How will these factors affect real gdp and inflation in the long run?

Question

1. A developed nation’s economy has been in a recession with deflation but the same forces which caused this are now reversing course—the economy is expected to return to a long run equilibrium within 6 months
2. fiscal policymakers decide to cut government spending across the board by 20% to reduce the budget deficit. Taxes will not change. 
3. The central bank is committed to fighting inflation whenever it is increasing beyond the level prior to the recession

Using the AD/AS model how will these factors affect inflation and real GDP in the long run? How will the model be effected in the long run?

Answer 1

The Long-Run Aggregate Supply (LRAS) curve is vertical at the economy's potential GDP, meaning in the long run, real GDP is determined by factors of production (labor, capital, technology) and is independent of the price level. Inflation in the long run is primarily a monetary phenomenon.

Initial Situation: The economy is in recession with deflation, meaning it's operating to the left of the LRAS curve (short-run equilibrium below potential GDP). The "reversing course" suggests a natural self-correction mechanism towards long-run equilibrium.

Factors and Their Long-Run Effects:

1. Reversing Forces Caused by Recession/Deflation:
2. Effect on Real GDP (Long Run): The economy is expected to return to its long-run equilibrium. This implies a movement along the LRAS curve to potential GDP. The LRAS itself is not shifting due to these "reversing forces" but rather the economy is moving back to it. In the long run, real GDP will be at its potential level.
3. Effect on Inflation (Long Run): As the economy self-corrects from deflation, the price level will rise back towards the long-run equilibrium price level. However, the exact long-run inflation rate will be determined by monetary policy.
4. Fiscal Policy: 20% Cut in Government Spending (G) (No Tax Change):
5. Effect on AD (Short Run): A cut in government spending is a contractionary fiscal policy. This will cause the Aggregate Demand (AD) curve to shift to the left.
6. Effect on Real GDP (Long Run): In the long run, fiscal policy primarily affects the composition of GDP, not its total level. The LRAS curve is vertical. A decrease in government spending, while shifting AD left in the short run, will not change long-run real GDP. The economy will eventually return to its potential output. However, it could reduce capital accumulation if the spending cut involves public investment, which could eventually shift LRAS left, but "across the board" cuts usually imply consumption cuts, which don't directly affect LRAS. Assuming no impact on productive capacity, real GDP returns to potential.
7. Effect on Inflation (Long Run): The leftward shift of the AD curve due to reduced government spending will put downward pressure on the price level, leading to lower inflation in the long run, all else equal.
8. Central Bank's Commitment to Fighting Inflation:
9. Effect on AD (Short Run): If inflation starts to increase beyond its pre-recession level, the central bank will likely implement contractionary monetary policy (e.g., raising interest rates, reducing money supply). This causes the AD curve to shift to the left.
10. Effect on Real GDP (Long Run): Monetary policy has no effect on long-run real GDP. Real GDP in the long run is determined by the economy's productive capacity (LRAS). The central bank's actions aim to stabilize prices around a target, not to change the fundamental productive capacity.
11. Effect on Inflation (Long Run): A central bank committed to fighting inflation will ensure that the long-run inflation rate remains stable and at its target level (the pre-recession level in this case). This commitment anchors inflation expectations and keeps the price level from spiraling upwards.

Overall Long-Run Effects on the AD/AS Model:

1. Real GDP: The economy will ultimately settle at its potential GDP (LRAS). The initial recession and subsequent AD shifts will cause short-run fluctuations, but in the long run, the economy self-corrects to its natural rate of output. No factor explicitly mentioned causes a shift in the LRAS (like changes in technology, labor force size, or capital stock).
2. Inflation:
3. The cut in government spending creates deflationary pressure, pushing the long-run equilibrium price level lower.
4. The central bank's commitment to fighting inflation means that any increase in inflation beyond the pre-recession level will be countered. This suggests that while the fiscal cut pushes prices down, the central bank will prevent them from rising too high if other factors push them up.