Chapter 10
Real GDP and
the Price Level
in the Long Run
Introduction
Though the prospect of deflation is
unlikely in the U.S., it has been a real
phenomenon in some Asian countries in
recent years. How do you expect your
economic decisions would be affected if
you anticipated a decline in the overall
price level?
Slide 10-2
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
Slide 10-3
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
Slide 10-4
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
Slide 10-5
Chapter Outline
 Long-Run Equilibrium and the Price
Level
 The Effects of Economic Growth
on the Price Level
 Causes of Inflation
Slide 10-6
Did You Know That...
 The Wonderful Wizard of Oz
was an allegory about how to achieve longrun price stability?
 The story looks at how the money supply
affects the price level?
 The characters and events in the story
represent political issues that arose in the
populist movement?
Slide 10-7
Output Growth and the Long-Run
Aggregate Supply Curve
 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
Slide 10-8
Output Growth and the Long-Run
Aggregate Supply Curve
Figure 10-1
Slide 10-9
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
Slide 10-10
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
Slide 10-11
Economic Growth and the
Long-Run Aggregate Supply Curve
Figure 10-2, Panels (a) and (b)
Slide 10-12
Economic Growth and Long-Run
Aggregate Supply
Figure 10-3
Slide 10-13
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
Slide 10-14
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?
Slide 10-15
The Aggregate Demand Curve
 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
Slide 10-16
The Aggregate Demand Curve
As the price level
rises, real GDP
declines
Price Level
160
140
A
120
AD
0
Figure 10-4
8
9
10
11
12
Real GDP per Year
($ trillions)
13
14
Slide 10-17
The Aggregate Demand Curve
Price Level
160
B
140
A
120
AD
0
Figure 10-4
8
9
10
11
12
Real GDP per Year
($ trillions)
13
14
Slide 10-18
The Aggregate Demand Curve
C
Price Level
160
B
140
A
120
AD
0
Figure 10-4
8
9
10
11
12
Real GDP per Year
($ trillions)
13
14
Slide 10-19
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
Slide 10-20
The Aggregate Demand Curve
 The Real-Balance Effect
– The change in the real value of money
balances when the price level changes
Slide 10-21
The Aggregate Demand Curve
 The Interest Rate Effect
– Higher price levels indirectly increase the
interest rate, which in turn cause a
reduction in borrowing and spending.
Slide 10-22
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).
Slide 10-23
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.
Slide 10-24
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.
Slide 10-25
Factors Increasing
Aggregate Demand
 A drop in the foreign exchange value of the dollar
 Increased security about jobs and future income
 Improving 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
Slide 10-26
GDP Deflator
Shifts in the Aggregate
Demand Curve
120
90
AD
0
1
2
3
4
5
Real GDP per Year
($ trillions)
6
7
Slide 10-27
GDP Deflator
Shifts in the Aggregate
Demand Curve
120
90
AD
0
1
2
3
4
5
Real GDP per Year
($ trillions)
6
7
Slide 10-28
Shifts in the Aggregate
Demand Curve
GDP Deflator
Increase in aggregate demand
120
90
AD
0
1
2
3
4
5
Real GDP per Year
($ trillions)
6
AD1
7
Slide 10-29
Factors Decreasing
Aggregate Demand
 A rise in foreign exchange value of the dollar
 Added fears about jobs and future income
 Declining economic conditions in other countries
 A rise in real interest rates not due to price level
changes
 Tax increases
 A decrease in the amount of money in circulation
Slide 10-30
Shifts in the Aggregate
Demand Curve
GDP Deflator
Decrease in aggregate demand
120
100
0
9
10
11
12
AD1
AD
13
14
Real GDP per Year
($ trillions)
15
Slide 10-31
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
Slide 10-32
Long-Run Equilibrium
and the Price Level
Figure 10-5
Slide 10-33
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
Slide 10-34
The Effects of Economic Growth
on the Price Level
Figure 10-6, Panel (a)
Slide 10-35
The Effects of Economic Growth
on the Price Level
Figure 10-6, Panel (b)
Slide 10-36
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.
Slide 10-37
E-Commerce Example:
Information Technology and LRAS
 The communication capabilities of
computer networks have enhanced
economic growth by
– Adding to the capital stock
– Allowing for the further development of
entrepreneurial talent
Slide 10-38
E-Commerce Example:
Information Technology and LRAS
 In countries where information
technologies have been most widely
adopted, they account for about onethird of the growth in real GDP.
Slide 10-39
Inflation Rates
in the United States
Figure 10-7
Source: Economic Report of the President;
Economic Indicators, various issues
Slide 10-40
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)
Slide 10-41
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)
Slide 10-42
International Example:
High Marginal Tax Rates and Inflation
 High marginal tax rates on income in
European nations have slowed the
growth rate of LRAS.
 One effect of this is a higher rate of
inflation than would prevail otherwise.
Slide 10-43
Causes of Inflation:
Economic Growth and Inflation
Figure 10-9
Source: Economic Report of the President;
Economic Indicators, various issues
Slide 10-44
Issues and Applications:
Different Sources of Deflation
 The deflation observed in the U.S. in
the 1930’s was the result of a leftward
shift of LRAS.
 The recent deflation in Japan and
China occurred with increases in real
output, suggesting that it resulted from
an increase in LRAS along with a
stable aggregate demand.
Slide 10-45
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 when input prices have adjusted to any
change in output prices.
 Economic growth is shown by an outward shift
of the LRAS curve or of the production
possibilities curve.
Slide 10-46
Summary Discussion
of Learning Objectives
 The aggregate demand curve slopes
downward because of the real-balance
effect, the interest rate effect, and the open
economy effect.
 Long-run equilibrium for the economy occurs
when the price level adjusts until total
planned real expenditures equal total
planned production.
Slide 10-47
Summary Discussion
of Learning Objectives
 If aggregate demand 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.
Slide 10-48
End of
Chapter 10
Real GDP and
the Price Level
in the Long Run