Real GDP and the Price Level in the Long Run 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.

Aggregates What is an economic aggregate? An abstraction Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Output Growth and the Long-Run Aggregate Supply Curve The total of all planned production for the economy Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Output Growth and the Long-Run Aggregate Supply Curve (cont'd) 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. 8

Figure 10-1 The Production Possibilities and the Economy’s Long-Run Aggregate Supply Curve Copyright © 2008 Pearson Addison Wesley. 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 Growth in labor-force participation rate Capital accumulation Improvements in technology Increase in resource base Copyright © 2008 Pearson Addison Wesley. All rights reserved. 11

Figure 10-2 The Long-Run Aggregate Supply Curve and Shifts in It Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Total Expenditures and Aggregate Demand The total of all planned expenditures in the entire economy Copyright © 2008 Pearson Addison Wesley. All rights reserved. 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? Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15

The 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.

Figure 10-4 The Aggregate Demand Curve As the price level rises, real GDP declines Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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 Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22

The Aggregate Demand Curve (cont'd) The Real-Balance Effect (The Wealth Effect) Purchasing Power of cash balances Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23

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. ↓ Price level  ↓ demand for loans  ↓ i-rate ↓ Price Level  ↓ i-rate  ↑ Investment ↑ Consumption Copyright © 2008 Pearson Addison Wesley. All rights reserved. 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). ↑ P-level  ↓ goods purchased Copyright © 2008 Pearson Addison Wesley. All rights reserved. 25

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. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 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. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27

Shifts in the Aggregate Demand Curve Increase in aggregate demand 120 GDP Deflator 90 AD1 AD 1 2 3 4 5 6 7 Real GDP per Year ($ trillions) Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Shifts in the Aggregate Demand Curve (cont'd) Decrease in aggregate demand 120 GDP Deflator 100 AD1 AD 9 10 11 12 13 14 15 Real GDP per Year ($ trillions) Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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 Copyright © 2008 Pearson Addison Wesley. 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). Equilibrium = Stability Copyright © 2008 Pearson Addison Wesley. All rights reserved. 37

Figure 10-5 Long-Run Economywide Equilibrium Copyright © 2008 Pearson Addison Wesley. 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 © 2008 Pearson Addison Wesley. 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 Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Secular Deflation versus Long-Run Price Stability in a Growing Economy 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. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 41

Figure 10-6 Secular Deflation versus Long-Run Price Stability in a Growing Economy, Panel (a) Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Figure 10-6 Secular Deflation versus Long-Run Price Stability in a Growing Economy, Panel (b) Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Secular Inflation A persistent rise in prices resulting from Aggregate Demand (AD) increasing faster that aggregate supply Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Supply Side Inflation • When LRAS1 shifts to LRAS2, the price level rises from 120 to 140 • Inflation is caused by a decrease in LRAS Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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 Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Figure 10-7 Inflation Rates in the United States Source: Economic Report of the President; Economic Indicators, various issues Copyright © 2008 Pearson Addison Wesley. All rights reserved.