Output Growth, Aggregate Supply, and Aggregate Demand in Macroeconomics

Output Growth and the Long-run Aggregate Supply Curve

Concept of Long-run Aggregate Supply (LRAS)

The long-run aggregate supply curve (LRAS) represents the total real output of goods and services that an economy can produce when all resources are fully employed and all adjustments have occurred. It is a key concept in understanding the productive capacity of an economy over time.

• Aggregate supply is the total of all planned production for the economy.

• Production Possibilities Curve (PPC) shows the maximum output combinations of goods and services that can be produced when resources are fully employed.

• The sum total of the inflation-adjusted value of all final goods and services is the nation's real GDP.

The Long-run Aggregate Supply (LRAS) Curve

The LRAS curve is a vertical line, indicating that in the long run, the economy's output is determined by its resources and technology, not by the price level.

• LRAS represents the real output of goods and services after full adjustment has occurred.

• It is also viewed as representing the real GDP of the economy under conditions of full employment.

• The position of LRAS is determined by the nation's base resources and technological capabilities.

• When resources are fully employed, the economy produces at its potential GDP.

• Because input prices and information adjust fully in the long run, LRAS is vertical.

The LRAS Curve and Full-Employment Real GDP

The LRAS curve occurs at the full-employment level of real GDP, which is consistent with the natural rate of unemployment (frictional and structural unemployment).

• When the economy reaches full employment along its PPC, no further adjustments occur unless other variables change.

• The LRAS curve is at the level of real GDP consistent with the natural rate of unemployment.

Why the LRAS Curve is Vertical

In the long run, all factors of production and input prices can change, and everyone has full information. Thus, the LRAS curve is vertical, reflecting that output is independent of the price level in the long run.

• All input prices, including wages, can adjust.

• Full adjustment to price level changes occurs.

Economic Growth and Long-run Aggregate Supply

Determinants of Growth in Per Capita Real GDP

Economic growth is driven by increases in labor, capital, and productivity. These factors shift the production possibilities curve outward and increase the economy's potential output.

• Annual growth rate of labor

• Rate of year-to-year capital accumulation

• Rate of growth of productivity of labor and capital

• As labor force participation rates rise or technology improves, the PPC shifts outward.

• Aggregate real GDP and per capita real GDP increase.

• LRAS shifts outward to the right of the original LRAS curve.

In a growing economy, the LRAS curve shifts farther to the right over time, resulting in an upward trend in real GDP growth.

Total Expenditures and Aggregate Demand

Aggregate Demand (AD) and Its Components

Aggregate demand is the total of all planned expenditures in the entire economy. The aggregate demand curve (AD) shows the various quantities of all final commodities demanded at different price levels, holding other things constant.

• GDP is the dollar value of total expenditures on domestically produced final goods and services.

• The total value of these expenditures is determined by the spending decisions of individuals, firms, and governments.

• An open economy includes foreign individuals, firms, and governments.

Components of GDP (Aggregate Demand)

• Consumption spending

• Investment expenditures

• Government purchases

• Net foreign demand for domestic production

Measured by government statisticians, aggregate demand gives the total amount, measured in base-year dollars, of real domestic final goods and services that will be purchased at each price level.

Depicting the Aggregate Demand Curve

The aggregate demand curve (AD) slopes downward, indicating an inverse relationship between the price level and the quantity of real GDP demanded.

• The higher the price level (measured by the GDP deflator), the lower the total real amount of final goods and services demanded.

• The lower the price level, the higher the total real GDP demanded.

What Happens When the Price Level Rises?

If the price level increases, the total quantities of real goods and services demanded fall. Consumers do not simply substitute one good for another; economy-wide effects cause aggregate demand to decrease.

Reasons for Downward Slope of AD Curve

1. The real-balance effect

2. The interest rate effect

3. The open economy effect

The Real-Balance Effect

The change in expenditures resulting from a change in the real value of money balances when the price level changes, all things being held constant. Also called the wealth effect.

• The amount of money people have influences the amount of goods and services they want to buy.

• If the price level rises, the real value of cash balances falls, reducing planned expenditures.

The Interest Rate Effect

Higher price levels increase the interest rate, which in turn causes businesses and consumers to reduce desired spending due to the higher cost of borrowing.

• Higher interest rates raise borrowing costs for consumers and businesses.

• They will borrow less and spend less.

• An increase in price level tends to reduce total planned spending.

The Open Economy Effect

A higher price level induces foreign residents to buy fewer US-made goods and US residents to buy more foreign-made goods, thereby reducing net exports and decreasing the amount of real goods and services purchased in the US.

• Net exports is the difference between exports and imports.

• An increase in the price level in the US makes US goods more expensive relative to foreign goods.

• Foreign residents buy fewer US goods; US residents buy more foreign goods.

• Result: fall in exports, rise in imports, and reduction in real GDP demanded.

What Happens When the Price Level Falls?

The lower the price level, the greater the total planned spending on goods and services. The AD curve shows the quantity of aggregate output that will be demanded at alternative price levels.

• The higher the price level, the lower the real amount of total planned expenditures, and vice versa.

Demand for All Goods and Services versus Demand for a Single Good or Service

Aggregate demand differs from demand for a single good because it refers to total planned expenditures on all goods and services.

Shifts in the Aggregate Demand Curve

Non-Price-Level Determinants of Aggregate Demand

Anytime a non-price-level determinant of demand for all items changes, the aggregate demand curve shifts inward (to the left) or outward (to the right).

Factors that Increase Aggregate Spending (Shift AD to the Right)

• An increase in the amount of money in circulation

• Increased security about jobs and future income

• Improvement in economic conditions in other countries

• A reduction in real interest rates (nominal interest rates corrected for inflation) not due to price level changes

• Tax decreases

• A drop in the foreign exchange value of the dollar

Factors that Decrease Aggregate Spending (Shift AD to the Left)

• A decrease in the amount of money in circulation

• Decreased security about jobs and future income

• Declines in economic conditions in other countries

• A rise in real interest rates (nominal interest rates corrected for inflation) not due to price level changes

• Tax increases

Summary Table: Key Differences Between LRAS and AD

Feature	Long-run Aggregate Supply (LRAS)	Aggregate Demand (AD)
Shape	Vertical	Downward sloping
Determined by	Resources, technology, full employment	Price level, spending decisions, wealth, interest rates, foreign trade
Shifts caused by	Changes in resources, technology, productivity	Changes in money supply, confidence, interest rates, taxes, foreign conditions
Relationship to price level	Independent in the long run	Inverse relationship