The Aggregate-Supply Curve

Why the Long-Run Aggregate-Supply Curve Might Shift

Because classical macroeconomic theory Opens in new window predicts the quantity of goods and services produced by an economy in the long run, it also explains the position of the long-run aggregate-supply curve Opens in new window.

The long-run level of production is sometimes called potential output or full-employment output. To be more precise, we call it the natural level of output because it shows what the economy produces when unemployment is at its natural, or normal, rate.

The natural level of output is the rate of production toward which the economy gravitates in the long run.

Natural level of output has been defined as the production of goods and services that an economy achieves in the long run when unemployment is at its normal rate.

Any change in the economy Opens in new window that alters the natural level of output shifts the long-run aggregate-supply curve Opens in new window.

Because output in the classical model depends on labor, capital, natural resources, and technological knowledge, we can categorize shifts in the long-run aggregate-supply curve as arising from these four sources.

Shifts Arising from Changes in Labor

Imagine that an economy experiences an increase in immigration.

Because there would be a greater number of workers, the quantity of goods and services supplied would increase. As a result, the long-run aggregate-supply curve would shift to the right.

Conversely, if many workers left the economy to go abroad, the long-run aggregate-supply curve would shift to the left.

The position of the long-run aggregate-supply curve also depends on the natural rate of unemployment

In this case, any change in the natural rate of unemployment shifts the long-run aggregate-supply curve.

For example, if Congress were to raise the minimum wage substantially, the natural rate of unemployment would rise and the economy would produce a smaller quantity of goods and services.

As a result, the long-run aggregate-supply curve would shift to the left. Conversely, if a reform of the unemployment insurance system Opens in new window were to encourage unemployed workers to search harder for new jobs, the natural rate of unemployment would fall and the long-run aggregate-supply curve would shift to the right.

Shifts Arising from Changes in Capital

An increase in the economy’s capital stock increases productivity and, thereby, the quantity of goods and services supplied.

As a result, the long-run aggregate-supply curve shifts to the right. Conversely, a decrease in the economy’s capital stock decreases productivity and the quantity of goods and services supplied, shifting the long-run aggregate supply curve to the left.

Notice that the same logic applies regardless of whether we are discussing physical capital such as machine and factories or human capital such as college degrees. An increase in either type of capital will raise the economy’s ability to produce goods and services and, thus, shift the long-run aggregate-supply curve to the right.

Shifts Arising from Changes in Natural Resources

An economy’s production depends on its natural resources, including its land, minerals, and weather. The discovery of a new mineral deposit shifts the long-run aggregate-supply curve to the right. A change in weather patterns that makes farming more difficult shifts the long-run aggregate-supply curve to the left.

In many countries, crucial natural resources are imported. A change in the availability of these resources can also shift the aggregate-supply curve.

For example, events occurring in the world oil market have historically been an important source of shifts in aggregate supply for the United States and other oil-importing nations.

Shifts Arising from Changes in Technological Knowledge

Perhaps the most important reason that the economy Opens in new window today produces more than it did a generation ago is that our technological knowledge Opens in new window has advanced.

The invention of the computer, for instance, has allowed us to produce more goods and services from any given amounts of labor, capital, and natural resources. As computer use has spread throughout the economy, it has shifted the long-run aggregate-supply curve to the right.

Although not literally technological, many other events act like changes in technology. For instance, opening up international trade has effects similar to inventing new production processes because it allows a country to specialize in higher-productivity industries; therefore, it also shifts the long-run aggregate-supply curve to the right. Conversely, if the government passes new regulations preventing firms from using some production methods, perhaps to address worker safety or environmental concerns, the result is a leftward shift in the long-run aggregate-supply curve.

Using Aggregate Demand and Aggregate Supply to Depict Long-Run Growth and Inflation

Having introduced the economy’s aggregate-demand curve Opens in new window and the long-run aggregate-supply curve Opens in new window, we now have a new way to describe the economy’s long-run trends. Figure I illustrates the changes that occur in an economy from decade to decade.

chiasmus diagram showing abba pattern Figure I, Long-Run Growth and Inflation in the Model of Aggregate Demand and Aggregate Supply | Source: EconomicsKey.com Opens in new window

Notice that both curves are shifting. Although many forces influence the economy in the long run and can in theory cause such shifts, the two most important forces in practice are technology Opens in new window and monetary policy Opens in new window.

Technological progress enhances an economy’s ability to produce goods and services, and the resulting increases in output are reflected in continual shifts of the long-run aggregate-supply curve to the right.

At the same time, because the Fed increases the money supply over time, the aggregate-demand curve also shifts to the right. As the figure illustrates, the result is continuing growth Opens in new window in output (as shown by increasing Y ) and continuing inflation Opens in new window (as shown by increasing P ).

The purpose of developing the model of aggregate demand and aggregate supply, however, is not to dress our previous long-run conclusions in new clothing. Instead, it is to provide a framework for short-run analysis, as we will see in a moment Opens in new window.

As we develop the short-run model Opens in new window, we keep the analysis simple by omitting the continuing growth and inflation shown by the shifts in Figure I. But always remember that long-run trends are the background on which short-run fluctuations are superimposed.

The short-run fluctuations Opens in new window in output and the price level we will be studying should be viewed as deviations from the long-run trends of output growth and inflation.