Questions: Long-Run Aggregate Supply and Potential Output

Question 1

A positive demand shock temporarily pushes GDP above potential. What happens in the long run if no policy intervention occurs?

• A. GDP stays above potential permanently because the new demand level supports it
• B. The SRAS shifts leftward as wages rise, returning GDP to potential at a higher price level
• C. The LRAS shifts rightward to accommodate the higher level of output
• D. The SRAS shifts rightward as firms expand capacity, locking in the higher GDP

Answer: (B)

When GDP exceeds potential, labor markets are tight: workers push for higher wages and firms raise prices. Rising wages increase production costs, shifting SRAS leftward. This continues until the economy returns to the LRAS at potential output — but at a higher price level than before the shock. The real output gain is temporary; the only permanent effect is inflation. Option C is a key misconception: the LRAS doesn't shift to meet actual output; actual output is pulled back to LRAS.

Question 2

What ultimately determines the level of potential output (the position of the LRAS curve)?

• A. The price level — higher prices incentivize more production
• B. Aggregate demand — more spending shifts LRAS rightward over time
• C. Real supply-side factors: the capital stock, labor force size and skills, and technology
• D. The natural rate of interest set by the central bank

Answer: (C)

The LRAS is vertical because the price level does not affect real output in the long run. What determines where the LRAS sits are the real factors of production: how much physical capital exists, how large and skilled the workforce is, and how productive technology is. A higher price level doesn't give workers better tools or more training — it just raises all nominal prices together. This is why the LRAS is about the supply side of the economy, not about nominal variables like prices or interest rates.

Question 3

An economy at potential output has zero unemployment.

• T. True
• F. False

Answer: False

Potential output corresponds to the natural rate of unemployment, which is greater than zero. Even at potential, frictional unemployment (people between jobs) and structural unemployment (skills mismatch) exist. Cyclical unemployment — caused by insufficient demand — is zero at potential, but total unemployment is not. Treating 'potential output' as 'maximum possible output with everyone employed' is a common error; it is better understood as 'sustainable full-employment output consistent with stable inflation.'

Question 4

The self-correction mechanism that eliminates a recessionary gap (GDP below potential) tends to operate more slowly than the correction of an inflationary gap (GDP above potential).

• T. True
• F. False

Answer: True

When GDP exceeds potential, tight labor markets push wages upward relatively quickly — workers and unions press for raises, and firms competing for scarce labor bid wages up. But when GDP is below potential and unemployment is high, wages are downwardly rigid: workers resist nominal pay cuts, employers worry about morale and productivity, and wage floors (including minimum wage laws) create barriers. This asymmetry — wages rise faster than they fall — means the self-correction of recessions is slow and potentially incomplete without policy intervention.

Question 5

Why might a Keynesian economist argue for active fiscal or monetary policy to address a recession rather than waiting for the self-correction mechanism to work?

Model answer: Because the self-correction of a recessionary gap relies on wages and prices falling, but wages are downwardly rigid — workers resist nominal cuts and contracts prevent rapid adjustment. This means the return to potential output could take years or even decades, during which unemployment remains high, human capital erodes, and long-term output potential is damaged. The social costs of waiting (sustained unemployment, poverty, lost skills) may far exceed the costs of intervention. As Keynes famously put it, 'in the long run, we are all dead.'

This is the central policy debate of macroeconomics. Classical economists trust the self-correction mechanism and worry about government intervention creating distortions. Keynesians emphasize the slow and painful nature of the downward adjustment, especially in deep recessions like the Great Depression. Both schools agree the economy eventually returns to potential — the disagreement is about how long it takes and what the costs of waiting are.