Real GDP and the Price Level in the Long Run: Aggregate Supply, Aggregate Demand, and Inflation

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Introduction

Overview of Long-Run Macroeconomic Concepts

This chapter explores the relationship between real GDP and the price level in the long run, focusing on the effects of changes in aggregate supply and aggregate demand. Real-world examples, such as permafrost melting in Russia, illustrate how changes in productive capacity can impact economic outcomes.

Real GDP: The inflation-adjusted value of final goods and services produced in an economy.
Long-run aggregate supply (LRAS): The total output an economy can produce when all resources are fully employed.
Aggregate demand (AD): The total planned expenditures in the economy.

Learning Objectives

Discuss the concept of long-run aggregate supply and describe the effect of economic growth on the LRAS curve.
Explain why the aggregate demand curve slopes downward and list key factors that cause this curve to shift.
Evaluate the meaning of long-run equilibrium for the economy and explain why economic growth can cause deflation.
Evaluate likely reasons for persistent inflation in recent decades.

Chapter Outline

Output Growth and the Long-Run Aggregate Supply Curve
Total Expenditures and Aggregate Demand
Long-Run Equilibrium and the Price Level
Causes of Inflation

Output Growth and the Long-Run Aggregate Supply Curve

Aggregate Supply

Aggregate supply is the total of all planned production for the economy. It represents the maximum output that firms are willing and able to produce at different price levels.

Long-Run Aggregate Supply (LRAS) Curve

The LRAS curve is a vertical line representing the real output of goods and services after full adjustment has occurred.
It shows the real GDP of the economy under conditions of full employment (on the production possibilities curve).

Key Properties of the LRAS Curve

Determined by technology and resource endowments.
Represents the full-employment level of real GDP.
Input prices have fully adjusted to changes in output prices.
Suppliers have no incentive to change output at this level.

Factors Affecting Long-Run Aggregate Supply

Growth rate of labor
Capital accumulation
Growth of productivity of labor and capital
Growth of population
Labor force participation rate
Improvements in technology

Example: Artificial Intelligence and LRAS

Widespread adoption of AI could significantly increase world aggregate supply, potentially raising global GDP by trillions of dollars annually.

Figure 10.1: Production Possibilities Curve and LRAS

Panel (a) shows the production possibilities curve (PPC), while Panel (b) illustrates the vertical LRAS curve at full employment real GDP.

Total Expenditures and Aggregate Demand

Aggregate Demand (AD)

Aggregate demand is the total of all planned expenditures in the entire economy.
The aggregate demand curve (AD) shows planned purchase rates for all final goods and services at various price levels, holding other factors constant.

Why the AD Curve Slopes Downward

Real-balance effect (wealth effect): As the price level rises, the real value of money balances falls, reducing expenditures.
Interest rate effect: Higher price levels increase interest rates, reducing spending due to higher borrowing costs.
Open economy effect: Higher price levels make domestic goods more expensive for foreigners and foreign goods more attractive to residents, reducing net exports.

Comparison: Aggregate Demand vs. Demand for a Single Good

Aggregate demand refers to total planned expenditures on all goods and services.
Demand for a single good refers to quantity demanded at different prices for that specific good.

Shifts in the Aggregate Demand Curve

Any non-price-level change that increases aggregate spending shifts AD to the right.
Any non-price-level change that decreases aggregate spending shifts AD to the left.

Table: Determinants of Aggregate Demand

Causes of Increase in AD	Causes of Decrease in AD
Increase in money in circulation	Decrease in money in circulation
Increased job/income security	Decreased job/income security
Improvements in foreign economic conditions	Declines in foreign economic conditions
Reduction in real interest rates	Rise in real interest rates
Tax cuts	Tax increases
Rise in foreign exchange value of the dollar	Fall in foreign exchange value of the dollar
Additional info: Nominal interest rates corrected for inflation not due to price level changes	Additional info: Nominal interest rates corrected for inflation not due to price level changes

Long-Run Equilibrium and the Price Level

Long-Run Equilibrium

Long-run equilibrium occurs at the price level where the aggregate demand curve intersects the long-run aggregate supply curve (LRAS). At this point, total planned real expenditures equal actual real GDP.

Effects of Economic Growth on the Price Level

Secular deflation: A persistent decline in prices resulting from economic growth with stable aggregate demand.
If LRAS increases and AD remains constant, the price level falls.
If AD shifts outward by the same amount as LRAS, the price level remains constant (long-run price stability).

Figure: Secular Deflation vs. Price Stability

Panel (a) shows secular deflation with a stationary AD curve and rightward-shifting LRAS. Panel (b) shows price stability when both AD and LRAS shift rightward together.

Causes of Inflation

Supply-Side Inflation

Arises from a decline in long-run aggregate supply (leftward shift of LRAS).
Causes include reductions in labor force participation, higher marginal tax rates, and government benefits that discourage labor supply.

Demand-Side Inflation

Arises from an increase in aggregate demand (rightward shift of AD).

International Example: Inflation in Argentina

Argentina experienced high inflation due to rapid growth in the money supply, causing AD to shift outward much faster than LRAS.

Summary of Key Learning Objectives

1. Long-Run Aggregate Supply and Economic Growth

LRAS is vertical at full-employment real GDP.
Economic growth shifts the production possibilities curve and LRAS rightward.

2. Aggregate Demand Curve and Its Shifts

AD slopes downward due to real-balance, interest rate, and open economy effects.
AD shifts with autonomous changes in planned expenditures.

3. Long-Run Equilibrium and Deflation

Long-run equilibrium is where AD intersects LRAS.
Economic growth with stationary AD leads to secular deflation.

4. Persistent Inflation

Persistent inflation is more likely when AD grows faster than LRAS.

Key Equations

Real GDP (Y):
Aggregate Demand:
Long-Run Equilibrium:

Additional Info

Technological advances (e.g., AI, nuclear fusion) can shift LRAS rightward, increasing productive capacity and real GDP.
Infrastructure damage (e.g., permafrost melting) can slow LRAS growth, leading to higher price levels if AD continues to rise.