Economic growth is traditionally viewed through the lens of expanding demand or increased capital accumulation. However, a significant, often overlooked, driver of long-run growth is the interplay between lower prices, downwardly adjusted inflation expectations, and enhanced supply-side efficiency. This model explores how a sustained, lower price environment, supported by lower inflationary expectations, can lead to a rightward shift in the Long-Run Aggregate Supply (LRAS) curve, stimulating potential output. By reducing the nominal cost of inputs and fostering productivity gains, an economy can experience sustainable, non-inflationary growth, reversing the conventional wisdom that lower prices only signify recessionary pressures.
Model Construction
The model relies on the AD-AS framework, operating in
the long run where all input costs and expectations are fully flexible. The
core equation for Long-Run Aggregate Supply is (Y_{L}=f(K,L,T,P^{e}), where
(Y_{L}) is potential GDP, (K) is capital, (L) is labor, (T) is technology, and (P^{e})
is expected price level. In this model, a lower price level (P) and lower
inflationary expectations (P^{e}) influence the supply side. When producers
expect lower future prices and costs, they invest in cost-saving technology and
productive capacity, shifting the Aggregate Supply curve rightward.
Graphically, this involves a downward adjustment in
input costs, such as nominal wages and raw material costs, shifting the
Short-Run Aggregate Supply (SRAS) curve rightward. In the long run, this
persistent shift, coupled with increased productivity from the lower-price
environment, causes the vertical LRAS curve to move to the right, indicating a
higher level of potential output (Y_{L}).
The mechanism works because, unlike a sudden negative
demand shock that reduces output, a gradual reduction in price levels and
inflationary expectations (a positive supply shock) allows for lower, more stable
production costs. The lower (P^{e}) reduces the need for workers to bargain for
high nominal wage increases, which lowers the cost of production and increases
the long-run capacity of the economy.
Data Analysis
Data analysis of inflationary periods, such as the
Volcker disinflation, indicates that while lower prices initially cause a
contraction in output, the long-term impact of lower inflation expectations is
stabilizing, enabling stronger growth. Empirical studies on supply shocks show
that when price expectations decrease alongside a positive supply-side adjustment,
the long-run Phillips curve shows a lower price level without a permanent drop
in output.
In a scenario where technology increases productivity,
costs fall, leading to lower prices, which allows for increased real income and
greater investment in the long run. Furthermore, research suggests that when
inflationary expectations are well-anchored at a lower level, the supply chain
becomes more efficient, leading to higher, more sustainable output levels. The
analysis of decreasing-cost industries, which often accompany lower prices due
to technological improvements, confirms that lower prices can coincide with
higher supply, shifting the long-run supply curve to the right.
The long-run model of economic growth with lower
prices and lower inflation expectations demonstrates that downward pressure on
prices can, in fact, drive economic growth. By reducing input costs and
aligning inflationary expectations to a lower, more stable rate, an economy
enhances its productive capacity, illustrated by a rightward shift in the LRAS
curve. While the transition may involve short-run adjustments, the long-run
equilibrium achieves higher potential GDP through increased efficiency and
lower costs. Therefore, policy frameworks that foster productivity-led, lower
price environments are conducive to sustainable, long-term expansion rather
than merely causing deflationary stagnation.
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