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Lesson 7 : Long Run Aggregate Supply

Module 1: Macro Fundamental Analysis

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Video Transcript

In this video we’re going to look at long run aggregate supply so this is very similar to what we just looked at in short run aggregate supply but this is in the long term and you can see that in the classic model that we have here long run aggregate supply is actually a straight line so it’s just a vertical line and the reason it is vertical is because if you remember the reasons why we discussed previously the short run aggregate supply curve was upward sloping so it was price sensitive as price increased supply increased as price decreased supply decreased well a vertical line here simply shows that there is no relationship to price so the changes in price level do not affect supply and long term in any way the term actually given to this would be price inelastic it means it’s not sensitive to prices the opposite of that of course being price elastic so something which is sensitive to prices is price elastic so what the long run aggregate supply curve shows you this vertical line is the single point of output that the economy will always produce at in the long run using all available factors of production sustainably now that is a very specific definition that you guys need to understand because what that relates to is full employment or the natural level of unemployment full employment is not zero percent if we look at this excerpt from the federal reserve website you can see that not only do they say that full employment actually changes the specific number actually changes its dynamic but in the fomc’s june 2020 summary of economic projections they estimated the longer run normal rate of unemployment so the natural rate of unemployment ranged from between 3.5 to 4.7 percent and it had a medium value of 4.1 percent so what they’re saying there is maximum employment on average is determined as being 4.1 percent so if unemployment or the unemployment rate in the u.s was 4.1 percent this would be considered an economy functioning at full employment so the key takeaway here is that the long run aggregate supply curve is showing you the maximum level of output when the economy the underlying economy is running at full employment so this would be labeled as y f e

and this is showing you the single regardless of the changes in price level the single level of output that the economy can perform at sustainably when it is running at full employment so if for example the implication of that is if you have unemployment in the usa running at six percent the u.s would be producing outputs to the left of its long-run aggregate supply curve because it would be producing less than it is able to if it had full levels of employment if the u.s had an unemployment rate of three percent or two and a half percent let’s say which may be unlikely but let’s say just for argument’s sake it had an unemployment rate of two and a half percent it would be performing and producing to the right of the long run aggregate supply curve it would be producing more than its maximum sustainable level of output and this is not something that would last if we were looking at the us and the economy was performing to the right of the long run aggregate supply curve we would expect this to adjust back to its long-term equilibrium after a period and equally if the u.s economy was performing to the left-hand side and it was underperforming its maximum level of output at full employment with full employment levels in the economy we would expect this to once again adjust back to the natural long run equilibrium level so in short the long run aggregate supply curve shows the maximum level of output of an economy running at full employment if the economy moves to the left or to the right in the short term the economy theoretically is expected to self-adjust back to its long-term equilibrium and this swinging to the left and to the right and adjusting back to the center is what causes the business cycle so we will look at this concept a bit more in the next video however this is really what is meant by the business cycle so the economy may be performing let’s say at long run aggregate supply levels in the short term it then exceeds it deviates to the right of the long run aggregate supply output so we start producing more in the short term this may actually bring in too much inflation central banks would look to step in to control inflation maybe raise interest rates push in productivity cooling down the economy pushing productivity back to the sustainable level of output so the long run aggregate supply level and if we start to deviate to the left this is your contraction your negative output gap this is what monetary authority central banks and governments will step in to actually close this negative output gap to push production back from this deviation to the left so an under performance all the way back to long run aggregate supply and even a little bit further is ideal in the short term so when you think about this when you look back at what we looked at at the beginning of the course which was the dual mandate of central banks so full employment was one part of their dual mandate this is what they mean by full employment is to get the economy performing at the same output as the long-run aggregate supply so at that full employment output

