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

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. Using real-world examples such as Iceland's economic growth, the chapter illustrates how resource endowments and technological advancements can shift an economy's productive capacity.

Learning Objectives

• Discuss the concept of long-run aggregate supply (LRAS) and describe the effect of economic growth on the LRAS curve.

• Explain why the aggregate demand (AD) curve slopes downward and identify 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.

• Assess 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 total quantity of goods and services that firms are willing and able to produce at different price levels.

• Long-run aggregate supply (LRAS) curve: 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, where the economy is on its production possibilities curve (PPC).

• The LRAS is determined by the economy's endowments (resources such as labor, capital, land, and technology).

Key Properties of the LRAS Curve

• The LRAS curve is vertical because input prices fully adjust to changes in output prices, so suppliers have no incentive to increase output beyond full employment.

• Unemployment is at its natural rate on the LRAS.

• Economic growth shifts the LRAS curve outward, indicating an increase in the economy's productive capacity.

Determinants of Economic Growth (Shifts in LRAS)

• Growth of population and labor force participation rate

• Capital accumulation (investment in physical capital)

• Improvements in technology

Example: Iceland's Economic Growth

Iceland's abundant geothermal resources and cool climate have attracted data centers, increasing the nation's LRAS and real GDP.

Figure: Production Possibilities Curve and LRAS

Panel (a) shows the PPC, representing the maximum possible output combinations of two goods. Panel (b) shows the LRAS as a vertical line at the full-employment level of real GDP.

Total Expenditures and Aggregate Demand

Aggregate Demand

Aggregate demand (AD) is the total of all planned expenditures in the entire economy. The AD curve shows the 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 consumer spending.

• Interest rate effect: Higher price levels increase the demand for money, raising interest rates and reducing investment and consumption.

• Open economy effect: Higher domestic price levels make exports less attractive and imports more attractive, reducing net exports.

Shifts in the AD Curve

• Any non-price-level change that increases aggregate spending (on domestic goods) shifts AD to the right.

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

Comparison: Aggregate Demand vs. Demand for a Single Good

• The AD curve represents total planned expenditures on all goods and services in the economy.

• A demand curve for a single good represents planned purchases in one market only.

Table: Determinants of Aggregate Demand

Changes That Cause an Increase in Aggregate Demand	Changes That Cause a Decrease in Aggregate Demand
Increase in the amount of money in circulation	Decrease in the amount of money in circulation
Increased security about jobs and future income	Decreased security about jobs and future income
Improvements in economic conditions in other countries	Declines in economic conditions in other countries
Reduction in real interest rates (not due to price level changes)	Rise in real interest rates (not due to price level changes)
Tax decreases	Tax increases
Decrease in the foreign exchange value of the dollar	Increase in the foreign exchange value of the dollar

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, and the economy is at full employment.

Effects of Economic Growth on the Price Level

• Secular deflation: A persistent decline in prices resulting from economic growth when aggregate demand is stable. As LRAS shifts rightward, the equilibrium price level falls.

• If the AD curve shifts outward by the same amount as the LRAS curve, the price level remains constant.

Example: The Eurozone

Low inflation in the Eurozone has been attributed to slower growth in the money supply and faster growth in real GDP, shifting LRAS rightward.

Causes of Inflation

Supply-Side Inflation

Inflation can result from a leftward shift in the LRAS curve, often caused by reductions in labor force participation or higher marginal tax rates on wages. This type of inflation is known as supply-side inflation.

Demand-Side Inflation

When aggregate demand increases faster than long-run aggregate supply, the price level rises. This is known as demand-side inflation.

Example: Turkey's Economy

Turkey experienced rapid real GDP growth and high inflation due to a fast-growing money supply, which shifted the AD curve outward faster than the LRAS curve.

Summary of Key Concepts

• The long-run aggregate supply curve is vertical at the full-employment level of real GDP, and economic growth shifts this curve outward.

• The aggregate demand curve slopes downward due to the real-balance, interest rate, and open economy effects, and shifts in response to non-price-level changes.

• Long-run equilibrium is achieved when total planned expenditures equal actual real GDP at the intersection of AD and LRAS.

• Persistent inflation can result from a decline in LRAS or when AD grows faster than LRAS.

Key Formulas and Equations

• Aggregate Demand (AD): $AD = C + I + G + (X - M)$ Where $C$ = Consumption, $I$ = Investment, $G$ = Government Spending, $X$ = Exports, $M$ = Imports.

• Real GDP (Y): $Y = f(L, K, T)$ Where $L$ = Labor, $K$ = Capital, $T$ = Technology.