1. GDP and the Price Level in the Long Run Chapter 19
LIPSEY & CHRYSTAL
ECONOMICS 12e

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.

3. 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.

4. [i]. A Recessionary Output Gap [ii]. An Inflationary Output Gap
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

5. [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
Gap AD
Output
Gap AD Y0 Y*
Real GDP Y* Y1
Real GDP
[i]. A Recessionary Output Gap
[ii]. An Inflationary Output Gap

6. 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.

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

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

9. 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.

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

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

12. 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.

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

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

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

16. 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*.

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

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

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

20. 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*.

21. [ii]. A Temporary Increase (iii). Permanent Increases
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
[i]. An increase in Aggregate Demand
[ii]. A Temporary Increase
in Aggregate Supply
(iii). Permanent Increases
in Aggregate Supply

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

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

24. 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.

25. 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 SRAS1 to SRAS2 raises GDP to Y2 and thereby opens up an inflationary gap.

26. 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*

27. 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.

28. 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

29. 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.

30. 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

31. 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.

32. 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

33. 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.

34. 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.

35. 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.

36. Effects of fiscal policies that are not reversed

37. UK budget deficit and public debt – projected in December 2009

38. UK earnings growth and RPI inflation

39. 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.

40. 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.

41. 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.

42. 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.

43. 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*.

44. 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.

45. 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.

46. 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.

47. 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.