so a good way to think about this concept this macro concept of an economy performing at maximum sustainable output levels and also having the ability to perform past maximum sustainable levels and also below maximum sustainable levels is to think of this macro concept of an economy here on the micro level so let’s just take an example of the average person the average person may decide that they want to work between nine and five five days a week and they’re going to have the weekends to themselves and they’re going to do that that will pay their bills they will be able to live their lives and they will be happy because they are performing at a level which does everything they need and it allows them to get enough sleep and this would be considered sustainable for them so they’re very happy they can get up every morning be in the office at nine they can be back by five they get the evenings and they get the weekends themselves that is something they can do for the rest of their lives that level of output would be considered the long run aggregate supply level that is the maximum sustainable level of output that that person could function at now that person may decide for a very short period of time that they actually don’t need any sleep do you know what i would like to earn a little bit more money so what i’m going to do is i’m going to go and ask my boss if i can work weekends and i’m going to ask him if i can actually be in the office at 4 and if i can leave the office at midnight every day i’ll get home i’ll have three hours sleep and i’ll be back at it again and that’s the best way to actually earn money and i’ll do that seven days a week well that person may be able to sustain those output levels for let’s say a month i mean if you did that for a month you’d probably be pretty burnt out if you went past that then i think you’d be struggling at that point but that is a level of performance that can be achieved in the short term that person can do that for a short period of time but eventually they’re going to need to get some sleep they’re going to be burnt out and even mentally they’re going to become demoralized by doing this amount of work constantly without any sleep without any time to themselves and eventually as much as they actually want to perform at that level and earn that much money for the rest of their lives that is not a sustainable level of output that would be a shift to the right that would be producing to the right of the long run aggregate supply curve in economic terms so an economy outperforming but outperforming sustainable levels so it can only do it for a short period of time in the short run so going back to that example that person then decides to go back to let’s say his long-run aggregate supply level and he decides to tell his boss okay you know i made a bit of a mistake i’m not really going to be able to keep this up so i’d like to go back to work in nine to five and i’d like to have the weekends for myself so he starts to go back to his long-term equilibrium so the sustainable level of output in the long term and after a month or so he really is still lacking some sleep so he he says to his boss look i can’t actually continue even to do five days a week now because i burnt myself out so much i need to actually reduce my hours i need to have a break because i work myself too hard and i can’t even perform at this level which i have done for you know the past 10 years so he decides to actually work two days a week and those two days a week he only works half days now he may do that for two months three months four months but then he’s going to start to need some money then he’s going to get bored and this would be performing to the left of his long run output so his maximum sustainable level of output in the long run is not being achieved here because he can do much more than that sustainably this would be an economy performing to the left of the long run aggregate supply curve this would be a deviation in output to the left where output in the short term is much lower than the maximum sustainable level of output using all factors of production which are available in the economy so after a certain amount of time that person may go back and decide he wants to he’s ready he feels refreshed he’s going to go back but he’s not going to make the same mistakes before he’s going to go back and he’s going to work the nine to five and he’s going to stick at that sustainable level for the rest of his life so he goes back and this would be a shift in back from the left into the long run equilibrium and then maybe after five months he forgets and he goes back and he decides to actually work hard again in the ass for the overtime and so he swings back to the right that’s what tends to happen in an economy it keeps going from left to right like a pendulum so hopefully that analogy actually helps you understand what we’re talking about here when we’re talking about long-run accurate supply and it being the maximum sustainable level of output for an economy so for the entire economy itself okay so now let’s have a think about the factors which can cause a shift in the long run aggregate supply curve so either to the right as we have an increase in long run aggregate supply or a shift to the left of the lras curve representing a decrease in long run aggregate supply so