Long-Run Aggregate Supply and Potential Output

Core Idea

The long-run aggregate supply (LRAS) curve is vertical at the economy's potential output — the level of real GDP consistent with the natural rate of unemployment when all prices are fully flexible. In the long run, output is determined by real factors (capital, labor, technology), not by the price level. If actual GDP exceeds potential (inflationary gap), wages and prices rise until the economy returns to LRAS. If GDP falls short (recessionary gap), wages and prices fall — though this self-correction can be slow and painful.

How It's Best Learned

Use the AS-AD diagram to trace the self-correction mechanism: start from an inflationary gap, then show how rising wages shift SRAS left over time until equilibrium is restored at LRAS. Ask: why might this take years?

Common Misconceptions

• The LRAS is vertical because all wages and prices are flexible in the long run, not because supply is inelastic.
• Potential output is not the maximum possible output — it is the sustainable full-employment level.
• Keynesians and classicals disagree on how fast the self-correction operates, not on the long-run result.

Explainer

You already understand the short-run aggregate supply (SRAS) curve: it slopes upward because in the short run, some prices and wages are sticky, so higher price levels can temporarily boost output. The long-run aggregate supply (LRAS) curve is what happens when all those stickiness frictions have worked themselves out — when workers renegotiate wage contracts, firms adjust prices, and the economy arrives at its new steady state. At that point, the price level does not affect output. The LRAS is vertical.

Why vertical? In the long run, the economy's output is determined entirely by real factors: the stock of capital, the size and skills of the labor force, and the level of technology. These are the supply-side fundamentals. A higher price level does not give workers more machines or better skills — it just means all nominal prices are higher together. Output pins at potential output: the level of real GDP consistent with the natural rate of unemployment, where frictional and structural unemployment exist but there is no cyclical unemployment. This is not maximum possible output — it is sustainable full-employment output.

The self-correction mechanism explains how the economy returns to LRAS after shocks. Suppose a positive demand shock (say, a burst of government spending) pushes actual GDP above potential — an inflationary gap. The economy is operating beyond its sustainable capacity: workers are overtime, and businesses are operating at above-normal intensity. With labor markets tight, workers push for higher wages, and firms raise prices. As wages and prices rise, the SRAS curve shifts leftward (higher input costs reduce short-run supply). This process continues until the SRAS has shifted left enough that the new equilibrium occurs right on the LRAS — at potential output but at a higher price level. The demand shock has been neutralized in real terms but has produced permanent inflation.

The symmetric case is a recessionary gap: actual GDP below potential, unemployment above the natural rate. In principle, excess labor supply should push wages down, lowering costs, shifting SRAS right, and returning GDP to potential at a lower price level. In practice, this is where the famous Keynesian critique bites: wages are downwardly rigid — workers resist nominal wage cuts, unions enforce wage floors, and morale effects make employers reluctant to cut pay. The self-correction mechanism operates very slowly on the downside. This asymmetry — fast correction upward, slow correction downward — is the core argument for activist macroeconomic policy: if self-correction would take years or decades, the social costs of waiting (sustained unemployment, lost output, eroded human capital) may justify policy intervention to speed the return to potential.