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

Introduction During the early 2000s, Japan’s price level declined at a steady pace. Between late 2003 and 2008, the price level oscillated very little. Then, in the late 2000s, the price level suddenly jumped upward at over 2 percent per year before plunging downward. What caused Japan’s price level to behave as it did across the 2000s? In this chapter, you will learn how a nation’s equilibrium price level is determined.

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 3

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 4

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 5

Did You Know That ... Until the spring 2008, the U.S. price level had not exhibited a decline during any single 12-month interval since 1955? Why did the U.S. economy experienced deflation, or a decrease in the price level over time, for the first time in half a century? 7

Output Growth and the Long-Run Aggregate Supply Curve 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 (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 8

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

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) 10

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

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 11

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

Figure 10-3 A Sample Long-Run Growth Path for Real GDP

Example: How Much Might “Going Green” Reduce U.S. Economic Growth? President Obama and the U.S. Congress have agreed on a goal to reduce greenhouse gas emissions to 2005 levels by 2014, and by an additional 30 percent by 2030. Attainment of these goals would lead to a decline in production of capital goods and thus future economic growth. According to the Environmental Protection Agency, these efforts to cut greenhouse gas emissions would lead to a cumulative reduction in real GDP of about 4 percent by 2030. 14 15

Total Expenditures and Aggregate Demand The total of all planned expenditures in the entire economy 14

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? 15

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

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 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 22

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 23

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 24

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. 25

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 26

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 27

Table 10-1 Determinants of Aggregate Demand

Example: Explaining the Drop in Aggregate Demand in the Late 2000s By late 2007, the market values of many U.S. houses purchased with mortgage loans from banks had fallen below the amount people had borrowed, leading many borrowers to simply walk away from their houses. Banks responded by cutting back on loans to businesses, which in turn cut back on hiring. A significant decrease in aggregate demand resulted when many U.S. residents experienced decreased security about their jobs, incomes and wealth. 37

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) 37

Figure 10-5 Long-Run Economywide 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 An increase in LRAS will, ceteris paribus, result in a decrease in the price level

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 41

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)

Why Not … pass a law that prohibits firms from raising their prices? Between 1971 and 1973, the U.S. government tried to reduce inflation by limiting price increases to specific allowed percentages. This policy of direct inflation controls led to widespread shortages and reductions in product quality.

Figure 10-7 Inflation Rates in the United States

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

Figure 10-8 Explaining Persistent Inflation, Panel (a) • When LRAS1 shifts to LRAS2, the price level rises from 120 to 140 • Inflation is caused by a decrease in LRAS

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

Figure 10-8 Explaining Persistent Inflation, Panel (b) 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 10-9 Real GDP and the Price Level in the United States, 1970 to the Present

You Are There: Fighting Inflation in Pakistan When Shamshad Akhtar became the governor of Pakistan’s central bank, inflation was around 18 percent while the quantity of money in circulation was growing at over 16 percent. As Akhtar has managed to reduce Pakistan’s money growth rate to below 10 percent, the nation’s annual inflation rate has dropped to a single digit.

Issues & Applications: Japan’s Deflation Rate Switches from Steady to Volatile During the early 2000s, secular deflation occurred in Japan as its aggregate demand was nearly stationary, but its long-run aggregate supply curve shifted rightward. From late 2003 through the middle of 2008, the deflation rate was lower as Japanese aggregate demand began to grow at a steadier pace.

Issues & Applications: Japan’s Deflation Rate Switches from Steady to Volatile (cont’d) During the latter part of 2008, Japan experienced a 2.5 percent inflation rate as its growing exports raised Japanese aggregate demand. By 2010, Japan experienced a deflation rate of 2.5 percent as purchases of Japanese export goods by residents of the United States and other nations plunged, causing a sudden drop in aggregate demand.

Figure 10-10 The Rate of Change of Japanese Prices Since 2000

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 Shown by an outward shift of the LRAS curve or of the production possibilities curve

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

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

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