when we’re looking at factors which shift the long run aggregate supply curve we’re looking at factors of production namely changes in the quantity and the quality of the factors of production so when we look at short-term aggregate supply we’re looking at cost of production when we look at long-term aggregate supply we’re looking at factors of production so changes in the quality and quantity of the factors of production so you can see here that the factors of production are as follows we have land we have labor we have capital and we have entrepreneurship which is the ability to combine the previous factors of production it’s all well and good having machinery or workmen or land arguably workmen on their own could produce something but certainly land and machinery is not going to produce something in and of itself it requires a combination of these factors of production in order to actually produce a good or a service and that is where the entrepreneurship comes in we also have technology and we have here for the purpose of this video ability to increase efficiency so let’s have a little think about how some of these factors could actually shift the long run aggregate supply curve to the left and to the right so to start with let’s think about how we can have an increase in the long run aggregate supply and how these factors can actually be affected to cause an increase in long-run aggregate supply so let’s start off with a very simple economy we have one person and this person goes out each day and they collect mushrooms from a piece of land which they know of and they know of no other pieces of land within this economy and they know of no other people within this economy but they go out each day and they look for mushrooms and they pick mushrooms and if they get up at nine in the morning and they come back at five in the evening when it begins to get dark they can pick one mushroom per day now if they go out very very early about four o’clock and they come back at 12 midnight they can collect two mushrooms but they start to feel tired they start to feel like they can’t concentrate during the day so they decide that although they can produce to the right of their long-run aggregate supply which is their sustainable long-term output level they may only do it every now and then to collect extra mushrooms but generally speaking if they do do that they will start to get tired and they’ll fall back to their long run aggregate supply level and they’ll go back to just picking mushrooms between nine and five now one day this person solves a bit of a problem because when they go out picking mushrooms one of the issues they actually have is they do not know which ones they can eat and which ones are poisonous they know some mushrooms are bad and they don’t really have a very good way of defining which ones are edible and which ones would be bad to eat or would be poisonous to them and one day they solved this problem by inventing a tool and this tool actually helps them to detect whether the mushroom is poisonous or is edible now by utilizing this tool instead of just going off of their own knowledge of which mushrooms they can and can’t eat they are able to collect two mushrooms every single day between the hours of nine and five so their long-run aggregate supply actually shifts to the right because of the increase here in the quantity of capital they go from none to one now after a while they work on this and what they find is they can make this slightly better and there is an increase in the quality of the capital being used and this tool actually gets slightly better and between the hours of nine and five this person can now collect not one not two but three mushrooms so because of an increase in the quantity of capital the long-run aggregate supply so the sustainable level of output rose from one to two and because of an increase in the quality of that capital their long-run aggregate supply actually increased from two to three so this person goes out each day now with their new tool their upgraded version and they can collect three mushrooms quite comfortably between the hours of nine and five and that is on the piece of land that they have now one day they actually discover a new piece of land and they can’t really believe it it’s exactly the same as the previous piece of land the same size and it also seems to have the same number of mushrooms growing on it so by an increase in the quantity of land instead of now being able to pick three mushrooms between the hours of nine and five in a sustainable way they can pick six because they can pick three more on the second piece of land so he says to himself this is great i can now pick three mushrooms on this piece of land and three mushrooms on this piece of land however he encounters a slight problem when he goes to the second piece of land after harvesting his first three mushrooms he finds that it’s taking him all day already to pick three mushrooms on the first piece of land so when he picks the three mushrooms on the second piece of land he starts to work unsustainably so his long-run aggregate supply is still three but in the short term if he works super hard through the night he can pick six but this is not sustainable so he goes back to just picking three on his first piece of land then one day out of the blue another person turns up

