3.4 Long-Run Aggregate Supply (LRAS)

In the long run, wages and all other input prices fully catch up with the price level. If the price level doubles, nominal wages and other costs eventually double too, so firms are no better off producing more. Real output returns to the level set by the economy's resources and technology. Picture every price and wage in the economy doubling overnight. Bread sells for twice as much, but flour, rent and the baker's wages cost twice as much too, so the bakery has no reason to bake more loaves.

On the AD–AS graph, draw LRAS as a vertical line at full-employment output, labeled YF (also called potential output). At YF, unemployment equals the natural rate (frictional plus structural).

LRAS and the production possibilities curve (1.2) are two pictures of the same limit, which economists call maximum sustainable capacity. It's the output the economy can keep producing, period after period, when its workers, machines and land are all in use, without overtime and other stretches it can't keep up.

A point on the PPC matches output at YF on the LRAS. A point inside the PPC matches output below YF, with some resources unemployed. Economic growth shifts the PPC outward and LRAS to the right.

Because LRAS is vertical, a higher price level in the long run doesn't bring more output or lower unemployment. In the long run, the economy produces YF with unemployment at the natural rate, whatever the price level is. There's no long-run trade-off between inflation and unemployment.

This explains why an increase in AD raises output only in the short run. Once wages adjust, the economy ends up back at YF with a higher price level. You'll see this process in 3.7, and its Phillips curve version in 5.2, where the long-run Phillips curve is vertical at the natural rate of unemployment.

When LRAS shifts right, SRAS usually shifts right with it, since the same resources and technology lower costs in the short run too. A temporary cost change, like a one-time jump in oil prices, shifts SRAS only.

• Quantity of resources: more workers (population growth, immigration), more capital (factories and machines), more natural resources found. These shift LRAS right; losing them shifts it left.
• Quality of resources: more human capital from education and training.
• Technology: better ways to combine resources, so the same inputs make more output.
• Institutions and policies that change long-run productivity, such as protecting property rights or funding research (5.7).