Slides by Alex Stojanovic

1. ECONOMICS ELEVENTHEDITION LIPSEY & CHRYSTAL Chapter 19 GDP AND THE PRICE LEVEL IN THE LONG RUN Slides by Alex Stojanovic

2. Learning Outcomes • Output gaps will stimulate changes in both output and input prices • If actual output is greater than potential output, there is an inflationary gap associated with a high level of activity and a tendency for the price level to rise • If actual output is less than potential output, there is a recessionary gap associated with low levels of activity and a tendency for the price level to fall • The long-run aggregate supply curve is vertical at the level of potential output • Economic growth determines the position of the long-run aggregate supply curve • Shocks to aggregate demand and aggregate supply are associated with business cycles • In principle, fiscal and monetary policies can stabilize cycles and keep GDP close to its potential level

3. Actual GDP, Potential GDP and the Output Gap Price Level Price Level Y* Real GDP Y* Real GDP [i]. A Recessionary Output Gap [ii]. An Inflationary Output Gap

4. Output Gap Output Gap Actual GDP, Potential GDP and the Output Gap SRAS SRAS E0 E0 Price Level Price Level AD AD Y0 Y1 Y* Real GDP Y* Real GDP [i]. A Recessionary Output Gap [ii]. An Inflationary Output Gap

5. Actual GDP, Potential GDP and the Output Gap • The output gap is the difference between potential GDP, Y* and actual GDP. • Potential GDP is shown as a vertical line. • Actual GDP is determined by the intersection of AD and SRAS. • If actual GDP is below potential there is a recessionary gap. • If actual GDP is above potential there is an inflationary gap.

6. Demand-shock Inflation SRAS0 SRAS0 Price Level Price Level E0 P0 P0 E0 AD0 AD0 Y* Y* Real GDP Real GDP [ii]. Induced shift in aggregate supply [i]. Autonomous increase in aggregate demand

7. Price Level Rises further Price Level Rises Inflationary Gap Opens Inflationary gap eliminated Demand-shock Inflation SRAS1 SRAS0 SRAS0 Price Level Price Level E2 E1 E1 P2 P1 P1 E0 AD1 P0 AD1 E0 AD0 AD0 Y* Y1 Y* Y1 Real GDP Real GDP [ii]. Induced shift in aggregate supply [i]. Autonomous increase in aggregate demand

8. Demand-shock inflation • A rightward shift of the AD curve first raises prices and output along the SRAS curve. • It then induces a shift of the SRAS curve that further raises prices but lower output along the AD curve. • In part (i) the AD curve shifts from AD0 to AD1 and the economy moves from E0 to E1. • In part (ii) the SRAS curve shifts left and the economy moves from E1 to E2.

9. 1 Demand-shock Deflation With Flexible Wages SRAS0 SRAS0 Price Level Price Level E0 E0 P0 AD0 AD1 Y* Real GDP Real GDP [i]. Autonomous Fall in Aggregate Demand [ii]. Induced Shift in Aggregate Supply

10. Price Level Falls 2 Price Level Falls Further Recessionary Gap Eliminated Recessionary Gap Opens Demand-shock Deflation With Flexible Wages SRAS0 SRAS0 SRAS1 Price Level Price Level 1 E0 E0 P0 E1 E1 P1 P1 AD0 E2 AD1 AD1 Y* Y1 Y1 Y* Real GDP Real GDP [i]. Autonomous Fall in Aggregate Demand [ii]. Induced Shift in Aggregate Supply

11. Demand-shock Deflation With Flexible Wages • A leftward shift of the AD curve first lowers prices and output along the SRAS curve as in the move 1. • Then it induces a slow shift of the SRAS curve to the right that further lowers prices but raises output along the AD curve. • The economy initially moves from E0 to E1 as in move 1. • It then moves slowly from E1 to E2 as in move 2.

12. The Long-run Aggregate Supply [LRAS] Curve LRAS Price Level 0 Real GDP Y*

13. The Long-run Aggregate Supply [LRAS] Curve LRAS Price Level P1 0 Real GDP Y*

14. The Long-run Aggregate Supply [LRAS] Curve LRAS P2 Price Level P1 0 Real GDP Y*

15. The long-run aggregate supply curve • The long-run aggregate supply curve (LRAS) is a vertical line drawn at the level of GDP that is equal to potential GDP, Y*. • It is vertical because the total amount output that the economy produces when all factors are efficiently used at their normal rate of utilization does not vary with the price level. • If the price level rose from P1 to P2 and all other factor prices (and wages) were to rise in the same proportion then total desired output of firms would remain at Y*.

