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

Copyright ©2014 Pearson Education, Inc. All rights reserved.10-2 Introduction Economic growth has trended steadily downward during the past four decades in nations with northern borders lying within the Arctic Circle, such as Canada, Russia, and the United States. Yet, there is evidence to suggest that resources lying within the Arctic zone could employed to boost the economic growth rate of these countries. In Chapter 10, we will look at how the overall performance of an economy is affected by the use of new resources.

Copyright ©2014 Pearson Education, Inc. All rights reserved.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 key factors that cause this curve to shift

Copyright ©2014 Pearson Education, Inc. All rights reserved.10-4 Learning Objectives (cont'd) 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

Copyright ©2014 Pearson Education, Inc. All rights reserved.10-5 Chapter Outline Output Growth and the Long-Run Aggregate Supply Curve Total Expenditures and Aggregate Demand Shifts in the Aggregate Demand Curve Long-Run Equilibrium and the Price Level Causes of Inflation

Copyright ©2014 Pearson Education, Inc. All rights reserved.10-6 Did You Know That... In Venezuela, the president has used his parliamentary powers to impose laws that prevent prices from increasing? This was an attempt to make inflation illegal. Few countries resort to such dramatic measures to prevent inflation. What causes inflation?

Copyright ©2014 Pearson Education, Inc. All rights reserved.10-7 Output Growth and the Long-Run Aggregate Supply Curve Aggregate Supply –The total of all planned production for the economy

Copyright ©2014 Pearson Education, Inc. All rights reserved.10-8 Output Growth and the Long-Run Aggregate Supply Curve (cont'd) Long-Run Aggregate Supply Curve (LRAS) –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 ©2014 Pearson Education, Inc. All rights reserved.10-9 Figure 10-1 The Production Possibilities Curve and the Economy’s Long-Run Aggregate Supply Curve

Copyright ©2014 Pearson Education, Inc. All rights reserved Output Growth and the Long-Run Aggregate Supply Curve (cont'd) 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 –Determined by endowments and technology (or existing resources)

Copyright ©2014 Pearson Education, Inc. All rights reserved Output Growth and the Long-Run Aggregate Supply Curve (cont'd) Base-year dollars –The value of a current sum expressed in terms of prices in a base year Endowments –The various resources in an economy, including both physical resources and such resources as ingenuity and management skills

Copyright ©2014 Pearson Education, Inc. All rights reserved 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 and the labor-force participation rate –Capital accumulation –Improvements in technology

Copyright ©2014 Pearson Education, Inc. All rights reserved Figure 10-2 The Long-Run Aggregate Supply Curve and Shifts in It

Copyright ©2014 Pearson Education, Inc. All rights reserved Figure 10-3 A Sample Long-Run Growth Path for Real GDP

Copyright ©2014 Pearson Education, Inc. All rights reserved Policy Example: Shrinking Rightward Shifts in the U.S. LRAS Curve Between 2000 and 2007, U.S. real GDP grew at an annual average rate of 2.6 percent. –This translated into an increase of about $250 billion per year in long-run aggregate supply. Since 2007, the annual growth of GDP has fallen to 0.5 percent. –Consequently, the annual increase in long-run aggregate supply has been reduced to about $70 billion per year.

Copyright ©2014 Pearson Education, Inc. All rights reserved Total Expenditures and Aggregate Demand Aggregate Demand –The total of all planned expenditures in the entire economy

Copyright ©2014 Pearson Education, Inc. All rights reserved 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?

