Long-Run Consensus Macroeconomic Theory

- Why Should I Care?

Comparing actual production levels to the full potential of our economy is useful to understand whether or not the government should intervene to create jobs, or to stem inflation.

- This Lecture Has 5 Parts

• What is the Long-Run?
• Long-Run AD
• Long-Run AS
• Explaining Recessions
• Explaining Over-Heating

- What is a Long-Run Macroeconomic Theory?

We will add the potential output to the AD-AS model. This helps to benchmark the economy’s actual production levels, and guide government intervention.

• What is the Long-Run?

The “run” refers to a theoretical framework where variables may or may not be changed (James, 2011: 224). This has nothing to do with short-term, or long-term, concepts, which refer to a time frame.

In the short-run, most variables are fixed, such as physical capital (buildings, machines), and land (minerals, energy). One variable is not fixed: labour. The only way to increase production is to hire more workers, or have them work more hours. When you decrease production, labour gets fired, but not the machines.

In the long-run, none of the variables are fixed. The economy’s resources are optimally allocated in order to maximize production, without over-using them. When you increase production, you increase all the factors of production, including labour, and capital.

Definitions

Short-run
A modelling format where some variables are fixed, and others may vary. Usually, physical capital is fixed, while labour costs are variable.

Long-run
A modelling format where all variables may vary, including physical capital.

Short-term
A time-frame that is short, such as 6 months, or less than 2 years.

Long-term
A time-frame that is long, such as more than 20 years.

• Long-Run AD

In the long-run, there is no reason to believe that inflation would not affect people’s real consumption. Inflation will always reduce purchasing power. Therefore, the aggregate demand curve keeps its’ position and shape as a downward sloping curve. Long-run AD is the same as short-run AD.

If the 3 curves intersect, you have hit the Macroeconomic Sweet Spot.

• Long-Run AS

In the long-run, the supply scenario is different. Inflation does not affect the productive capacity of an economy.

For this reason, the aggregate supply curve is vertical. This is because the long-run AS curve represents a situation of full employment when production is at full capacity. In this situation, output is fixed at the optimal level, no matter what the price level is. This concept is the same idea as the Production Possibility Curve. Long-run AS is useful in showing the difference between the actual level of production in the economy and its capacity.

Factors that affect short-run Aggregate Supply will also shift the LR-AS curve. However, the difference is that these shifts need to be permanent in nature. For example, an increase in population, radical technological change, or an increase in the Participation Rate (Women entering the Labour Force), will shift both SR-AS, and LR-AS to the right. Economists usually posit that an increase in taxes which is perceived as permanent by the population will have a negative impact on LR-AS.

Economists believe the LR-AS curve is constantly shifting to the right because of constant innovation, and population growth. This makes the “sweet spot” a moving target. Economic growth, as opposed to business cycles, is thus a long-run phenomenon. In this way, LR-AS is another way of expressing ideas in the productions possibility frontier model. When technology and capacity increase, so does the productive potential of an economy. Given the importance of environmental issues, growth has become a critical issue. It may be possible to keep growing the economy in monetary terms, but not in physical terms, since the earth's resources are becoming depleted by over-population and over-consumption.

The short-run AS curve can “outproduce” the long-run potential. This is because in the short-run, producers can over-use their resources, by asking workers to work overtime, or by excessively using machines. This is not deemed “optimal” in the long-run, and can be dubbed as “stretching the elastic”.

The Long-Run Aggregate Supply curve is vertical because it represents a situation of full-employment, when production is at optimal capacity, no matter what the price level is.

Long-Run Model

• Definitions
  1. Long-Run: no variables are fixed.
  2. Potential output is a function of the quantity and quality of

• Assumptions
  1. It is possible to calculate potential output.
  2. None of the resources are idle.

• Hypotheses
  1. Over-production is not sustainable in the long-run.

• Predictions
  1. Producing more than potential is inflationary.
  2. Producing less than potential is recessionary.

• Principles

Positive:
Aggregate supply increases are deflationary.
Aggregate demand increases are inflationary.
Insufficient aggregate demand creates a stable output gap and associated surplus of labour.

Normative:      
(Left-wing)
Government should use its borrowing power to stimulate the economy if there is a recessionary output gap.

(Right-wing)
Government should beware its interventions are usually inflationary in the short-run.
In the long-run, government intervention should focus on helping to increase productive capacity (physical capital, labour, land) and aggregate supply.

• Explaining Recessions

Actual production represents the equilibrium of AD and AS. When actual production also equals long-run potential, the economy is at full-employment. This is what we call the “sweet spot”. However, when the short-run equilibrium is inferior to potential, we call this a recession. Surpluses in resource markets will soften price levels.

Note: the Long-Run AS curve is a very theoretical position, and represents a “benchmark”, to be kept in mind, in the background.

Graph - Government Intervention Attempts to Bring AD Back to Potential

As you can see on the graph, an 80 B$ stimulus program (using a multiplier of 5) won't be enough to fill the output gap cause by a recession. This said, the gap is now much narrower and manageable.

• Explaining Over-Heating

During an expansion phase, increased demand generates more production and higher prices. When this creates jobs, the economy is doing its job. But when AD is expanding too much, past potential output, this added spending will be inflationary, creating shortages in resource and product markets. Too much spending can be caused by consumers, investors, governments, or foreign demand (exports).

Graph - An Over-Heating Economy

An over-heating economy is when GDP has grown larger than Potential GDP. This can be inflationary, as you can see on the graph above. Remember that potential GDP is characterized here by Long-Run AS (yellow curve).

- Wrap-Up

In the long-run, the economy is producing at optimal, full-potential output, at full-employment.

Having this benchmark helps to compare actual production levels to the desired level of production. If we are under-producing, we will have unemployment. If we produce too much, prices will rise too high.

In the short-run, keep in mind that suppliers can stretch the elastic and produce more than potential.

The long-run potential is constantly growing because of innovation and population growth. This makes the “sweet spot” a moving target.

- Cheat Sheet with Memory Helper

Short-Run:
A theoretical framework where most variables are fixed, such as wages and capital.

Long-Run:
A theoretical framework where all variables are not fixed. LRAS represents potential output when resources are not idle.

- References and Further Reading

Blanchard, O. (2009). The State of Macro. Annual Review of Economics. Vol. 1, pp. 209-228 (20 pages)

Jones, C. I. (2020). The End of Economic Growth? Unintended Consequences of a Declining Population. NBER Working Paper.