16. The Long-run Equilibrium and Aggregate Supply LRAS P2 Price Level P1 AD0 0 Real GDP Y* [i]. A rise in aggregate demand

17. The Long-run Equilibrium and Aggregate Supply LRAS0 E1 P1 Price Level E0 P0 AD1 AD0 0 Y*0 Real GDP [i]. A rise in aggregate demand

18. The Long-run Equilibrium and Aggregate Supply LRAS0 LRAS1 Price Level P0 E0 E2 P2 AD0 0 Y*0 Y1* Real GDP [ii]. A rise in long-run aggregate supply

19. Long-run equilibrium and aggregate supply • When the LRAS curve is vertical, aggregate supply determines the long-run equilibrium value of GDP at Y*. • Given Y*, aggregate demand determines the long-run equilibrium value of the price level. • With given LRAS0 a shift of AD from AD0 to AD1 leaves Y* unchanged but raises the price level from P0 to P1. • With a given AD curve a rightward shift of the LRAS curve to LRAS1 lowers the price level and increases Y*.

20. Three Ways of Increasing GDP LRAS0 LRAS SRAS0 LRAS SRAS Price level Price Level Price Level AD AD AD0 Real GDP Real GDP Real GDP Y1 Y* Y1 Y* Y*0 [ii]. A Temporary Increase in Aggregate Supply (iii). Permanent Increases in Aggregate Supply [i]. An increase in Aggregate Demand

21. Three Ways of Increasing GDP LRAS0 LRAS SRAS0 LRAS SRAS Price level Price Level Price Level SRAS1 AD1 AD AD AD0 Real GDP Real GDP Real GDP Y1 Y* Y1 Y* Y*0 [ii]. A Temporary Increase in Aggregate Supply (iii). Permanent Increases in Aggregate Supply [i]. An increase in Aggregate Demand

22. LRAS1 LRAS2 LRAS3 Y*1 Y*2 Y*3 Three Ways of Increasing GDP LRAS0 LRAS SRAS0 LRAS SRAS Price level Price Level Price Level SRAS1 SRAS2 AD2 AD1 AD AD AD0 Real GDP Real GDP Real GDP Y1 Y* Y2 Y1 Y* Y2 Y*0 [ii]. A Temporary Increase in Aggregate Supply (iii). Permanent Increases in Aggregate Supply [i]. An increase in Aggregate Demand

23. Three Ways of Increasing GDP • In part (i) of the figure the AD curve shifts to the right. If the initial level of output is Y1 then the shift from AD0 to AD1 eliminates the recessionary gap and raises GDP to Y*. If the initial level of GDP is Y*, then the shift from AD1 to AD2 raises GDP to Y2 and thereby opens up an inflationary gap. • In part (ii) the SRAS curve shifts to the right. If the initial level of output is Y1, then the shift from SRAS0 SRAS1 eliminates the recessionary gap and raises GDP to Y*. If the initial level of output is Y*, then the shift from SRAS1 to SRAS2 raises GDP to Y2 and thereby opens up an inflatory gap.

24. Three Ways of Increasing GDP • In the cases shown in part (i) and (ii) any increase in output beyond potential is temporary, since, in the absence of any additional shocks, the inflationary gap will cause wages and other factor prices to rise; this will cause the SRAS curve to shift upward and, hence, GDP to converge to Y* • In part (iii) the LRAS curve shifts to the right, causing potential GDP to increase. Whether or not actual output increases immediately depends on what happens to the AD and SRAS curves. • Since, in the absence of other shocks, actual GDP eventually converges to potential GDP, a rightward shift in the LRAS curve eventually leads to an increase in actual GDP. If the shift in the LRAS curve is recurring, then GDP will grow continually.

25. Removal of a Recessionary Gap SRAS0 SRAS0 AD0 LRAS AD0 AD1 LRAS SRAS1 Price level Price Level E2 E0 P2 P0 P0 E0 E1 P1 Y0 Y* Real GDP Y0 Y* Real GDP [i]. A recessionary gap removed by a rightward shift in SRAS [ii]. A recessionary gap removed by a rightward shift in AD

26. Removal of a Recessionary Gap • A recessionary gap may be removed by a (slow) rightward shift of the SRAS curve, a natural revival of private sector demand, or a fiscal-policy-induced increase in aggregate demand. Initially equilibrium is at E0, with GDP at Y0 and the price level at P0. The recessionary gap is Y*-Y0. • In part (i) the gap might be removed by a shift in the SRAS curve to SRAS1 as a result of reductions in wage rates and other input prices. The shift in the SRAS curve causes a movement down and to the right along AD0 establishes a new equilibrium at E1, achieving potential GDP, Y*, and lowering the price level to P1

27. Removal of a Recessionary Gap • In part (ii) the gap might also be removed by a shift of the AD curve to AD1. That occurs either because of a natural revival of private sector expenditure or because of a fiscal-policy-induced increase in expenditure. The shift in the AD curve causes a movement up and to the right along SRAS0 and shifts the equilibrium to E2 raising GDP to Y* and the price level to P2.

