Question

Explain why the long-run aggregate supply curve is vertical.

Short answer

The long-run aggregate supply curve is vertical because in the long run, the quantity of goods and services that firms are willing to produce remains constant at the economy's potential level of output, regardless of the overall price level. This is because, in the long run, all prices are fully flexible, and the economy reaches an equilibrium state of full employment where unemployment equals the natural rate of unemployment.

Step-by-step solution

Understand the concept of the LRAS curve

The long-run aggregate supply curve is a graphic representation that shows the relationship between the price levels and the quantity of output that firms are willing and able to supply. It represents the final stage after all economic adjustments have played out and is based on the premise of 'full flexibility of prices', meaning the economy has adequately adjusted to any demand and supply changes.

Identify Full-employment Real GDP

The long-run supply is determined by the productive resources that the economy has such as labor, capital, technology, and institutional arrangements. It corresponds to the real GDP at full employment meaning unemployment is equal to the natural rate of unemployment. In the long run, the economy reaches this state of equilibrium.

Explaining Vertical Nature of LRAS curve

In the long run, it is assumed that the economy's productive resources and technology do not change. Therefore, the amount of goods and services that firms are willing and able to produce - the real GDP - remains constant regardless of the overall price level. This infers that the LRAS curve is vertical. Any change in the price level does not alter the output that firms wish to supply in the long run.

Key concepts

Full-employment GDP

Full-employment GDP is a crucial concept in understanding the long-run aggregate supply (LRAS) curve. It refers to the level of real GDP that an economy can produce when operating at full employment. Full employment doesn't mean that every single worker has a job; rather, it means the economy is utilizing its available human resources efficiently, and any unemployment present is at its "natural" rate.

This natural rate comprises frictional, structural, and seasonal unemployment, which is considered unavoidable even in a well-functioning economy. There is no cyclical unemployment at this point, as full-employment GDP occurs during periods where output is maximized without overheating the economy.

Full-employment GDP is significant because it is the point where the LRAS curve becomes vertical. It indicates the maximum output that an economy can sustain over the long term without causing inflationary pressures.

Productive Resources

Productive resources are the building blocks an economy uses to produce goods and services. These include labor, capital, technology, and institutional policies. In the context of the LRAS curve, these resources dictate the economy's potential output capacity.

• Labor refers to the workforce, both in terms of quantity and quality. An increase in the labor force or improvements in skills can boost productive capacity.
• Capital involves machinery, buildings, and infrastructure. More or better capital means more potential for producing goods.
• Technology changes increase efficiency and productivity, allowing the same amount of resources to produce more.
• Institutional arrangements like legal systems and property rights ensure that resources are efficiently allocated and utilized.

In the long run, the fixed nature of these resources keeps the LRAS curve vertical. This implies that any shift in price level won't affect the quantity of output supplied, as it is tied to these constant resources.

Natural Rate of Unemployment

The natural rate of unemployment is another key element in understanding why the LRAS curve is vertical. It represents the unemployment rate that occurs even in a healthy economy and includes frictional and structural unemployment.

Frictional unemployment happens when workers are between jobs or are entering the workforce for the first time, while structural unemployment results from mismatches between workers' skills and job requirements. These types of unemployment exist regardless of the economic cycle.

The natural rate is vital for determining full-employment GDP, as it indicates a baseline level of unemployment that an economy can sustain without triggering inflationary or deflationary pressures. This is why, in the long run, changes in price levels don't affect real GDP output represented by the vertical LRAS curve. Since the natural rate does not change with fluctuating demand or prices, it underscores the verticality of the curve, which remains stable at the full-employment level.