and they arrive and the first person says to them okay would you be able to help me picking mushrooms on the second piece of lamb because i do not have the time to pick mushrooms on both it takes up all my time picking these three mushrooms and what i’m going to do is i’m going to be able to build you this tool to help you go and pick mushrooms but the tool is going to take six months to build so in the meantime if you could just go each day and pick one up that would be fantastic so the second person goes and they start to pick up one mushroom each day and therefore every single day this entire economy with an increase now in the quantity of labor the long run aggregate supply of this entire economy goes from three to four so every single day four mushrooms can be baked on both pieces of land for the first six months after six months a tool is made finally for the second person and this person can now immediately go and start collecting three mushrooms because there is no intermediate stage here because there was already an upgraded version of this so now because of an increase in the quantity of capital from one to two the long-run aggregate supply so the output of this economy sustainably so between the hours of nine and five nobody gets tired has now risen to six mushrooms overall now after a while of this person number one has actually been doing this for quite a long time and their skill of picking mushrooms increases so although there is no additional land and there is no additional capital this person becomes better at picking mushrooms and they are able to produce four mushrooms in a day instead of three so now because of an increase in the quality of labor

the long run aggregate supply has actually shifted to the right for this economy once again because overall now the output sustainable output of this small economy becomes seven mushrooms per day now all of the experience this first person has actually learnt can be quickly passed on to the second person so he goes and explains to the second person exactly what he’s doing to pick four mushrooms instead of three this person then becomes skilled also in what they’re doing there’s an increase in the educational standards here and he can now pick four mushrooms and the overall output of this economy becomes eight so the long run aggregate supply has shifted to the right once again because of an increase in the quality of labor now finally we actually have another person arrive and this person is an old lady and this old lady sees what they’re doing and she says to them you know you guys are just a couple of young guys and i know you’ve been doing this for a while but from where i come from we pick mushrooms and i think i can actually create a strategy for you guys to do this better because i don’t think you’re looking in all the right places so what i’m going to do is if you come with me i’m going to organize you as a team and i’m going to tell you exactly where to go and what mushrooms to pick and i’m going to show you the best places to pick these mushrooms so you can become more efficient in what you’re doing she has the ability to combine all of these factors of production from the labor the capital and the land in order to produce more than just eight mushrooms per day with her help they can produce 10. so now the long-run aggregate supply curve of this economy has shifted once again to the right and it stands at 10 mushrooms per day because of now the introduction of an entrepreneur who can more efficiently combine all of the factors of production to produce a better overall result so now in order to think of a shift to the left so a decrease in aggregate supply we can just simply do the reverse perhaps the old lady has had enough because she feels like these people are not really listening to what she’s saying and she could be getting 12 mushrooms a day but she’s only getting 10 because they’re not really listening to her so she decides to leave and long run aggregate supply declines because of this from 10 back to 8. now the second person here feels bit disillusioned with this they came afterwards they haven’t been here for so long and perhaps they’re feeling a little bit homesick now so they destroy their tool and they say to the first person i’m really not interested in doing this anymore and uh hopefully you’ll understand but i’m gonna go back to where i came from so the second person leaves and there is a reduction in the quantity of labor so there is already a reduction in entrepreneurship there is now a reduction in the quantity of labor and as a result the second piece of land which is not being worked becomes overgrown and is unusable so there becomes a reduction in the quantity and quality of land and this again shifts the long run aggregate supply curve to the left so where we started out with 10 mushrooms this person now really can only collect three mushrooms per day in a sustainable way between the hours of nine and five now this person at this point is a little bit older and they’re starting to age and their motor skills and their memory are starting to fade a bit and because of this because of this diminishing of the quality of the labor here they actually now can only collect two mushrooms per day they only really have the ability to do that and finally just to take this to its final conclusion the original worker he’s been using this tool for a long long time and eventually it breaks and he has no way of repairing this so he has to go back to just picking by hand the one mushroom per day so once again the long run aggregate supply curve shifts to the left because the most amount of output that can be produced in this economy now by this one person on this one piece of land sustainably between the hours of nine to five is one mushroom

so the key takeaway is really that if the factors of production are increasing in quality or quantity this is going to shift the long run aggregate supply curve to the right if the factors of production are decreasing in quantity and quality this is going to shift the long run aggregate supply curve to the left so if we look up here on the right hand side we have gdp per capita you can see that this actually relates directly to the efficiency in the productivity so increases and decreases in efficiency and productivity gdp per capita when you think about it is essentially output per person this is actually quite a good way of measuring in an economy not absolutely gauging as a scientific fact but as an indication of the direction of the long run aggregate supply curve is to look at gdp per capita if you look down here in the right hand side you can see a chart of u.s gdp per capita and ukrainian gdp per capita you can see there is a sharp dip in ukrainian gdp per capita this is actually reflective of a decrease in long run aggregate supply so you start to see this decline in the output per person this is reflective generally speaking of fundamental structural problems within the economy and these are longer term issues generally speaking because we are seeing a decrease in productivity and conversely if you see gdp per capita increasing which very often economies certainly monetary authorities and governments want to see a consistent uptrend in gdp per capita this is an indication once again of potential shifts to the right in long run aggregate supply so when you’re making your macro analysis gdp per capita is a very good measurement that you can put into your toolbox when assessing structural supply and productivity within the economy