Univ. Of Ghana ECON 212: ELEMENTS OF ECONOMICS GDP AND THE PRICE LEVEL IN THE LONG RUN Dr. Priscilla T. Baffour

Transcription

1 Univ. Of Ghana ECON 212: ELEMENTS OF ECONOMICS GDP AND THE PRICE LEVEL IN THE LONG RUN Dr. Priscilla T. Baffour

2 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 P 1 to P 2 and all other factor prices (and wages) were to rise in the same proportion then total desired output of firms would remain at Y*.

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

4 The Long-run Aggregate Supply [LRAS] Curve LRAS P1 0 Y*

5 The Long-run Aggregate Supply [LRAS] Curve LRAS P2 P1 0 Y*

6 The Long-run Equilibrium and Aggregate Supply LRAS P2 P1 AD 0 0 Y* [i]. A rise in aggregate demand

7 The Long-run Equilibrium and Aggregate Supply LRAS 0 P 1 E 1 P 0 E 0 AD 1 AD 0 0 Y* 0 [i]. A rise in aggregate demand

8 The Long-run Equilibrium and Aggregate Supply LRAS 0 LRAS 1 P 0 E 0 P 2 E 2 AD 0 0 Y* 0 Y 1 * [ii]. A rise in long-run aggregate supply

9 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 LRAS 0 a shift of AD from AD 0 to AD 1 leaves Y* unchanged but raises the price level from P 0 to P 1. With a given AD curve a rightward shift of the LRAS curve to LRAS 1 lowers the price level and increases Y*.

10 Three Ways of Increasing GDP LRAS SRAS LRAS SRAS 0 LRAS 0 AD AD 0 AD Y 1 Y* Y 1 Y* Y* 0 [i]. An increase in Aggregate Demand [ii]. A Temporary Increase in Aggregate Supply (iii). Permanent Increases in Aggregate Supply

11 Three Ways of Increasing GDP LRAS SRAS LRAS SRAS 0 LRAS 0 SRAS 1 AD 1 AD AD 0 AD Y 1 Y* Y 1 Y* Y* 0 [i]. An increase in Aggregate Demand [ii]. A Temporary Increase in Aggregate Supply (iii). Permanent Increases in Aggregate Supply

12 Three Ways of Increasing GDP LRAS SRAS LRAS SRAS 0 LRAS 0 LRAS 1 LRAS 2 LRAS 3 SRAS 1 SRAS 2 AD 2 AD 1 AD AD 0 AD Y 1 Y* Y 2 Y 1 Y* Y 2 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

13 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 Y 1 then the shift from AD 0 to AD 1 eliminates the recessionary gap and raises GDP to Y*. If the initial level of GDP is Y*, then the shift from AD 1 to AD 2 raises GDP to Y 2 and thereby opens up an inflationary gap.

14 Three Ways of Increasing GDP In part (ii) the SRAS curve shifts to the right. If the initial level of output is Y 1, then the shift from SRAS 0 SRAS 1 eliminates the recessionary gap and raises GDP to Y*. If the initial level of output is Y*, then the shift from SRAS 1 to SRAS 2 raises GDP to Y 2 and thereby opens up an inflationary gap.

15 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*

16 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.

17 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 E 0, with GDP at Y 0 and the price level at P 0. The recessionary gap is Y*-Y 0.

18 Removal of a Recessionary Gap AD 0 LRAS SRAS 0 AD SRAS 0 0 AD 1 LRAS SRAS 1 E 2 E 0 P 2 P 0 E 1 P 0 E 0 P 1 Y 0 Y* Y 0 Y* [i]. A recessionary gap removed by a rightward shift in SRAS [ii]. A recessionary gap removed by a rightward shift in AD

19 Removal of a Recessionary Gap In part (i) the gap might be removed by a shift in the SRAS curve to SRAS 1 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 AD 0 establishes a new equilibrium at E 1, achieving potential GDP, Y*, and lowering the price level to P 1

20 Removal of a Recessionary Gap In part (ii) the gap might also be removed by a shift of the AD curve to AD 1. 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 SRAS 0 and shifts the equilibrium to E 2 raising GDP to Y* and the price level to P 2.

21 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 E 0, with GDP at Y 0 and the price level at P 0. The inflationary gap is Y*-Y 0.

22 Removal of an Inflationary Gap AD 0 LRAS SRAS 1 LRAS SRAS 0 SRAS 0 E 1 E 0 P 1 P 0 E 0 P 2 E 2 AD 0 P 0 AD 1 Y* Y 0 [i]. An inflationary gap removed by a left-ward shift in SRAS Y* Y 0 [ii]. An inflationary gap removed by a left-ward shift in AD

23 Removal of an Inflationary Gap In part (i) the gap might be removed by a shift in the SRAS curve to SRAS 1 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 AD 0 establishes a new equilibrium at E 1, reducing GDP to its potential level, Y*, and raising the price level to P 1.

24 Removal of an Inflationary Gap In part (ii) the gap might also be removed by a shift of the AD curve to AD 1 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 SRAS 0. This movement shifts the equilibrium to E 2 lowering GDP to Y* and the price level to P 2.

25 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.

26 GDP AND THE PRICE LEVEL IN THE LONG RUN 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 longrun aggregate supply [which is called economic growth]. The first two changes are typically associated with business cycles.

27 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 (Fiscal Policy). To remove an inflationary gap, governments can pursue the opposite policies.

28 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.