the economy's full-employment level of output, often denoted as (Y_F) or potential output.
- Full-Employment Output ((Y_F)): The level of real GDP produced when all of an economy's resources (labor, capital, etc.) are utilized at their natural, sustainable rates. It is the maximum sustainable capacity of the economy.
This concept directly links the LRAS curve to another model: the Production Possibilities Curve (PPC).
The PPC illustrates the different combinations of two goods an economy can produce with its available resources and technology. A point on the PPC represents the maximum efficient production.
The LRAS curve represents this same concept of maximum sustainable capacity, but in the context of the aggregate economy. The level of output at which the LRAS curve stands ((Y_F)) corresponds to the economy operating on its PPC.
Graphical Analysis (Text-Only)
The LRAS curve is a key component of the Aggregate Demand-Aggregate Supply (AD-AS) model.
Axes Declaration
Vertical axis: Aggregate Price Level (PL)
Horizontal axis: Real GDP (Y)
Curve Specification
Name: Long-Run Aggregate Supply (LRAS)
Shape: A perfectly vertical line.
Position: The LRAS curve is positioned on the horizontal axis at the full-employment level of real GDP ((Y_F)).
Interpretation of the Graph
Equilibrium: A long-run equilibrium occurs where the aggregate demand (AD) curve intersects the LRAS curve. At this point, the economy is at full employment.
Price Level Independence: Because the curve is vertical, a change in the aggregate price level (a movement up or down the vertical axis) does not lead to a change in the long-run quantity of real GDP supplied. For example, if the price level increases from (PL_1) to (PL_2), the economy's output in the long run remains at (Y_F).
Step-by-Step Example
This example shows how an economy returns to its long-run potential output after a demand shock, illustrating the role of the vertical LRAS.
Scenario: The economy is initially in long-run equilibrium. A stock market boom causes a massive increase in household wealth, leading to a sharp rise in consumer spending and shifting the Aggregate Demand (AD) curve to the right.
Step 1: The Short-Run Effect
The AD curve shifts to the right. In the short run, nominal wages are sticky.
Firms receive higher prices for their goods, but their labor costs remain fixed. This increases their profitability.
In response, firms increase production. The economy moves to a new short-run equilibrium where real GDP is greater than full-employment output ((Y > Y_F)) and the price level is higher. This is an inflationary gap.
Step 2: The Long-Run Adjustment Process
The economy is now "overheating." Output is above its sustainable level, and unemployment is very low. The high price level means workers' real wages have fallen.
There is now upward pressure on nominal wages. As labor contracts expire, workers negotiate for higher wages to compensate for the increased cost of living.
As nominal wages rise across the economy, firms' costs of production increase.
Step 3: Return to Long-Run Equilibrium
The rising production costs cause the short-run aggregate supply (SRAS) curve to shift to the left.
This leftward shift continues as long as output is above its potential. The SRAS curve will stop shifting once it intersects the new, higher AD curve at the LRAS curve.
The final result is a new long-run equilibrium. The economy is back at its full-employment output level ((Y_F)), but at a permanently higher price level. This process demonstrates that while demand shocks can push output away from its potential in the short run, the economy self-corrects back to the LRAS in the long run.
AP Exam Tips & Common Pitfalls
[FRQ Task]: Be prepared to draw a correctly labeled AD-AS graph showing the economy in long-run equilibrium. A common task is to show the short-run and long-run effects of a policy or shock that shifts the AD curve.
[MCQ Task]: Questions will often test your understanding of why the LRAS is vertical. The correct answer is always related to the full flexibility of wages and prices in the long run.
[Common Pitfall ①]: Confusing a shift in LRAS with a movement caused by AD. The LRAS curve only shifts if the economy's potential to produce changes (e.g., due to new technology, a change in the quantity of resources, or improved institutions). A change in aggregate demand does not shift the LRAS curve; it only causes a short-run deviation and a long-run adjustment back to the original LRAS.
[Common Pitfall ②]: Defining the "long run" as a specific calendar period. The long run is a conceptual period defined by wage and price flexibility. Its actual duration can vary depending on how quickly contracts can be renegotiated and prices adjust in a given economy.
Key Vocabulary
Long Run: The period of time in which all prices and nominal wages are fully flexible and have adjusted to market changes.
Short Run: The period of time in which some input prices, particularly nominal wages, are fixed or "sticky."
Long-Run Aggregate Supply (LRAS) Curve: A vertical curve at the full-employment level of output, showing that the quantity of aggregate output supplied is independent of the price level in the long run.
Full-Employment Output ((Y_F)): The level of real GDP produced when an economy's resources are fully and sustainably employed; also known as potential output.
Maximum Sustainable Capacity: The total output an economy can produce over a set period if all resources are fully employed, a concept represented by both the LRAS curve and the Production Possibilities Curve (PPC).