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Chapter 10

Real GDP and the Price Level in the Long Run

Chapter Overview • • • Aggregate Demand (AD) Long Run Aggregate Supply (LRAS) Long Run Equilibrium  Price Level  Real GDP • Inflation / Deflation Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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Aggregates • What is an economic aggregate?

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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 Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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Figure 10-1

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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 Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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Figure 10-2

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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?

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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 Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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Figure 10-4

The Aggregate Demand Curve (cont'd) • What happens when the price level changes?

 The real-balance effect (or

wealth effect

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The Aggregate Demand Curve (cont'd) • The Interest Rate Effect  Lower price levels indirectly decrease the interest rate, which in turn causes an increase in borrowing and spending.

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The Aggregate Demand Curve (cont'd) • 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).

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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.

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Shifts in the Aggregate Demand Curve • Any non-price-level change that increases aggregate spending (on domestic goods) shifts

to the right.

• Any non-price-level change that decreases aggregate spending (on domestic goods) shifts

to the left.

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Shifts in the Aggregate Demand Curve Increase in aggregate demand 120 90

AD AD 1

6 7 10-19

Shifts in the Aggregate Demand Curve (cont'd) Decrease in aggregate demand 120 100

AD 1 AD

14 15 10-20

Non Price Determinants of Aggregate Demand (AD) • • • • • • • • Government Spending Fiscal Policy Tax Policy Expectations Money Supply Population Foreign exchange rate Interest Rate Monetary Policy Economic Conditions in other countries Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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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 (

) crosses the long-run aggregate supply curve (

LRAS

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Figure 10-5

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Long-Run Equilibrium and the Price Level (cont'd) • The effects of economic growth on the price level  Economic growth and secular deflation Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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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 Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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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

curve shifts outward by the same amount as the

LRAS

curve, the price level remains constant.

 The

curve can be shifted outward by increasing the money supply.

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Figure 10-6

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Figure 10-6

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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.

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Supply Side Inflation

• When

LRAS 1

shifts to

LRAS 2

, the price level rises from 120 to 140 • Inflation is caused by a decrease in

LRAS

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Demand Side Inflation

An increase in to

AD 2 AD

from

AD 1

causes the price level to rise from 120 to 140, and an increase in

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Figure 10-7

Inflation Rates in the United States Source:

Economic Report of the President; Economic Indicators

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