Question

Suppose concems about the size of the federal budget deficit lead the U.S. Congress to cut all funding for research and development for ten years. Assuming this has an impact on technology growth, what does the AD/AS model predict would be the likely effect on equilibrium GDP and the price level?

Short answer

Cutting all funding for research and development for ten years will likely lead to slower technology growth, which in turn affects the Aggregate Demand/Aggregate Supply (AD/AS) model. Consequently, the long-run aggregate supply (LRAS) curve will likely shift to the left, resulting in a lower equilibrium GDP. Moreover, this policy change will also cause the short-run aggregate supply (SRAS) curve to shift upwards, leading to a higher price level in the economy.

Step-by-step solution

1. Understand the impact of research and development on technology growth.

Since R&D funding contributes to advancements in technology, cutting all funding for R&D will likely result in a slower growth of technology.

2. Identify the relationship between technology growth and the AD/AS model.

A slower growth in technology will slow down the potential growth of the economy as well. Technology growth increases the potential output of the economy, which contributes to the long-run aggregate supply (LRAS) curve in the AD/AS model. In this case, a decrease in technology growth will likely shift the LRAS curve to the left, reducing the potential output of the economy.

3. Analyze the effect on equilibrium GDP and the price level.

When the LRAS curve shifts to the left, it implies that there is less potential output available for the same level of resource utilization. This would lead to a lower equilibrium GDP in the economy, indicated by the intersection between the new LRAS curve and the AD curve. In addition, the shift in the LRAS curve is likely to have an impact on the price level as well. Since the economy's potential output has fallen, the resources available to produce goods and services will become relatively scarcer. This situation leads to an increase in the price level as suppliers have pricing power due to the relatively lower potential output. Hence, the Short-Run Aggregate Supply (SRAS) curve will shift upwards as the price level rises for the same output level.

4. Conclusion.

Based on the AD/AS model's analysis, cutting all funding for research and development for ten years will likely lead to slower technology growth. This slower growth will result in a shift of the LRAS curve to the left, leading to a lower equilibrium GDP and a higher price level in the economy.

Key concepts

Technology Growth

Technology growth refers to the advancement and improvement of technologies over time. This progress is crucial for enhancing productivity and efficiency in the economy. Technology grows when new ideas are developed and implemented. These can transform industries, create new markets, and increase the overall production capacity of an economy.
When technology growth slows, the economy's ability to produce more with the same amount of resources is stunted. This means that improvements in productivity will lag, and the potential output will diminish. In the context of the AD/AS model, technology growth directly impacts the Long-Run Aggregate Supply (LRAS) curve. As technology becomes more advanced, this curve can shift to the right, signifying higher potential output.
If there is an interruption in technology growth, it can lead to an economic slowdown, reducing the potential for long-term growth. This is why a steady investment in research and development is critical to sustaining technological advancement and economic expansion.

Research and Development

Research and Development, often referred to as R&D, involves the activities undertaken by companies and governments to innovate and introduce new products and services. R&D is crucial for fostering technological growth and sustaining competitive advantages in various sectors.
Funding for R&D is fundamental because it supports the research demanded for new inventions and the development required for refining existing technologies. When R&D funding is cut or reduced, the pace of innovation slows, hampering the process of technological advancement. This slowdown can have substantial impacts on several economic factors, including the potential output and productivity.

• Less innovation leads to slower technological growth.
• Reduced productivity improvements across various sectors.
• Affected global competitiveness of an economy.

In the AD/AS model, a cut in R&D funding would translate to a leftward shift in the LRAS curve, indicating that the economy can't achieve the same level of potential output as before.

Equilibrium GDP

Equilibrium GDP is where the aggregate demand (AD) and aggregate supply (AS) curves intersect in the AD/AS model. This point reflects the level of economic activity at which the quantity of goods and services demanded equals the quantity supplied.
When technological growth slows down—owing to a decrease in R&D funding, for example—the equilibrium GDP can be adversely affected. The long-term equilibrium GDP is determined by an economy's productive capacity, which includes technology, labor, and capital.
Reductions in technology growth mean the potential output decreases, causing the LRAS curve to shift left. This shift results in a new, lower equilibrium GDP, indicating a decrease in the economy's capacity to produce goods and services sustainably.

• Decreased technological advancements lead to lower GDP growth.
• Fewer resources are efficiently utilized, affecting production.

Ultimately, a slower growth in equilibrium GDP may also impact living standards, as the economy isn't producing as effectively as it potentially could.

Price Level

The price level in an economy is the average of current prices across the entire spectrum of goods and services. It plays a vital role in determining purchasing power and inflation rates.
In the context of the AD/AS model, fluctuations in the price level are often the result of shifts in aggregate demand or aggregate supply curves. If technology growth slows due to reduced R&D investment, it reduces the economy's potential output, leading to scarcity of goods and services.
As a result, suppliers may raise prices due to the reduced supply but consistent, if not increased, demand. This situation shifts the Short-Run Aggregate Supply (SRAS) curve upwards, increasing the overall price level.

• Scarcity leads to suppliers raising prices.
• Increased inflation rates may result in reduced purchasing power.

Thus, in a scenario where research and development funding is cut, leading to slower technology growth, we would expect both equilibrium GDP to lower and the general price level to increase.