Actual > Potential gdp growth LEADS TO INFLATION

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rodra333

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I ve read on the book that when actual gdp growth rate is higher than potential GDP growth rate, concerns about inflation increase.
I dont see how having today a higher % of gdp than in the future (potential gdp growth) will lead to inflation. I assume people will consume more if the potential growth of gdp is higher than the actual growth of gdp and by consuming more prices will go up.
My understanding is completely refutate by the book buy I seriously dont know why?
Can anyone please help me?
 
What I can see is that the long-term supply curve is tottaly vertical, and the demand curve is negative sloped, so when the demand curve expands (you need to graph it), only the prices go up, but real GDP (Y) is static. So if you graph multiple long-term supply curve and demand curves expanding, you can see that if the proportion of expansions differ between both curves you may have inflation or desinflation.
Regards
 
Don’t you mean expected? Because nominal GDP includes inflation.
 
Harrogath! I see what you mean, but why are u assuming a vertically long term supply curve???
MrSmart! The book says potential… Potential and expected are synonyms but is not the same to compare:
1. 31/01/2015: the actual data with what you expected and forecasted to be your potential data for example 3 months ago
2. 31/01/2015: the actual data with what you are expecting to be in 3 months.
So, the statement “If actual gdp growth rate is higher than potential GDP growth rate, concerns about inflation increase.”, does refer to option 1 and 2.
 
Because a LTAS curve is adjustable given enough time, so it can be whatever output the suppliers choose to, in aggregate of course.
I guess Harrogath is correct in this case, if the demand curve shifts to the right in the short run, then there might be concerns of inflation that is not mitigated by a proportional increase in supply, moving price levels up the supply curve.
 
Sorry guys,
Dont really see the conexions btw actual vs potential GDP causing inflation or deflation and the LTAS and AD…
Am I missing smth?
 
rodra333.
The pontencial output of an economy is represented by the long-run aggregate supply curve which is totally vertical (slope = infinite). It is vertical because it represents the fixed amount of capital invested in the economy, so this LT supply curve only moves when the summatory of short run supply curves gives it a enough change to be seen.
This graphic explains it all. The red line is the LTS curve and the blue ones are the aggregate short run demand curve. When the SR demand curve expands you can see that at a fixed amount of assets on the economy the real output cannot be changed, so the only effect is inflation. But imagine in a few years a new technology of production is developed, the red line expands to the right eliminating the inflation because REAL output has increased due an increased supply of goods and services. This can explain the constantly increase of the inflation over time, the demand curves moves faster than the supply curves so the inflation is an inherent phenomenon of an economy.
Regards
 
thanks a lot Harrogath. I think I got it.
I still confused with one of the statements of the notes. It says that it is more likely for a government to run a fiscal deficit when actual GDP growth rate is lower than its potential growth rate. Why is it so? What could be a practical explanation?
Thanks a lot for your help.
 
rodra333 wrote:
thanks a lot Harrogath. I think I got it.
I still confused with one of the statements of the notes. It says that it is more likely for a government to run a fiscal deficit when actual GDP growth rate is lower than its potential growth rate. Why is it so? What could be a practical explanation?
Thanks a lot for your help.
Click to expand...
I’m not totally sure but we can think the following:
Fiscal deficit occurs when total fiscal expenditures are higher than fiscal revuenue (taxes). This commonly happens when aggregate demand has decreased so the GDP growth rate has decreased and the goverment spends its resources in goods, services or investment assets by issuing national debt to try to increase the aggregate demand.
Remember PIB = AD = C + G exp + Inv + X - M …. (Inv = Public + private Investments)
So, we can see that goverment expenditures and goverment (public) investment can increase the Aggregate Demand.
In your question, actual GDP growth rate is represented by the AD growth rate, so if AD growth rate is lower than potencial AD growth rate, the goverment will enter to the game and try to equate this both rates actual and potencial AD growth rates. In this road, the goverment will try to spend more assets than it has generating Fiscal Deficit.
This is an explanation I can present, maybe there is other variables in the game too.
Regards.
 
Harrogath!
I understood everything!!
Thank a lot!
U really helped me a lot!
 
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