Question

Suppose that the economy is at full employment, the price level is 100 , and the multiplier is 2 . Investment increases by \(\$ 100\) billion. a. In the long run, does real GDP increase by more than, less than, or the same amount as the immediate increase in the quantity of real GDP demanded? b. Explain how the price level changes in the long run.

Short answer

a. In the long run, real GDP increases by less than the immediate increase. b. The price level rises in the long run.

Step-by-step solution

- Understand the Multiplier Effect

The multiplier effect describes how an initial change in spending leads to a larger change in real GDP. Here, the multiplier is 2, meaning every dollar of investment increases real GDP by two dollars.

- Calculate Immediate Increase in Real GDP

Investment increases by \(\$100\) billion. With the multiplier effect of 2, the immediate increase in real GDP will be calculated as follows: \[\text{{Immediate Increase in Real GDP}} = 100 \text{{ billion}} \times 2 = 200 \text{{ billion}}\]

- Real GDP Change in the Long Run

In the long run, the economy will adjust back to full employment. As a result, the increase in real GDP will not be sustained at the level influenced by the multiplier. Hence, real GDP in the long run increases by less than the immediate increase.

- Price Level Adjustment in the Long Run

In the long run, the economy is at full employment, and any increase in demand leads to higher prices rather than an increase in real output. Therefore, the price level will rise to accommodate the initial increase in investment.

Key concepts

full employment

Full employment means that all available labor resources are being used in the most efficient way possible. There is no cyclical or deficient-demand unemployment in such a state. However, some frictional and structural unemployment will still exist. When an economy is at full employment, it operates at its maximum productive capacity.

This state is crucial because:

• It leads to the optimal use of labor resources.
• Unemployment rates are minimized.
• Inflation pressures can occur due to higher demand for goods and services.

Even if the economy is at full employment, new investments and spending can lead to short-term increases in real GDP. However, adjustments in the long run may return the economy to its full employment output.

real GDP

Real GDP, or Gross Domestic Product, measures the value of economic output, adjusted for price changes or inflation. This gives us a more accurate measure of an economy's size and how well it's performing.

Key points about real GDP:

• It reflects the actual output produced, unlike nominal GDP which can be distorted by price changes.
• Increases in real GDP indicate economic growth as it means more goods and services are being produced.
• Reductions in real GDP indicate economic downturns.

In the given exercise, the immediate increase in real GDP due to increased investment is determined by the multiplier effect. Here, the initial \(\text{\textdollar}100\) billion investment, with a multiplier of 2, leads to an immediate increase of \(\text{\textdollar}200\) billion in real GDP.

price level adjustment

Price level adjustment refers to changes in the overall price level of goods and services in an economy. When an economy experiences increased demand, the price level adjusts to reflect this higher demand.

Understanding how price levels change can help explain different economic phenomena:

• During times of high demand, prices tend to rise to balance out the demand and supply.
• Conversely, in times of low demand, prices may drop as sellers try to attract buyers.
• Inflation occurs when the price level increases across an economy over a period of time.

In the scenario given, when the economy is already at full employment, an increase in investment will lead to higher prices because the economy cannot produce more than its full capacity. This price increase balances out the new level of demand with the available supply.

long run equilibrium

Long run equilibrium is a state where all adjustments in the economy have been made, and all markets are in balance—meaning supply equals demand in every market.

In a state of long run equilibrium:

• The economy operates at full employment with no output gaps.
• Prices are stable, reflecting the total supply and demand in the economy.
• There are no external pressures leading to economic booms or busts.

After an initial increase in investment, short-term rises in real GDP occur due to the multiplier effect. However, in the long run, the economy returns to equilibrium. Any initial increase in real GDP will not be sustained, as the price level adjusts and the economy returns to its full employment output. The long-term effect is typically higher prices rather than higher long-term output.