Real GDP and the Price Level in the Long Run: Study Notes

Real GDP and the Price Level in the Long Run

Introduction

This chapter explores the relationship between real GDP and the price level in the long run, focusing on the concepts of aggregate supply and aggregate demand. It uses real-world examples, such as Iceland's resource endowments, to illustrate how economic growth affects a nation's productive capacity and equilibrium price level.

10.1 Output Growth and the Long-Run Aggregate Supply Curve

The aggregate supply represents the total planned production for the economy. The long-run aggregate supply (LRAS) curve is a vertical line indicating the real output of goods and services after full adjustment has occurred, reflecting the economy's real GDP under full employment.

• LRAS is vertical: Input prices fully adjust to changes in output prices, suppliers have no incentive to increase output, and unemployment is at the natural rate.

• Determinants of LRAS: Endowments (resources, including physical and human capital) and technology.

• Base-year dollars: The value of a current sum expressed in terms of prices in a base year.

• Growth: Outward shifts of the production possibilities curve or LRAS curve are caused by population growth, capital accumulation, and technological improvements.

Example: Iceland's abundance of geothermal steam and cool climate has increased its LRAS by attracting data centers and boosting productive capacity.

10.2 Total Expenditures and Aggregate Demand

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

• Why AD slopes downward:

  • Real-balance effect (Wealth effect): Changes in the real value of money balances affect expenditures.

  • Interest rate effect: Higher price levels increase interest rates, reducing borrowing and spending.

  • Open economy effect: Higher price levels reduce net exports as foreigners buy fewer domestic goods and residents buy more foreign goods.

• AD vs. demand for a single good: AD considers total planned expenditures for all goods and services, while a demand curve focuses on a single market.

• Shifts in AD: Any non-price-level change that increases aggregate spending shifts AD right; decreases shift AD left.

Example: A tax reduction and improved economic security both increase AD, shifting the curve rightward.

Table: Determinants of Aggregate Demand

Determinant	Effect on AD
Consumer confidence	Increase shifts AD right
Government spending	Increase shifts AD right
Tax reductions	Increase shifts AD right
Interest rates	Increase shifts AD left
Foreign demand	Increase shifts AD right
Additional info: Table entries inferred from standard macroeconomic determinants.

10.3 Long-Run Equilibrium and the Price Level

Long-run equilibrium occurs where the AD curve crosses the LRAS curve. The price level adjusts so that total planned real expenditures equal actual real GDP.

• Economic growth and price level: If AD is stationary during growth, LRAS shifts right, and the equilibrium price level falls (secular deflation).

• Secular deflation: Persistent decline in prices due to economic growth with stable AD.

• Avoiding secular deflation: If AD shifts outward as much as LRAS, the price level remains constant. Increasing the money supply can shift AD outward.

Example: The "Eurozone" experienced low inflation due to slower money supply growth and faster real GDP growth, shifting LRAS rightward.

10.4 Causes of Inflation

Inflation can result from supply-side or demand-side factors.

• Supply-side inflation: Caused by a decline in LRAS (e.g., reduced labor force participation, higher marginal tax rates).

• Demand-side inflation: Occurs when AD increases faster than LRAS, raising the price level.

Example: Turkey's rapid economic growth and high money supply growth led to AD shifting outward faster than LRAS, causing inflation.

Applications and International Examples

• Japan: Reducing work hours to increase productivity and LRAS.

• Iceland: Cool climate and geothermal steam have shifted LRAS rightward, increasing equilibrium price level.

Summary of Learning Objectives

• Long-run aggregate supply: Vertical at full employment; growth shifts LRAS outward.

• Aggregate demand: Slopes downward due to real-balance, interest rate, and open economy effects; shifts with non-price-level changes.

• Long-run equilibrium: Price level adjusts to equate planned expenditures and real GDP; growth can cause deflation if AD is stable.

• Persistent inflation: Caused by declining LRAS or AD growth outpacing LRAS growth.