introduction chapter 10

Chapter 10

Real GDP and the Price Level in the Long Run

Slide 10-2

Introduction

Though the prospect of deflation is unlikely in the U.S., it has been a real

phenomenon in some Asian countries in recent years. How do you expect your

economic decisions would be affected if you anticipated a decline in the overall

price level?

Slide 10-3

Learning Objectives

� Understand the concept of long-run aggregate supply

� Describe the effect of economic growth on the long-run aggregate supply curve

� Explain why the aggregate demand curve slopes downward and list the factors that cause the curve to shift

Slide 10-4

Learning Objectives

� Discuss the meaning of long-run equilibrium for the economy as a whole

� Evaluate why economic growth can cause deflation

� Evaluate likely reasons for persistent inflation in recent decades

5

Chapter Outline

� Output Growth and the Long-Run Aggregate Supply Curve

� Spending and Total Expenditures

� The Aggregate Demand Curve

� Shifts in the Aggregate Demand Curve

Slide 10-6

Chapter Outline

� Long-Run Equilibrium and the Price Level

� The Effects of Economic Growth on the Price Level

� Causes of Inflation

Slide 10-7

Did You Know That...

� The Wonderful Wizard of Ozwas an allegory about how to achieve long-run price stability?

� The story looks at how the money supply affects the price level?

� The characters and events in the story represent political issues that arose in the populist movement?

Slide 10-8

Output Growth and the Long-Run Aggregate Supply Curve

� Long-Run Aggregate Supply Curve– An amount of real GDP– People have full information and have adjusted– The price level is fixed– Technology does not change– All resources are fully employed

� The economy is on its production possibilities curve

9

Output Growth and the Long-Run Aggregate Supply Curve

Figure 10-1 Slide 10-10

The Long-Run Aggregate Supply Curve

� LRAS is vertical– Input prices fully adjust to changes in

output prices

– Suppliers have no incentive to increase output

– Unemployment is at the natural rate

Slide 10-11

Economic Growth and Long-Run Aggregate Supply

� Growth is shown by outward shifts of either the production possibilities curve or the LRAS curve caused by:– Growth of population and the labor-force

participation rate

– Capital accumulation

– Improvements in technology

Slide 10-12

Economic Growth and the Long-Run Aggregate Supply Curve

Figure 10-2, Panels (a) and (b)

13

Economic Growth and Long-Run Aggregate Supply


Spending and Total Expenditures

� Aggregate Demand– The total of all planned expenditures in

the economy

� Aggregate Supply– The total of all planned production in the

economy

Slide 10-15

Spending and Total Expenditures

� Questions– What determines the total amount that

individuals, governments, firms, and foreigners want to spend?

– What determines the equilibrium price level?

Slide 10-16

The Aggregate Demand Curve

� Aggregate Demand Curve– A curve showing planned purchase rates

for all goods and services in the economy at various price levels, all other things held constant

17


Real GDP per Year($ trillions)

Pric

e Le

vel

10 110

140

AD

120

160

8 9 13 1412

A

As the price levelrises, real GDPdeclines




Pric

e Le

vel

10 110

140

AD

A120

160

8 9 13 1412

B

Figure 10-4

Slide 10-19



Pric

e Le

vel

10 110

140

AD

A120

160

8 9 13 1412

B

C



� What happens when the price level rises?– The Real-Balance Effect (wealth effect)

– The Interest Rate Effect

– The Open Economy Effect

21


� The Real-Balance Effect– The change in the real value of money

balances when the price level changes

Slide 10-22


� The Interest Rate Effect– Higher price levels indirectly increase the

interest rate, which in turn cause a reduction in borrowing and spending.

Slide 10-23


� The Open Economy Effect– Higher price levels result in foreigners’

desiring to buy fewer American-made goods while Americans desire more foreign-made goods (i.e., net exports fall).

Slide 10-24

Aggregate Demand versus Demand for a Single Good

� When the aggregate demand curve is derived, we are looking at the entire circular flow of income and product.

� When a demand curve is derived, we are looking at a single product in one market only.

25

Shifts in the Aggregate Demand Curve

� Any non-price-level change that increases aggregate spending (on domestic goods) shifts AD to the right.

� Any non-price-level change that decreases aggregate spending (on domestic goods) shifts AD to the left.

