Tuesday, January 13, 2015

Prepare to Have Your Mind Blown Pt.2

In this post, I'll follow up on why expanding aggregate supply is the only way to grow GDP. 

Looking again at the aggregate demand option, I've provided a red arrow.  This red arrow shows the shift in aggregate demand from AD1 to AD2.  AD2 is represented in orange.  You'll notice that a shift "up" or "right" actually mean the same thing, because AD1 is shifting outwards to AD2.  Equilibrium in the economy moves from (Y1, P1) to (Y1, P2). 

As you can see, there is no change in GDP.  There is only an increase in prices.  The reason is that the long run aggregate supply curve is vertical.  RE-AS is the rational expectations AS curve, also known as the new classical aggregate supply curve. 

Next it's time for the supply side option:

You've expanded aggregate supply in the economy.  As a result, RE-AS shifts rightward.  The economy moves from (Y1, P1) to (Y2, P2), and I have circled in red the final equilibrium.  As a result, GDP is higher.  You'll also notice the price level has dropped.  

Click here to read part 3.