Last night I got into a heated discussion over the slope of the LRAS curve. The shocking thing was that it was the most excitement I’ve had all week.
Now, before my dear readers haze me for inappropriate acronym usage: Long Run Aggregate Supply.
The key to understanding some of the practice questions in the CFA curriculum is the assumption that the LRAS curve is vertical (slope is infinite). I’m game for that. Long-term growth in real GDP would then be represented by parallel shifts to the right, by some amount equal to increased worker productivity (increase in technology, skills), mobility, and population. Oversimplified… but intuitive, right? To take it a step further…. in equity valuation exercises, finance geeks often use 3% for ‘g’: the rate of long-term growth in the economy, and this rate is used in the perpetuity calculations. In the long run, it is difficult to make a case for any firm’s revenue growth to exceed ‘g’.
Complete flexibility in prices (factor prices, price levels) and the notion that there is a finite limit to the aggregate supply of an economy (in the long run, at full employment) are concepts that contribute to the infinite slope theory. But you might argue some other possibilities, namely the Keynesian view.
In this model, LRAS starts out horizontal, curves and ends up vertical at maximum full-employment output. The idea here is that, when we’re below the maximum full-employment level of output, an increase in demand will not cause inflationary pressure. Hey, that sounds reasonable too, doesn’t it?
But we’re splitting hairs. In my opinion, the argument centres on the time period considered. What if there is a “medium-run”? We could have a “medium-run” supply curve with a Keynesian shape, and argue that in the long run, in a free market by definition, equilibrium is reached at the maximum output at full employment.
I’ll stop while I’m ahead.
