GDP and the Price Level

in the Long Run

Chapter 19
LIPSEY & CHRYSTAL
ECONOMICS 12e
 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.
 Learning Outcomes

• 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.
 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
 Actual GDP, Potential GDP and the Output Gap

SRAS SRAS

E0 E0

Price Level
Price Level

Output AD
Gap Output
Gap AD

Y0 Y* Real GDP Y* Y1 Real GDP

[i]. A Recessionary Output Gap [ii]. An Inflationary Output Gap
 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.
 Demand-shock Inflation

SRAS0
Price Level

Price Level
SRAS0

E0
P0
P0 E0

AD0 AD0

Y* Y*
Real GDP Real GDP

[i]. Autonomous increase in aggregate demand [ii]. Induced shift in aggregate supply
 Demand-shock Inflation

SRAS1
SRAS0
Price Level

Price Level
SRAS0

E2

E1 P2 E1
Price Level
P1 Rises further
Price Level P1
E0
Rises AD1
P0 AD1
E0

Inflationary AD0 AD0

Gap Opens Inflationary
gap eliminated

Y* Y1 Y* Y1
Real GDP Real GDP

[i]. Autonomous increase in aggregate demand [ii]. Induced shift in aggregate supply
 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 lowers 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.
 Demand-shock Deflation With Flexible Wages

SRAS0
Price Level

SRAS0

Price Level
1

E0
E0
P0

AD0

AD1

Y* Real GDP Real GDP

[i]. Autonomous Fall in Aggregate Demand [ii]. Induced Shift in Aggregate Supply
 Demand-shock Deflation With Flexible Wages

SRAS0 SRAS1
Price Level

Price Level
SRAS0

1
Price
Level
E0
Falls E0
2
P0
Price Level
Falls E1
E1 Further
P1 P1

AD0
E2

AD1
AD1

Recessionary Recessionary
Gap Opens Gap Eliminated

Y* Y1
Y1 Y* Real GDP Real GDP
[i]. Autonomous Fall in Aggregate Demand [ii]. Induced Shift in Aggregate Supply
 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.
 The Long-run Aggregate Supply [LRAS] Curve

LRAS
Price Level

0 Real GDP
Y*
 The Long-run Aggregate Supply [LRAS] Curve

LRAS
Price Level

P1

0 Real GDP
Y*
 The Long-run Aggregate Supply [LRAS] Curve

LRAS

P2
Price Level

P1

0 Real GDP
Y*
 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*.
 The Long-run Equilibrium and Aggregate Supply
LRAS

P2
Price Level

P1

AD0

0 Real GDP
Y*

[i]. A rise in aggregate demand

 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

 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
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*.
 Three Ways of Increasing GDP

LRAS0
LRAS SRAS0
LRAS

Price Level

Price Level
Price level

SRAS

AD

AD0 AD

Real GDP Y1 Y* Real GDP Real GDP

Y1 Y* Y*0

[i]. An increase in Aggregate Demand [ii]. A Temporary Increase (iii). Permanent Increases
in Aggregate Supply in Aggregate Supply
 Three Ways of Increasing GDP

LRAS0
LRAS SRAS0
LRAS

Price Level

Price Level
Price level

SRAS
SRAS1

AD1 AD

AD0 AD

Real GDP Y1 Y* Real GDP Real GDP

Y1 Y* Y*0

[i]. An increase in Aggregate Demand [ii]. A Temporary Increase (iii). Permanent Increases
in Aggregate Supply in Aggregate Supply
 Three Ways of Increasing GDP

LRAS0
LRAS1
LRAS2

LRAS3
LRAS SRAS0
LRAS

Price Level

Price Level
Price level

SRAS
SRAS1

SRAS2

AD2

AD1 AD

AD0 AD

Real GDP Y1 Y* Y2 Real GDP Real GDP

Y1 Y* Y2 Y*0 Y*1 Y*2 Y*3

[i]. An increase in Aggregate Demand [ii]. A Temporary Increase (iii). Permanent Increases
in Aggregate Supply in Aggregate Supply
 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.
 Three Ways of Increasing GDP

 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 SRAS 1
to SRAS2 raises GDP to Y2 and thereby opens up an
inflationary gap.
 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*
 Three Ways of Increasing GDP

 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.
 Removal of a Recessionary Gap

SRAS0 SRAS0
AD0 LRAS AD0 AD1 LRAS

Price level
Price Level

SRAS1

E2
E0 P2
P0 P0 E0
E1
P1

Y0 Y* Y0 Y* Real GDP
Real GDP
[i]. A recessionary gap removed by a [ii]. A recessionary gap removed by a
rightward shift in SRAS rightward shift in AD
 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.
 Removal of a Recessionary Gap

 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
 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.
 Removal of an Inflationary Gap

SRAS1 SRAS0
AD0 LRAS LRAS

Price level
Price Level

SRAS0

E1 E0
P1 P0
E0 P2 E2 AD0
P0

AD1

Y* Y0 Real GDP Y* Y0 Real GDP

[i]. An inflationary gap removed by a [ii]. An inflationary gap removed by a

left-ward shift in SRAS left-ward shift in AD
 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.
 Removal of an Inflationary Gap

 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.
 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.
Effects of fiscal policies that are not
reversed
UK budget deficit and public debt –
projected in December 2009
UK earnings growth and RPI inflation
 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.
 GDP AND THE PRICE LEVEL IN THE LONG RUN

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.
 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.
 GDP AND THE PRICE LEVEL IN THE LONG RUN

• 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.
 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*.
 GDP AND THE PRICE LEVEL IN THE LONG RUN

The Long-run Consequences of Aggregate Demand

Shocks
• 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.
 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.
 GDP AND THE PRICE LEVEL IN THE LONG RUN

Government Policy and the Business Cycle

• In principle, fiscal policy can be used to stabilize 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.
 GDP AND THE PRICE LEVEL IN THE LONG RUN

Government Policy and the Business Cycle

• 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.