Economics Today Chapter 10 Roger LeRoy Miller Economics Today Chapter 10 Real GDP and the Price Level in the Long Run

Introduction In January 1989, a New York Times feature article examined the “P” model developed by the Federal Reserve. The “new theory” proposed finding a price level, P*, consistent with the economy’s long-run growth rate.

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 the factors that cause the curve to shift 3

Learning Objectives 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 Spending and Total Expenditures The Aggregate Demand Curve Shifts in the Aggregate Demand Curve 5

Chapter Outline Long-Run Equilibrium and the Price Level The Effects of Economic Growth on the Price Level Causes of Inflation 6

Did You Know That... The Wonderful Wizard of Oz was an allegory about how to achieve long-run price stability? The story looks at how the money supply affects the price level? 7

Output Growth and the Long-Run Aggregate Supply Curve An amount of real GDP People have full information and have adjusted The price level is fixed Technology does not change All resources are fully employed The economy is on its production possibilities curve 8

Output Growth and the Long-Run Aggregate Supply Curve Figure 10-1

The Long-Run Aggregate Supply Curve 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 10

Economic Growth and Long-Run Aggregate Supply 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

Economic Growth and the Long-Run Aggregate Supply Curve Figure 10-2, Panels (a) and (b)

Economic Growth and Long-Run Aggregate Supply Figure 10-3

Spending and Total Expenditures Aggregate Demand The total of all planned expenditures in the economy Aggregate Supply The total of all planned production in the economy 14

Spending and Total Expenditures 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 A curve showing planned purchase rates for all goods and services in the economy at various price levels, all other things held constant Aggregate demand = C + I + G + X

The Aggregate Demand Curve AD As the price level rises, real GDP demand declines 140 120 Price Level A 100 6 7 8 9 10 11 12 Real GDP per Year ($ trillions)

The Aggregate Demand Curve 140 B 120 Price Level A 100 AD 6 7 8 9 10 11 12 Real GDP per Year ($ trillions)

The Aggregate Demand Curve 140 B 120 Price Level A 100 AD 6 7 8 9 10 11 12 Real GDP per Year ($ trillions) Figure 10-4

The Aggregate Demand Curve What happens when the price level rises? The Real-Balance Effect (wealth effect) The Interest Rate Effect The Open Economy Effect 22

The Aggregate Demand Curve The Real-Balance Effect The change in the real value of money balances when the price level changes 23

The Aggregate Demand Curve The Interest Rate Effect Higher price levels indirectly increase the interest rate. 24

The Aggregate Demand Curve 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). 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. 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

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. 28

Factors Increasing Aggregate Demand A drop in the foreign exchange value of the dollar Increased security about jobs and future income Improvements in economic conditions in other countries A reduction in real interest rates (nominal interest rates corrected for inflation) not due to price level changes Tax decreases An increase in the amount of money in circulation

Shifts in the Aggregate Demand Curve AD 120 GDP Deflator 90 1 2 3 4 5 6 7 Real GDP per Year ($ trillions)

Shifts in the Aggregate Demand Curve 120 GDP Deflator 90 AD 1 2 3 4 5 6 7 Real GDP per Year ($ trillions)

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)

Factors Decreasing Aggregate Demand A rise in the foreign exchange value of the dollar Decreased security about jobs and future income Declines in economic conditions in other countries A rise in real interest rates (nominal interest rates corrected for inflation) not due to price level changes Tax increases A decrease in the amount of money in circulation

Shifts in the Aggregate Demand Curve 120 GDP Deflator 90 AD 1 2 3 4 5 6 7 Real GDP per Year ($ trillions)

Shifts in the Aggregate Demand Curve 120 GDP Deflator 90 AD 1 2 3 4 5 6 7 Real GDP per Year ($ trillions)

Shifts in the Aggregate Demand Curve Decrease in aggregate demand 120 GDP Deflator 90 AD1 AD 1 2 3 4 5 6 7 Real GDP per Year ($ trillions)

The Aggregate Supply Curve The Long-Run Aggregate Supply Curve Real output at full employment A vertical line representing real output based on full information and after full adjustment has occurred 37

Long-Run Equilibrium and the Price Level Figure 10-5 38

Long-Run Equilibrium and the Price Level Long-run equilibrium occurs at the intersection of the LRAS curve and the AD curve Equilibrium price level is determined Planned real expenditures for the economy are equal to total planned production along the economy’s trends growth path 39

The Effects of Economic Growth on the Price Level Figure 10-6, Panel (a) 40

The Effects of Economic Growth on the Price Level Figure 10-6, Panel (b) 40

The Effects of Economic Growth on the Price Level 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. 41

Inflation Rates in the United States Source: Economic Report of the President; Economic Indicators, various issues Figure 10-7

Causes of Inflation: Supply-Side Inflation • When LRAS1 shifts to LRAS2, the price level rises from 120 to 140 • Inflation is caused by a decrease in LRAS. Figure 10-8, Panel (a)

Causes of Inflation: Demand-Side Inflation An increase in AD from AD1 to AD2 causes the price level to rise from 120 to 140. An increase in AD causes inflation. Figure 10-8, Panel (b)

Causes of Inflation: Economic Growth and Inflation Source: Economic Report of the President; Economic Indicators, various issues Figure 10-9

Policy Example: Is There a Simple Explanation for the Price Level’s Upward Drift? As you will learn in Chapter 17, a group of economists known as monetarists believe that changes in the quantity of money in circulation are the predominant cause of changes in the position of the aggregate demand curve.

Policy Example: Is There a Simple Explanation for the Price Level’s Upward Drift? Source: Economic Report of the President; Economic Indicators, various issues Figure 10-10

Issues and Applications: What is P* and Why Should We Care? P* is the equilibrium price level that emerges in the economy’s long-run equilibrium. If the Fed caused the money supply to grow at the same rate as LRAS then inflation could be avoided. 46

Base Drift Figure 10-11

Web Links The following Web links appear in the margin of this chapter in the textbook: http://stats.bls.gov http://stls.frb.org/fred

Summary Discussion of Learning Objectives 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 complete adjustment to input and output changes. Economic growth can be shown by an outward shift of the LRAS curve or of the production possibilities curve. The aggregate demand curve slopes downward because of the real-balance effect, the interest rate effect, and the open economy effect. 47

Summary Discussion of Learning Objectives Long-run equilibrium for the economy occurs when the price level adjusts until total planned real expenditures equal total planned production. If the AD curve is stable during a period of economic growth the price level falls. Because real GDP has been increasing, the most likely factor causing inflation is that AD increases faster than LRAS. 48

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