Over the long run, the actual GDP of an economy and the associated price levels are determined by where the aggregate demand curve and the long-run aggregate supply curve intersect. This point is where the economy settles into long-run macroeconomic equilibrium. It is also the point at which the economy's potential output is fully attained by producers.
Before equilibrium is attained in the long run, fluctuations in short-run aggregate supply and aggregate demand can lead to output gaps, where real GDP differs from potential GDP. When real GDP is higher than potential GDP, the difference between the two is called an inflationary gap; when real GDP is lower than potential GDP, the difference is called a recessionary gap. Over the long term, this gap approaches zero as the economy approaches long-run equilibrium. In the event of any short-term gaps, the government can use fiscal policy as a tool and the Federal Reserve, the central bank of the U.S., can use monetary policy as a tool to close these gaps and return to long-run equilibrium.In the event of a recessionary gap, expansionary fiscal and monetary policy can be enacted to increase aggregate demand and reach potential GDP. Expansionary fiscal policy is enacted by the government and consists of tax cuts and increased government spending. Expansionary monetary policy consists of lowering interest rates and open-market operations that increase the money supply. In the event of an inflationary gap, contractionary fiscal and monetary policy can be used to decrease aggregate demand and return to long-term equilibrium. With fiscal policy, the government can increase taxes and decrease government spending. In addition, the Federal Reserve can enact contractionary monetary policy. This consists of raising interest rates and decreasing the money supply through open-market operations. When the aggregate demand curve shifts, the price level at which it intersects with the long-run aggregate supply curve (the equilibrium point) changes, but output (and thus real GDP) holds steady. Because potential output holds steady under long-term equilibrium, greater aggregate demand naturally leads to higher price levels. When producers can charge more for their goods and services, they will, and greater aggregate demand allows them to do so. (This reflects the assumption held by most economic theory that all actors in an economy will make whatever decisions maximize their profits.) Conversely, when aggregate demand falls, producers must charge less to sell the same quantity of goods and services.