Copyright ©2014 Pearson Education, Inc. All rights reserved The Aggregate Demand Curve Aggregate Demand Curve (AD) –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 ©2014 Pearson Education, Inc. All rights reserved Figure 10-4 The Aggregate Demand Curve

Copyright ©2014 Pearson Education, Inc. All rights reserved The Aggregate Demand Curve (cont'd) What happens when the price level rises? –The real-balance effect (or wealth effect) –The interest rate effect –The open economy effect What happens when the price level falls? –The greater the total planned spending

Copyright ©2014 Pearson Education, Inc. All rights reserved The Aggregate Demand Curve (cont'd) The Real-Balance Effect –The change in expenditures resulting from a change in the real value of money balances when the price changes, all other things held constant; also called the wealth effect

Copyright ©2014 Pearson Education, Inc. All rights reserved The Aggregate Demand Curve (cont'd) The Interest Rate Effect –Higher price levels indirectly increase the interest rate, which in turn causes a reduction in borrowing and spending –One of the reasons that the aggregate demand curve slopes downward

Copyright ©2014 Pearson Education, Inc. All rights reserved 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) –Equivalent to a reduction in the amount of real goods and services purchased in the U.S.

Copyright ©2014 Pearson Education, Inc. All rights reserved The Aggregate Demand Curve (cont'd) Aggregate Demand versus Demand for a Single Good or Service –When the aggregate demand curve is derived, we are looking at total planned expenditures on all goods and services (i.e., the entire economic system) –When a demand curve is derived, we are looking at a single good or service in one market only

Copyright ©2014 Pearson Education, Inc. All rights reserved 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

Copyright ©2014 Pearson Education, Inc. All rights reserved Table 10-1 Determinants of Aggregate Demand

Copyright ©2014 Pearson Education, Inc. All rights reserved Policy Example: The Consumer Confidence Index and Aggregate Demand The Consumer Confidence Index (CCI) is a measure of the degree of security that U.S. households have about their future employment and income. Variations in the CCI normally provide an indication of changes in U.S. aggregate demand. Between late 2007 and early 2008, the CCI lost nearly half of its value. Immediately following this drop in consumer confidence, U.S. aggregate demand decreased by $350 billion.

Copyright ©2014 Pearson Education, Inc. All rights reserved 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)

Copyright ©2014 Pearson Education, Inc. All rights reserved Figure 10-5 Long-Run Economywide Equilibrium

Copyright ©2014 Pearson Education, Inc. All rights reserved Long-Run Equilibrium and the Price Level (cont'd) The effects of economic growth on the price level –Economic growth and secular deflation

Copyright ©2014 Pearson Education, Inc. All rights reserved 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 –An increase in LRAS will, ceteris paribus, result in a decrease in the price level

Copyright ©2014 Pearson Education, Inc. All rights reserved Long-Run Equilibrium and the Price Level (cont’d) 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

Copyright ©2014 Pearson Education, Inc. All rights reserved Figure 10-6 Secular Deflation versus Long-Run Price Stability in a Growing Economy, Panel (a)

Copyright ©2014 Pearson Education, Inc. All rights reserved Figure 10-6 Secular Deflation versus Long-Run Price Stability in a Growing Economy, Panel (b)

Copyright ©2014 Pearson Education, Inc. All rights reserved Figure 10-7 Inflation Rates in the United States Sources: Economic Report of the President; Economic Indicators, various issues.

Copyright ©2014 Pearson Education, Inc. All rights reserved Causes of Inflation Supply-Side Inflation –Figure 10-8 panel (a) shows a rise in price level caused by a decline in long-run aggregate supply –A leftward shift could be caused by: Reductions in labor force participation Higher marginal tax rates on wages

Copyright ©2014 Pearson Education, Inc. All rights reserved Figure 10-8 Explaining Persistent Inflation, Panel (a)

Copyright ©2014 Pearson Education, Inc. All rights reserved Causes of Inflation (cont’d) Demand-Side Inflation –Figure 10-8 panel (b) If aggregate demand increases for a given level of long- run aggregate supply, the price level must increase

Copyright ©2014 Pearson Education, Inc. All rights reserved Figure 10-8 Explaining Persistent Inflation, Panel (b)

Copyright ©2014 Pearson Education, Inc. All rights reserved Figure 10-9 Real GDP and the Price Level in the United States, 1970 to the Present Sources: Economic Report of the President; Economic Indicators, various issues; author’s estimates.

