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Lesson M07.L05: Long-Run Aggregate Supply and Macroeconomic Equilibrium

Module: Aggregate Demand and Aggregate Supply; Macroeconomic Policy Level: intro Duration: 30 minutes Learning Objective: Explain why the LRAS curve is vertical at potential output. Data as of: 2023 Provenance: OpenStax Macro 3e | Khan Academy Macro

Explanation

The Long-Run Aggregate Supply (LRAS) curve represents the total output the economy can produce when all prices — including wages — have fully adjusted to the overall price level. It is drawn as a vertical line at potential output (Y*).

Potential output (Y*) is the level of real GDP produced when unemployment is at its natural rate — meaning there is no cyclical unemployment, only frictional and structural unemployment. In Australia, economists at the RBA estimate the Non-Accelerating Inflation Rate of Unemployment (NAIRU) at approximately 4.0–4.5% in recent years.

Why is LRAS vertical?
In the long run, wages and all input prices adjust fully. If the price level rises, workers bargain for higher nominal wages to restore their real purchasing power. Once wages rise to match prices, real labour costs return to their original level, and firms have no incentive to produce more or less than before. Output returns to Y* regardless of the price level — hence, the curve is vertical.

The Self-Correcting Mechanism:

  • Recessionary gap (output below Y): Unemployment is high, workers accept lower wages. Lower wages reduce production costs → SRAS shifts right → output rises back toward Y, price level falls.
  • Inflationary gap (output above Y): Labour is scarce, workers demand higher wages. Higher wages raise costs → SRAS shifts left → output falls back toward Y, price level rises.

This automatic adjustment means the economy tends to self-correct without policy intervention — but it can take years, which is why active fiscal and monetary policy may be justified in the meantime.

Worked Example

Scenario: Australia enters a recession (recessionary gap)

Initial potential output: Y = \(2,000 billion** After a negative demand shock, actual output falls to: Y = **\)1,850 billion
Recessionary gap = Y − Y = $2,000b − \(1,850b = **\)150 billion**
Unemployment rises above the natural rate.

Self-correction process:

Step 1: With high unemployment, workers have less bargaining power.
Suppose average wages fall from $80,000 to $76,000 (a 5% cut).
Wage change = $76,000 − \(80,000 = **−\)4,000 per worker**

Step 2: Lower wages reduce firms' unit costs.
If there are 13 million workers, total labour cost saving = 13,000,000 × \(4,000 = **\)52 billion/year**

Step 3: Lower costs make production more attractive at every price level.
SRAS shifts rightward.

Step 4: As SRAS shifts right, output rises and the price level falls gradually.
The economy moves back toward Y* = $2,000 billion.

Step 5: In long-run equilibrium, output = Y* = $2,000 billion, wages have adjusted, and the price level is lower than before the self-correction began.

Policy implication: The RBA could accelerate this by cutting the cash rate (shifting AD right) rather than waiting for the slow wage-adjustment process.

Common Misconception

Misconception: The LRAS curve can shift to the right only if the government increases spending.

Correction: The LRAS curve shifts right when the economy's productive capacity increases — i.e., when potential output Y* rises. This happens through improvements in technology (TFP), growth in the labour force (population/participation), or increases in the capital stock (investment). Government spending can contribute indirectly (e.g., infrastructure investment), but the LRAS is determined by supply-side factors, not demand-side policy. Demand-side policies only shift AD and temporarily affect SRAS.

Practice Prompts

  1. Australia's working-age population grows as skilled migrants arrive. How does this affect the LRAS? → Answer: A larger labour force increases the economy's productive capacity, shifting LRAS to the right — potential output Y* rises.

  2. Describe the self-correcting mechanism for an inflationary gap (actual output above Y). → Answer: When output exceeds Y, unemployment is below the natural rate and labour markets are tight. Workers demand higher nominal wages; firms face higher costs, causing SRAS to shift left. Output falls back to Y* and the price level rises — the economy self-corrects to long-run equilibrium.

  3. Why might policymakers choose to use fiscal or monetary policy rather than waiting for the economy to self-correct after a recession? → Answer: The self-correction process relies on wages falling, which can be very slow (wages are "sticky downward"). The economy may remain in recession for years. Active policy (e.g., the RBA cutting rates or the government launching stimulus) can shift AD right more quickly, reducing the duration of unemployment and lost output.

Visual — Long-Run Equilibrium, a Recessionary Gap, and Self-Correction

1. Long-run equilibrium Real GDP Price level SRAS AD LRAS E Y* 2. Recessionary gap Real GDP Price level SRAS AD₀ AD₁ LRAS Output below Y* 3. Self-correction Real GDP Price level SRAS₀ SRAS₁ AD₁ LRAS Weak labour markets reduce wage pressure, SRAS shifts right, and output returns to Y*.

Figure: In long-run equilibrium, AD, SRAS, and LRAS intersect at potential output. A recessionary gap opens when AD shifts left, and over time lower wage pressure shifts SRAS right, restoring output to potential.

Further Resources