Long-Run vs Short-Run Aggregate Supply

   The major controversies about modern macroeconomics today swirl around the determination and shape of aggregate supply.Some economists,particularly those adhering to the Keynesian approach,believe that the AS curve is relatively flat; others,especially those who argue for the classical approach,hold that the AS curve is relatively steep or even vertical.

   Figure 5-8 depicts two AS curves.On the left is one that is relatively flat,particularly at low levels of output.This relatively flat AS curve would pertain to the short run; that is,it would show the relationship between the price level and output for a period of a year or two.For the short run,firms are willing to supply more and output if they can also increase their prices as output rises.

   Why do firms raise both prices and output in the short run as aggregate demand increases? Because they have certain costs that are fixed in the short run,it is profitable to raise prices and sell extra output as aggregate demand increases.Let us see why.

   Suppose that a burst of extra spending occurs.Firms know that in the short run many of their costs are fixed in dollar terms-workers are paid $15 per hour,rent is $1500 per month,and so forth.If firms can successfully raise their prices in response to the extra burst of spending,they will also find it profitable to increase their output.Hence,in the short run,before wages and rents and other dollar-fixed costs have adjusted,firms will rationally react to aggregate demand increases by raising both prices and output.This positive association between prices and output is seen in the upward-sloping AS curve.

   As an aside,we note that the most important of these temporarily fixed costs is wage rates.Many firms,covering almost one-half of manufacturing workers,have long-term agreements with labor unions.These agreements generally extend for 3 years and specify a dollar wage rate (with partial adjustment for price changes).Thus for the life of the labor contract,the wage rates facing firms are partially fixed in dollar terms.When consumers or businesses demand more cars or trucks or other goods in the short run,firms react by raising prices,earning higher profits,and producing more output.

   Once we appreciate why the AS curve may slope gently upward in the short run,we can begin to understand why it is likely to be vertical or near-vertical in the long run.As the inflexible or "sticky" elements of cost-wage contracts or rent agreements,for example-expire and are renegotiated,wages,rents,and other costs begin to adjust to the higher prices.If the price (P) in Figure 5-8(a) moves up 10 percent because of the higher demand,then money wages will eventually move up 10 percent as well.As a result,the firm will in the long run be unable to profit from the higher level of aggregate demand.As costs move up to meet prices,the level of output will come back to its long-run equilibrium level at potential output.Therefore,output may increase in response to higher aggregate demand for a while,but in the long run,as costs rise proportionally with prices,output will come back to its long-run equilibrium level.

    The right-hand panel of Figure 5-8 illustrates the long-run response of aggregate supply to different price levels. We see there that the long-run AS curve is drawn as a vertical line at a level of real output equal to potential output. The long-run AS curve is vertical because, given sufficient time, all costs adjust. Firms cannot take advantage of fixed money wage rates in their labor agreements forever: after a time, labor will recognize that prices have risen. Workers will insist on compensating increases in wages. Eventually, after all elements of cost have fully adjusted, firms will face the same ratio of price to costs as in the initial state, and there will no longer be any incentive for the firms to increase their output. Thus, the long-run AS curve is vertical.

Output in the Short and Long Run 

   The shape of the AS curve has an implication that is absolutely critical to understanding certain important controversies in modern macroeconomics. Numerous empirical studies confirm that the AS curve is relatively flat for a year or two, as pictured in Figure 5-8(a). On the other hand, for periods of a decade or more, the AS curve tends to be nearly vertical, as shown in Figure 5-8(b). This difference in behavior is key to understanding the determinants of real output. It suggests that, as long as output is at or below potential, changes in spending can have a significant effect upon output; as demand changes sweep back and forth on a relatively flat AS curve, output tends to decrease and increase.

   In the longer run, however, aggregate demand becomes less important for real output. If the AS curve is vertical, output is solely determined by the level of potential output; AD changes affect the price level but not the level of real output.

   Aggregate demand has a significant impact upon movements of real output in the short run. In the long run, however, real output is determined chiefly by potential output, and aggregate demand affects mainly the level of prices. 

   This completes our introduction to the analysis of aggregate supply and demand. However, before we proceed to examine some applications of aggregate supply-and-demand analysis, one word of caution is in order. We must take care not to confuse this set of curves with the market supply and demand curves of microeconomics, such as those discussed in Chapter 4. Aggregate supply and demand refer to the determination of output and price for the entire economy; market supply and demand refer to the equilibrium for one small part of the economy. The difference can be seen on the axes of the diagrams. The wheat supply and-demand diagram has bushels of wheat and the price of wheat on the axes; by contrast, the AS and AD diagrams have the national output and the overall price level on the axes. Keep these different approaches clearly distinct in your mind as you move into the exciting world of macroeconomics in the pages that follow.