Copyright ©2014 Pearson Education, Inc. All rights reserved What If... There was a sustained increase in the amount of money in circulation intended to increase GDP? A sustained increase in the quantity of money would cause persistent rightward shifts in the position of the aggregate demand curve. Because the long-run aggregate supply curve is vertical, increases in aggregate demand cannot influence the equilibrium level of real GDP. Increases in aggregate demand can, however, raise the price level. So the consequence of an increase in the money supply would be sustained inflation.

Copyright ©2014 Pearson Education, Inc. All rights reserved Example: Will Slowed Growth of Potential U.S. Real GDP Fuel Inflation? Economists measure the growth of potential real GDP as a way of determining the rate of which long-run aggregate supply shifts outward. –The growth rate was about 3.5 percent in the 1940s and above 4 percent in the 1960s. –Between the 1970s and the 1990s, however, the growth rate dropped to around 3 percent. –By the early 2010s, potential GDP growth had fallen to a rate of somewhere between 1.0 and 1.5 percent.

Copyright ©2014 Pearson Education, Inc. All rights reserved Example: Will Slowed Growth of Potential U.S. Real GDP Fuel Inflation? (cont’d) This is the slowest expansion of long-run aggregate supply in more than 80 years. If aggregate demand continues to grow at the same pace as it has in the past, inflation will necessarily increase.

Copyright ©2014 Pearson Education, Inc. All rights reserved You Are There: A Nation Confronts a Leftward-Shifting LRAS Curve Since 2007, Portugal’s real GDP has been shrinking at an average pace of 1 percent per year. Thus, the long-run aggregate supply curve for Portugal has been shifting leftward. The cause of this decline is the lack of investment in productive capital goods. Portuguese manufacturing resources have been wearing out and haven’t been replaced.

Copyright ©2014 Pearson Education, Inc. All rights reserved Issues & Applications: Will Arctic Assets Unfreeze Long-Run Aggregate Supply? The Arctic Circle contains only about 4 percent of the earth’s surface area. Yet, nearby areas stretching southward to 45 degrees latitude encompass another 11 percent of the earth’s surface and an additional 25 percent of its land mass. These lands contain significant endowments of untapped natural resources.

Copyright ©2014 Pearson Education, Inc. All rights reserved Issues & Applications: Will Arctic Assets Unfreeze Long-Run Aggregate Supply? (cont’d) There are three reasons for the meager use of Arctic resources: –The region is not a hospitable environment for people –Large tracts of land are covered with thick permafrost and glaciers. –Much of land in the region is publicly owned. Governments have little incentive to extract the productive resources deposited there. By placing these lands in private hands, the adjacent nations would experience an increase in economic growth.

Copyright ©2014 Pearson Education, Inc. All rights reserved Summary Discussion of Learning Objectives Long-run aggregate supply –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 and the long-run aggregate supply curve –Shown by an outward shift of the LRAS curve or of the production possibilities curve

Copyright ©2014 Pearson Education, Inc. All rights reserved Summary Discussion of Learning Objectives (cont'd) Why the aggregate demand curve slopes downward and factors that cause it to shift –Slopes downward due to the real-balance effect, the interest rate effect, and the open economy effect –May shift due to a number of factors

Copyright ©2014 Pearson Education, Inc. All rights reserved Summary Discussion of Learning Objectives (cont'd) Long-run equilibrium for the economy –Occurs when the price level adjusts until total planned real expenditures equal actual real GDP

Copyright ©2014 Pearson Education, Inc. All rights reserved Summary Discussion of Learning Objectives (cont'd) Why economic growth can cause deflation –If AD is stationary during a period of economic growth, the LRAS curve shifts rightward along the AD curve and the equilibrium price level falls Likely reasons for persistent inflation –One event that causes inflation is a decline in LRAS; another occurs in a growing economy when AD growth exceeds the increase in LRAS