Long-Run Aggregate Supply reflects an economy's maximum output when all resources are fully and efficiently employed, independent of the general price level.
Definition of long-run aggregate supply (LRAS)
Long-Run Aggregate Supply (LRAS) refers to the total quantity of goods and services an economy is capable of producing when operating at full employment, using all its resources efficiently. Unlike short-run aggregate supply (SRAS), which assumes fixed input prices, LRAS reflects a period where input prices—including wages and raw materials—can adjust fully.
In this long-run context, output is determined not by price levels but by the economy’s supply-side capabilities, including:
Quantity and quality of the factors of production
Technological innovation
Education and training
Regulatory environment
Institutional efficiency and infrastructure
Since LRAS shows the economy’s potential output, it is often referred to as the productive capacity or full employment level of output. Any increase in LRAS indicates economic growth as it shows the economy can produce more goods and services over time.
Shapes of the LRAS curve
The LRAS curve can take two primary forms based on different economic schools of thought: the classical (vertical) view and the Keynesian (curved) view.
Classical LRAS curve
According to Classical economists, the LRAS curve is perfectly vertical. This view is based on the belief that markets are fully flexible in the long run, especially in terms of prices and wages.
Key features of the Classical LRAS curve:
A vertical line represents a fixed level of output at full employment.
This output level does not change with price levels. Any increase in aggregate demand only leads to higher prices (inflation), not more output.
The economy is assumed to self-correct quickly. If there is a recessionary or inflationary gap, wages and prices will adjust, returning the economy to full employment.
Supply-side policies are crucial under this model because the only way to increase real output is by shifting the LRAS curve to the right through improvements in productive capacity.
This vertical LRAS is often referred to as Yfe (full employment level of output).
Keynesian LRAS curve
The Keynesian approach challenges the Classical assumption that the economy always operates at full capacity. Keynesians argue that due to market imperfections, rigid wages, and sticky prices, economies can remain below full employment for extended periods.
The Keynesian LRAS curve has three distinct segments:
Horizontal segment (spare capacity):
Occurs when there is high unemployment and significant spare capacity.
Firms can increase output without raising prices, as there are idle resources.
In this range, aggregate demand increases lead to higher output, not inflation.
Upward-sloping segment (bottlenecks):
As the economy approaches full employment, shortages in labour, capital, and raw materials begin to emerge.
Increasing output leads to some inflationary pressure as firms compete for scarce resources.
Costs of production rise, pushing prices upward.
Vertical segment (full capacity):
At this point, all resources are fully employed.
The economy cannot increase output further without creating inflation.
Any rise in aggregate demand here leads to pure inflation.
The Keynesian view is particularly relevant during periods of economic downturns, where demand-side stimulus can increase real output without causing inflation.
Policy implications of Classical vs Keynesian LRAS views
Understanding the policy implications of each LRAS model is vital in shaping fiscal and monetary responses.
Classical perspective
Emphasises supply-side policies to improve productivity and shift LRAS to the right.
Argues that government intervention is unnecessary and potentially harmful.
Believes the economy is self-correcting through market forces, including flexible wages and prices.
Views demand-side policy (e.g., fiscal stimulus) as inflationary and ineffective in the long run.
Encourages measures such as:
Tax cuts to incentivise work and investment
Deregulation to reduce business costs
Free markets and competition
Keynesian perspective
Advocates for active government intervention, especially during recessions.
Believes that aggregate demand can remain persistently low, keeping the economy below full capacity.
Supports fiscal policy (government spending and taxation changes) to boost demand.
Recognises the importance of monetary policy, but notes it may be less effective when interest rates are already low (liquidity trap).
Accepts that in the long run, supply-side policies matter, but in the short to medium run, stimulating demand is critical.
In summary, while Classical economists stress the importance of long-term structural reforms, Keynesians emphasise short-run demand management during economic downturns.
Factors influencing LRAS
LRAS can shift rightward or leftward depending on changes in the economy’s supply-side conditions. A rightward shift indicates economic growth, while a leftward shift suggests a decline in productive capacity, often caused by war, pandemics, or natural disasters.
Technological advances
Technological progress plays a pivotal role in enhancing the productive efficiency of an economy.
It leads to better production methods, allowing more output with the same input.
Advances in technology improve labour productivity and capital efficiency.