Slide 10-26

Factors Increasing Aggregate Demand

� A drop in the foreign exchange value of the dollar

� Increased security about jobs and future income

� Improving economic conditions in other countries

� A reduction in real interest rates (nominal interest rates corrected for inflation) not due to price level changes

� Tax decreases

� An increase in the amount of money in circulation

Slide 10-27



GD

P D

efla

tor

3 40

120

1 2 6 75

90

AD

Slide 10-28



GD

P D

efla

tor

3 40

120

1 2 6 75

90

AD

29



GD

P D

efla

tor

3 40

120

1 2 6 75

90

AD1AD

Increase in aggregate demand

Slide 10-30

Factors Decreasing Aggregate Demand

� A rise in foreign exchange value of the dollar

� Added fears about jobs and future income

� Declining economic conditions in other countries

� A rise in real interest rates not due to price level changes

� Tax increases

� A decrease in the amount of money in circulation

Slide 10-31



GD

P D

efla

tor

11 120

120

9 10 14 1513

100

AD

Decrease in aggregate demand

AD1

Slide 10-32

The Aggregate Supply Curve

� The Long-Run Aggregate Supply Curve– Real output at full employment

– A vertical line representing real output based on full information and after full adjustment has occurred

33

Long-Run Equilibrium and the Price Level


Long-Run Equilibrium and the Price Level

� Long-run equilibrium occurs at the intersection of the LRAS curve and the AD curve– Equilibrium price level is determined

– Planned real expenditures for the economy are equal to total planned production along the economy’s trends growth path

Slide 10-35

The Effects of Economic Growth on the Price Level

Figure 10-6, Panel (a) Slide 10-36


Figure 10-6, Panel (b)

37


� Secular Deflation– An increase in LRAS will, ceteris paribus, result

in a decrease in the price level.

� Avoiding Secular Deflation– If the AD curve shifts outward by the same

amount as the LRAS curve, the price level remains constant.

– The AD curve can be shifted outward by increasing the money supply.

Slide 10-38

E-Commerce Example:Information Technology and LRAS

� The communication capabilities of computer networks have enhanced economic growth by– Adding to the capital stock

– Allowing for the further development of entrepreneurial talent

Slide 10-39

E-Commerce Example:Information Technology and LRAS

� In countries where information technologies have been most widely adopted, they account for about one-third of the growth in real GDP.

Slide 10-40

Inflation Rates in the United States

Figure 10-7Source: Economic Report of the President;

Economic Indicators, various issues

41

Causes of Inflation:Supply-Side Inflation

Figure 10-8, Panel (a)

• When LRAS1 shifts to LRAS2, the price level rises from 120 to 140

• Inflation is caused by a decrease in LRAS.

Slide 10-42

Causes of Inflation:Demand-Side Inflation

Figure 10-8, Panel (b)

An increase in AD from AD1to AD2 causes the price level to rise from 120 to 140. An increase in AD causes inflation.

Slide 10-43

International Example:High Marginal Tax Rates and Inflation

� High marginal tax rates on income in European nations have slowed the growth rate of LRAS.

� One effect of this is a higher rate of inflation than would prevail otherwise.

Slide 10-44

Causes of Inflation:Economic Growth and Inflation

Figure 10-9Source: Economic Report of the President;

Economic Indicators, various issues

45

Issues and Applications: Different Sources of Deflation

� The deflation observed in the U.S. in the 1930’s was the result of a leftward shift of LRAS.

� The recent deflation in Japan and China occurred with increases in real output, suggesting that it resulted from an increase in LRAS along with a stable aggregate demand.

Slide 10-46

Summary Discussion of Learning Objectives

� The long-run aggregate supply curve is vertical at the level of real GDP that firms plan to produce when they have full information and when input prices have adjusted to any change in output prices.

� Economic growth is shown by an outward shift of the LRAS curve or of the production possibilities curve.

Slide 10-47


� The aggregate demand curve slopes downward because of the real-balance effect, the interest rate effect, and the open economy effect.

� Long-run equilibrium for the economy occurs when the price level adjusts until total planned real expenditures equal total planned production.

Slide 10-48


� If aggregate demand is stable during a period of economic growth, the price level falls.

� Because real GDP has been increasing, the most likely factor causing inflation is that AD increases faster than LRAS.

End of Chapter 10Real GDP and the Price Level in the Long Run

introduction chapter 10

Documents