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

Chapter 10

Real GDP and the Price Level in the Long Run

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 10-2

Chapter Overview

• Aggregate Demand (AD)

• Long Run Aggregate Supply (LRAS)

• Long Run Equilibrium Price Level Real GDP

• Inflation / Deflation


Aggregates

• What is an economic aggregate? An abstraction


Output Growth and the Long-Run Aggregate Supply Curve

• Aggregate Supply

The total of all planned production for the economy


Output Growth and the Long-Run Aggregate Supply Curve (cont'd)

• Long-Run Aggregate Supply Curve

A vertical line representing the real output of goods and services after full adjustment has occurred

It represents the real GDP of the economy under conditions of full employment; the economy is on its production possibilities curve


Figure 10-1 The Production Possibilities and the Economy’s Long-Run Aggregate Supply Curve


Output Growth and the Long-Run Aggregate Supply Curve (cont'd)

• Growth is shown by outward shifts of either the production possibilities curve or the LRAS curve caused by

Growth of population

Growth in labor-force participation rate

Capital accumulation

Improvements in technology

Increase in resource base


Figure 10-2 The Long-Run Aggregate Supply Curve and Shifts in It


Total Expenditures and Aggregate Demand

• Aggregate Demand

The total of all planned expenditures in the entire economy


Total Expenditures and Aggregate Demand (cont'd)

• Questions

What determines the total amount that individuals, governments, firms, and foreigners want to spend?

What determines the equilibrium price level?


The Aggregate Demand Curve

• Aggregate Demand Curve

A curve showing planned purchase rates for all final goods and services in the economy at various price levels, all other things held constant


Figure 10-4 The Aggregate Demand Curve

As the price level rises, real GDP declines


The Aggregate Demand Curve (cont'd)

• What happens when the price level changes? The real-balance effect (or wealth effect)

The interest rate effect

The open economy effect



• The Real-Balance Effect(The Wealth Effect)

Purchasing Power of cash balances



• The Interest Rate Effect

Lower price levels indirectly decrease the interest rate, which in turn causes an increase in borrowing and spending.

↓ Price level ↓ demand for loans ↓ i-rate

↓ Price Level ↓ i-rate ↑ Investment

↑ Consumption



• 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).

↑ P-level ↓ goods purchased


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.


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.


Shifts in the Aggregate Demand Curve

Real GDP per Year($ trillions)

GD

P D

efla

tor

3 40

120

1 2 6 75

90

AD1AD

Increase in aggregate demand


Shifts in the Aggregate Demand Curve (cont'd)

Real GDP per Year($ trillions)

GD

P D

efla

tor

11 120

120

9 10 14 1513

100

AD

Decrease in aggregate demand

AD1


Non Price Determinants of Aggregate Demand (AD)

• Government Spending

• Tax Policy

• Expectations

• Money Supply

• Population

• Foreign exchange rate

• Economic Conditions in other countries

• Interest Rate

Fiscal Policy

Monetary Policy


Long-Run Equilibrium and the Price Level

• For the economy as a whole, long-run equilibrium occurs at the price level where the aggregate demand curve (AD) crosses the long-run aggregate supply curve (LRAS).

• Equilibrium = Stability


Figure 10-5 Long-Run Economywide Equilibrium

Equilibrium


Long-Run Equilibrium and the Price Level (cont'd)

• The effects of economic growth on the price level

Economic growth and secular deflation


Long-Run Equilibrium and the Price Level (cont'd)

• Secular Deflation

A persistent decline in prices resulting from economic growth in the presence of stable aggregate demand


Secular Deflation versus Long-Run Price Stability in a Growing Economy

• 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.


Figure 10-6 Secular Deflation versus Long-Run Price Stability in a Growing Economy, Panel (a)


Figure 10-6 Secular Deflation versus Long-Run Price Stability in a Growing Economy, Panel (b)


International Example: Deflation is the Norm in Japan

• Since 1998, Japan’s real GDP has increased every year except 2002.

• As the LRAS curve shifted rightward, the price level gradually declined.

• Consequently Japan experienced deflation.


Secular Inflation

• A persistent rise in prices resulting from Aggregate Demand (AD) increasing faster that aggregate supply


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

• Inflation is caused by a decrease in LRAS

Supply Side Inflation


Demand Side Inflation

An increase in AD from AD1 to AD2 causes the price level to rise from 120 to 140, and an increase in AD causes inflation


Figure 10-7 Inflation Rates in the United States

Source: Economic Report of the President; Economic Indicators, various issues

Documents

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