Innovation in industries such as automation, artificial intelligence, and biotechnology can radically boost output potential.
For example, replacing manual processes with robotics in manufacturing increases speed and reduces waste.
A significant technological improvement would shift the LRAS curve to the right, representing increased capacity.
Changes in relative productivity
Productivity refers to the output per unit of input. Improvements in labour productivity and capital productivity directly affect LRAS.
Higher labour productivity: More output can be produced with the same number of workers.
More efficient capital use: New machinery and better production techniques increase capital productivity.
Productivity gains can come from:
Better management techniques
Research and development
Investment in infrastructure
Rising productivity allows the economy to produce more goods and services, causing a rightward shift in LRAS.
Changes in education and skills
A more skilled and educated workforce improves the quality of labour.
Education and training equip workers with the ability to adapt to new technologies.
A better-trained workforce is more flexible, innovative, and productive.
Human capital development leads to:
Higher employability
Improved job performance
Lower structural unemployment
Government investment in vocational training, universities, and apprenticeships is a key supply-side measure to boost LRAS.
Changes in government regulations
Regulations can either enhance or hinder productive potential.
Deregulation removes excessive red tape, making it easier for businesses to operate efficiently.
For example, easing planning laws can stimulate construction and housing supply.
Overregulation, however, may lead to:
Increased administrative burden
Delays in production
Reduced incentives for firms to expand or innovate
Smart regulation that ensures consumer and environmental protection without stifling enterprise can support long-term growth.
Demographic changes and migration
The size and composition of the labour force significantly affect LRAS.
Population growth, particularly among the working-age group, increases the available labour supply.
Net migration of skilled workers can:
Fill shortages in key sectors
Enhance productivity
Inject new skills and perspectives into the economy
An ageing population may have the opposite effect:
Shrinks the working population
Increases dependency ratios
Puts pressure on public finances
Policies that encourage labour force participation, such as affordable childcare or pension reform, can mitigate these demographic challenges.
Competition policy
Competition policy aims to promote fair competition in markets, encouraging efficiency and innovation.
Strong competition:
Discourages complacency
Forces firms to cut costs and improve service
Drives investment in new technologies
It prevents monopolies from charging high prices and producing at inefficient levels.
The presence of dynamic efficiency—continuous improvement through innovation—is a long-term result of a competitive environment.
Regulatory bodies like the Competition and Markets Authority (CMA) in the UK ensure that firms comply with fair competition rules, supporting a more productive economy.
Diagrammatic illustration of LRAS shifts
A diagram is essential for understanding how LRAS behaves and how it can shift.
In a Classical LRAS diagram:
The vertical LRAS curve intersects the x-axis (real GDP) at Yfe.
A rightward shift (from LRAS1 to LRAS2) shows an increase in productive capacity due to improved technology, higher productivity, or increased labour supply.
The aggregate demand curve (AD) intersects the new LRAS at a higher level of output.
In a Keynesian LRAS diagram:
The curve includes a horizontal, upward-sloping, and vertical section.
Rightward shifts of the entire curve indicate growth in all three segments—greater spare capacity, increased bottleneck range, and higher full capacity.
These shifts result from supply-side improvements, moving the economy closer to or beyond its previous full employment level.
FAQ
Yes, LRAS can shift left if the economy’s productive capacity is reduced. This means the potential output level at full employment has decreased. Several factors can lead to a leftward shift. For example, a large-scale natural disaster or war can destroy physical capital like factories, transport infrastructure, or power networks. A pandemic might significantly reduce the labour force, either through illness, long-term health consequences, or demographic decline. Long-term underinvestment in education and training can erode human capital, lowering workforce productivity. Stricter government regulations, if excessively burdensome, may reduce business efficiency or discourage investment. Political instability and economic uncertainty may drive away investment or encourage brain drain, where skilled workers emigrate. Additionally, a significant fall in net migration or a rapidly ageing population with rising retirement rates may shrink the labour supply. Any of these can cause the LRAS curve to shift to the left, representing a fall in the economy’s full capacity output.
