Chapter 10
Real GDP and
the Price Level
in the Long Run
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
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
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
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
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?
Output Growth and the Long-Run
Aggregate Supply Curve
• Aggregate Supply
– 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
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)
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
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.
Total Expenditures and Aggregate
Demand
• Aggregate Demand
– The total of all planned expenditures in the entire
economy
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?
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
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
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
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.
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
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
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.
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)
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
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 longrun 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