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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.

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Chapter 10

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Chapter 10

Chapter 10

Real GDP and the Price Level in the Long Run


Introduction

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

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

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

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

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

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

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

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 d1

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 d2

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 d3

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


Figure 10 3 a sample long run growth path for real gdp

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


Example how much might going green reduce u s economic growth

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

Total Expenditures and Aggregate Demand

Aggregate Demand

The total of all planned expenditures in the entire economy


Total expenditures and aggregate demand cont d

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

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

Figure 10-4 The Aggregate Demand Curve

As the price level rises, real GDP declines


The aggregate demand curve cont d

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 d1

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 d2

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 d3

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 d4

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

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

Table 10-1 Determinants of Aggregate Demand


Example explaining the drop in aggregate demand in the late 2000s

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

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

Figure 10-5 Long-Run Economywide Equilibrium


Long run equilibrium and the price level cont d

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 d1

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 d2

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 (a)


Figure 10 6 secular deflation versus long run price stability in a growing economy panel b

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

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

Figure 10-7 Inflation Rates in the United States


Causes of inflation

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

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

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

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

Figure 10-9 Real GDP and the Price Level in the United States, 1970 to the Present


You are there fighting inflation in pakistan

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

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

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

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


Summary discussion of learning objectives

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

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 d1

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 d2

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


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