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
Y*
[i]. A Recessionary Output Gap
Real GDP
Y*
[ii]. An Inflationary Output Gap
Real GDP
Actual GDP, Potential GDP and the Output Gap
SRAS
SRAS
E0
E0
AD
Output
Gap
Output
Gap
Y0
[i]. A Recessionary Output Gap
Y*
Real GDP
Y*
Y1
[ii]. An Inflationary Output Gap
AD
Real GDP
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
SRAS0
E0
P0
P0
E0
AD0
AD0
Y*
Real GDP
[i]. Autonomous increase in aggregate demand
Y*
Real GDP
[ii]. Induced shift in aggregate supply
Demand-shock Inflation
SRAS1
SRAS0
SRAS0
E2
E1
P1
P0
Price Level
Rises
P2
P1
E0
E1
Price Level
Rises further
AD1
AD1
E0
Inflationary
Gap Opens
AD0
Inflationary
gap eliminated
Y*
Real GDP
AD0
Y1
[i]. Autonomous increase in aggregate demand
Y*
Real GDP
Y1
[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
SRAS0
1
E0
E0
P0
AD0
AD1
Y* Real GDP
[i]. Autonomous Fall in Aggregate Demand
Real GDP
[ii]. Induced Shift in Aggregate Supply
Demand-shock Deflation With Flexible Wages
SRAS0
Price
Level
Falls
SRAS1
SRAS0
1
E0
E0
P0
Price Level
Falls
Further
E1
P1
2
E1
P1
AD0
E2
AD1
AD1
Recessionary
Gap Eliminated
Recessionary
Gap Opens
Y1
Y* Real GDP
[i]. Autonomous Fall in Aggregate Demand
Y*
Y1
Real GDP
[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
0
Y*
Real GDP
The Long-run Aggregate Supply [LRAS] Curve
LRAS
P1
0
Y*
Real GDP
The Long-run Aggregate Supply [LRAS] Curve
LRAS
P2
P1
0
Y*
Real GDP
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
P1
AD0
0
Y*
[i]. A rise in aggregate demand
Real GDP
The Long-run Equilibrium and Aggregate Supply
LRAS0
E1
P1
E0
P0
AD1
AD0
0
Y*0
[i]. A rise in aggregate demand
Real GDP
The Long-run Equilibrium and Aggregate Supply
LRAS0
P0
LRAS1
E0
E2
P2
AD0
0
Y*0
Y1*
[ii]. A rise in long-run aggregate supply
Real GDP
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*.
LRAS
LRAS
SRAS0
LRAS0
Three Ways of Increasing GDP
SRAS
AD
AD
AD0
Y1
Y*
Real GDP
[i]. An increase in Aggregate Demand
Y1
Y*
Real GDP
[ii]. A Temporary Increase
in Aggregate Supply
Y*0
Real GDP
(iii). Permanent Increases
in Aggregate Supply
LRAS
LRAS
SRAS0
LRAS0
Three Ways of Increasing GDP
SRAS
SRAS1
AD1
AD
AD
AD0
Y1
Y*
Real GDP
[i]. An increase in Aggregate Demand
Y1
Y*
Real GDP
[ii]. A Temporary Increase
in Aggregate Supply
Y*0
Real GDP
(iii). Permanent Increases
in Aggregate Supply
LRAS3
LRAS2
SRAS0
LRAS1
LRAS
LRAS
LRAS0
Three Ways of Increasing GDP
SRAS
SRAS1
SRAS2
AD2
AD1
AD
AD
AD0
Y1
Y*
Y2
Real GDP
[i]. An increase in Aggregate Demand
Y1
Y*
Y2
Real GDP
[ii]. A Temporary Increase
in Aggregate Supply
Real GDP
Y*0 Y*1 Y*2 Y*3
(iii). Permanent Increases
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 SRAS1
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
AD0
LRAS
SRAS0
AD0
AD1
LRAS
SRAS0
SRAS1
E2
E0
P2
P0
P0
E1
E0
P1
Y0
Y*
Real GDP
[i]. A recessionary gap removed by a
rightward shift in SRAS
Y0
Y*
Real GDP
[ii]. A recessionary gap removed by a
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 fiscalpolicy-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
AD0
SRAS1
LRAS
SRAS0
LRAS
SRAS0
E0
E1
P0
P1
E0
P2
E2
AD0
P0
AD1
Y*
Y Real GDP
Y*
Y0
Real GDP
0
[i]. An inflationary gap removed by a
left-ward shift in SRAS
[ii]. An inflationary gap removed by a
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.