Investment in infrastructure is a key supply-side measure that can increase LRAS by improving the efficiency and productivity of economic activity. Infrastructure includes transport networks (like roads, railways, and ports), communication systems, energy supply, and public services. Better transport links reduce travel time and costs, making it easier and cheaper for businesses to move goods and services. Improved internet access and faster communication systems enhance coordination and productivity across sectors. Reliable energy supply prevents production disruptions and increases capacity utilisation. Infrastructure projects also create multiplier effects by stimulating related industries and encouraging private investment. Over time, these improvements make the economy more competitive and attractive to investors, raising potential output. For instance, high-speed rail can connect labour markets to more job opportunities and link businesses to wider consumer bases. Thus, well-targeted and efficient infrastructure spending can lead to a rightward shift in the LRAS curve by enhancing the long-term productive potential of the economy.
Labour market flexibility refers to how easily workers can be hired, retrained, or moved between jobs and industries in response to changes in economic conditions. A more flexible labour market contributes to a more efficient allocation of human resources, which in turn supports an increase in LRAS. Flexibility can be achieved through policies such as reducing employment protection legislation, enabling part-time or temporary work, promoting retraining schemes, and encouraging geographical mobility through housing and transport support. When workers can move quickly to where they are most needed, structural unemployment falls, and firms can respond more efficiently to demand. Additionally, flexible wage structures allow for adjustments that can prevent persistent unemployment or labour shortages. This adaptability ensures that the economy can make better use of its existing labour force, which boosts potential output. Therefore, greater labour market flexibility can enhance productive capacity, raise the full employment level of output, and shift the LRAS curve to the right over time.
Environmental policies can affect LRAS both positively and negatively, depending on how they are designed and implemented. On the positive side, well-structured environmental regulations can encourage firms to innovate and adopt cleaner, more efficient technologies. This not only reduces environmental harm but may also improve productivity and resource efficiency, contributing to long-term growth. Policies that promote renewable energy investment can reduce reliance on volatile fossil fuel markets, ensuring a more stable and secure energy supply—crucial for long-term productive capacity. However, if environmental policies are too rigid, costly, or poorly targeted, they can impose significant compliance costs on businesses. This may reduce profitability, discourage investment, and lower productive efficiency, thereby constraining LRAS. For instance, excessive restrictions on emissions without sufficient support for transition technologies may raise production costs and limit output. Thus, the impact of environmental policies on LRAS depends on whether they balance ecological sustainability with economic efficiency and support innovation.
Changes in interest rates primarily influence aggregate demand in the short run, but they can have indirect long-term effects on LRAS through their impact on investment and capital formation. Lower interest rates reduce the cost of borrowing, encouraging firms to invest in capital equipment, research and development, and infrastructure. This investment enhances productive capacity over time, thereby increasing LRAS. Additionally, lower interest rates can incentivise household spending on education and skills development, contributing to improvements in human capital. On the other hand, persistently high interest rates may discourage business investment and innovation, reducing capital accumulation and slowing down productivity growth. Over time, this limits the economy’s ability to expand its potential output. While the immediate effect of interest rate changes is on spending behaviour and aggregate demand, their cumulative impact on capital stock, technology adoption, and human capital development means they can influence the long-run productive potential and shift the LRAS curve accordingly.
Practice Questions
Explain how technological advancements can lead to a rightward shift in the long-run aggregate supply (LRAS) curve.
Technological advancements increase the efficiency of capital and labour, allowing more output to be produced with the same input. This improves productivity across industries, enabling firms to expand output without raising costs. Over time, innovation facilitates the development of new production methods and processes, which can boost total factor productivity. As a result, the economy’s productive capacity expands, leading to a rightward shift of the LRAS curve. This reflects long-term economic growth, as the economy can now produce a higher level of real GDP at full employment without generating inflationary pressure, assuming aggregate demand also increases proportionately.
Evaluate the effectiveness of supply-side policies in increasing long-run aggregate supply.
Supply-side policies, such as investing in education, reducing regulations, or improving infrastructure, can enhance labour productivity and efficiency, shifting LRAS rightward. In the long run, this boosts potential output and supports sustainable growth without inflation. However, these policies often have long time lags, are costly, and outcomes are uncertain. For instance, improving education may take years to yield a more skilled workforce. Additionally, some supply-side reforms, like deregulation, may lead to negative externalities or inequality. While supply-side policies are effective in principle, their success depends on implementation, supporting macroeconomic conditions, and the responsiveness of the private sector.
