Suppose that potential GDP were to climb by 1 percent from an initial level of $10,000 during a year in which aggregate demand changed from Y = 11,000 - 10P to Y = 11,100 - 10P. The rate of inflation in the flexible price long-run growth model is

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In the flexible price long-run growth model, the rate of inflation is determined by the relationship between potential GDP and aggregate demand. Initially, potential GDP is $10,000, and the aggregate demand equation is Y = 11,000 - 10P. When potential GDP climbs by 1 percent, it increases to $10,100. The new aggregate demand equation is Y = 11,100 - 10P, which exactly matches the new potential GDP level. Since aggregate demand increases in line with potential GDP, there is no excess demand or supply in the economy, implying that the price level does not need to adjust. Therefore, the rate of inflation is 0 percent, as there is no change in the price level.

Suppose That Potential GDP Were to Climb by 1 Percent