Lecture 14
EQUILIBRIUM GDP AND PRICE LEVEL

1. Equilibrium in the goods market

• Intersection of DD and SS curves
• Eqbm GDP and price level
• Actual GDP vs Potential GDP
  • High or low unemployment
  • Recessionary gap or inflationary gap

2. Inflationary gap

• Excessive aggregate demand
• Actual GDP > Potential GDP
• Unemployment is less than the natural rate

2.1 Self correcting mechanism

• Inflationary gap does not last for long (why?)
• Long-run eqbm: Output = Potential GDP

3. Recessionary gap

• Does the self correcting mechanism work?
• Wage rigidity could lead to unemployment eqbm
• Justification for expansionary fiscal policy
  • Cut taxes
  • Increase govt. spending

4. Changes in GDP and price level

• Changes in parameters of DD and SS curves
• Draw graphs for each

4.1 Increase in interest rates

• Decline in consumption and investment (why?)
• Decrease in aggregate expenditure
• The DD curve shifts to the ...?
• Result: GDP falls; Price level falls

• Note: How much P falls will depend on the initial economic situation

4.2 Improvement in labor productivity

• Same as improvement in technology (why?)
• Increase in aggregate supply (why?)
• Result: Increase in GDP; fall in P
• The best of both worlds!

5. Changes in Aggregate Supply

• Explanation for stagflation in the 1970s
• "The New Economy" of the 1990s