28. Removal of an Inflationary Gap SRAS1 SRAS0 AD0 LRAS LRAS SRAS0 Price level Price Level E0 E1 P0 P1 E0 P2 E2 AD0 P0 AD1 Y* Y0 Real GDP Y* Y0 Real GDP [i]. An inflationary gap removed by a left-ward shift in SRAS [ii]. An inflationary gap removed by a left-ward shift in AD

29. Removal of an Inflationary Gap • An inflationary gap may be removed by a leftward shift of the SRAS curve, a reduction in private sector demand, or a fiscal-policy-induced reduction in aggregate demand. Initially equilibrium is at E0, with GDP at Y0 and the price level at P0. The inflationary gap is Y*-Y0. • In part (i) the gap might be removed by a shift in the SRAS curve to SRAS1 that occurs as a result of increase in wage rates and other input prices. The shift in the SRAS curve causes a movement up and to the left along AD0 establishes a new equilibrium at E1, reducing GDP to its potential level, Y*, and raising the price level to P1.

30. Removal of an Inflationary Gap • In part (ii) the gap might also be removed by a shift of the AD curve to AD1 that occurs either because of a fall in private spending or because of contractionary fiscal policy. The shift in the AD curve causes a movement down and to the left along SRAS0. This movement. shifts the equilibrium to E2 lowering GDP to Y* and the price level to P2.

31. UK earnings growth and RPI inflation, 1964-2006

32. GDP AND THE PRICE LEVEL IN THE LONG RUN • Potential GDP is represented by a vertical line at Y*, which means that it does not vary with the price level. • The output gap is equal to the horizontal distance between Y* and the actual level of GDP, as determined by the intersection of the AD and SARS curves. Induced Changes in Input Prices • An inflationary gap means that actual GDP, Y, is greater than Y*, and hence excess demand in the labour market. As a result wages rise faster than productivity, causing unit labour costs to rise. • The SRAS curve shifts leftward, and the price level rises.

33. GDP AND THE PRICE LEVEL IN THE LONG RUN • A recessionary gap means that Y is less than Y*, and hence demand in the labour market is relatively low. • Although there is some resulting tendency for wages to fall relative to productivity, asymmetrical behaviour means that this force will be much weaker than in the case of an inflationary gap. • Unit labour costs will fall only slowly, so the output gap will persist for some time. • An expansionary demand shock creates an inflationary gap. • A contractionary demand shock works in the opposite direction by creating a recessionary gap.

34. GDP AND THE PRICE LEVEL IN THE LONG RUN The Long-run Consequences of Aggregate Demand Shocks • The long-run aggregate supply [LRAS] curve relates the price level and real GDP after all wages and other costs have been adjusted fully to long-run equilibrium. The LRAS curve is vertical at the level of potential GDP, Y*. • Because the LRAS curve is vertical, output in the long-run is determined by the position of the LRAS curve, and the only long-run role of the AD curve is to determine the price level. Economic growth determines the position of the LRAS curve. • Because of asymmetries in the shape of the SRAS curve, and in the adjustment mechanism that shifts that curve, the automatic adjustments that tend to return the economy to its LRAS curve tend to be much slower in the face of deflationary that inflationary gaps.

35. GDP AND THE PRICE LEVEL IN THE LONG RUN Real GDP in the Short and Long Runs • GDP can increase [or decrease] for any of three reasons: a change in aggregate demand, a change in short-run aggregate supply, or a change in long-run aggregate supply [which is called economic growth]. • The first two changes are typically associated with business cycles.

36. GDP AND THE PRICE LEVEL IN THE LONG RUN Government Policy and the Business Cycle • In principle, fiscal policy can be used to stabilise the position of the AD curve at or near potential GDP. • To remove a recessionary gap, governments can shift AD curve to the right by cutting taxes and increasing spending. • To remove an inflationary gap, governments can pursue the opposite policies. • Because government tax and transfer programmes tend to reduce the size of the multiplier, they act as automatic stabilisers. When national income changes, in either direction, disposable income changes by less because of taxes and transfers. • Discretionary fiscal policy is subject to information, decision, and execution lags that limit its ability to stabilize the economy at or near potential GDP • Monetary policy-makers can react quickly, but the impact of interest rate changes is subject to a lag.