Question

How is long-term growth illustrated in an AD/AS model?

Short answer

Long-term growth in an AD/AS model is illustrated through an outward shift of the Long-run Aggregate Supply (LRAS) curve, which represents the potential output or long-run productive capacity of the economy. This shift is driven by factors such as advancements in technology, increases in the labor force, capital accumulation, and improvements in education and infrastructure. The movement from the initial equilibrium point A to the new long-run equilibrium point C, where the AD, SRAS, and LRAS curves intersect, shows the process of long-term growth in the economy.

Step-by-step solution

Understand the AD/AS model components

In the AD/AS model, there are three main components: the Aggregate Demand (AD) curve, the Short-run Aggregate Supply (SRAS) curve, and the Long-run Aggregate Supply (LRAS) curve. The AD curve shows the total quantity of goods and services demanded by the economy at different price levels, while the SRAS curve depicts the total quantity of goods and services that firms in the economy are willing to supply in the short run at different price levels. The LRAS curve, on the other hand, represents the potential output or long-run productive capacity of the economy, which is determined by factors such as technology, labor, and capital.

Short-run vs. long-term growth

In the short run, growth occurs when there is an increase in aggregate demand (a shift to the right of the AD curve) or an increase in short-run aggregate supply (a shift to the right of the SRAS curve). However, these changes do not necessarily reflect long-term growth, as they may be influenced by temporary factors such as fiscal and monetary policies, changes in consumer confidence, or external shocks. Long-term growth, on the other hand, occurs when there is an increase in the productive capacity of the economy, and consequently, an outward shift in the LRAS curve. Factors that contribute to long-term growth include advancements in technology, increases in the labor force, capital accumulation, and improvements in education and infrastructure.

Illustrate long-term growth using the AD/AS model

To illustrate long-term growth in the AD/AS model, we focus on shifts in the LRAS curve. Since long-term growth is driven by factors such as technology, labor, and capital, an increase in any of these factors will result in an outward shift of the LRAS curve to the right. This shift depicts a higher potential output for the economy, which can be sustained without causing inflationary pressures. For example, consider the following steps: 1. Assume the economy starts in a long-run equilibrium, where the AD curve, SRAS curve, and LRAS curve intersect at point A. 2. Improvements in technology, an increase in the labor force, or an increase in capital accumulation cause the LRAS curve to shift outward from LRAS1 to LRAS2. 3. In the short run, the intersection of the AD and SRAS curves moves to point B, representing a new short-run equilibrium with a higher level of output and a lower price level. 4. In the long run, the SRAS curve will also shift to the right, as firms adjust to the increased productive capacity, moving the new long-run equilibrium to point C, where AD, SRAS2, and LRAS2 curves intersect. The outward shift in the LRAS curve and the movement from point A to point C on the graph illustrate the process of long-term growth in the economy.

Key concepts

Aggregate Demand (AD) Curve

The Aggregate Demand (AD) curve represents the total quantity of all goods and services demanded by an economy at various price levels within a certain time period. Imagine a snapshot of an economy where the demand for everything is summed up; from apples to zippers, at prices from low to high. This curve slopes downward, indicating that as prices fall, the quantity demanded typically increases, an economic principle known as the law of demand.

Several factors can shift the AD curve, including changes in consumer confidence, fiscal and monetary policies, and external factors like foreign exchange rates. An important point for students to note is that these shifts can indicate different economic scenarios. For example, a rightward shift suggests an increase in total demand, often happening because of expanded fiscal policy or increased consumer spending.

Long-run Aggregate Supply (LRAS) Curve

The Long-run Aggregate Supply (LRAS) curve is a vertical line at the potential output level of the economy. This line does not slope because, in the long run, the total quantity of goods and services supplied is determined by the economy's resources—technology, labor, and capital—not by the price level.

It reflects an economy’s maximum sustainable output, given its existing resources. An outward shift of the LRAS curve represents real economic growth. Therefore, an important distinction for students is that LRAS changes only with the productive capacity of the economy, unlike the AD curve, which can shift with the day-to-day sentiments and policies affecting demand.

Factors Affecting Long-term Growth

Long-term growth is shaped by factors that influence an economy's productive capacity. These include:

• Technological advancements: Innovation can improve efficiency and productivity, leading to more output with the same or fewer inputs.
• Capital accumulation: Investment in physical assets like machinery and infrastructure enhances production capabilities.
• Labor force growth: Increases in the number or quality of workers, through population growth or better education, expand an economy's output.
• Institutional changes: Improvements in government policies, legal systems, and other institutions can also foster a better environment for economic growth.

These factors, when improved upon, can shift the LRAS curve to the right, indicating increased potential output without corresponding increases in the price level.

Illustrating Economic Growth with AD/AS Model

To illustrate economic growth within the context of the AD/AS model, let's consider a situation where an economy experiences technological growth. This technological improvement is a factor affecting long-term growth that shifts the LRAS curve outward. Initially, the economy is at equilibrium with the AD, Short-run Aggregate Supply (SRAS), and LRAS curves intersecting at one point.

When technology improves, it increases the potential output, and the LRAS curve shifts from LRAS1 to LRAS2. Initially, this may lead to an intersection of the AD and new SRAS at a point of lower price level indicating an increase in output. Over time, as the economy adjusts, the SRAS curve will shift to match the new LRAS, and the economy will reach a new long-run equilibrium, where all three curves—AD, SRAS2, and LRAS2—intersect, representing long-term growth.