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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Real GDP and the Price Level in the Long Run
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.
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
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
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
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?
The total of all planned production for the economy
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
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)
The value of a current sum expressed in terms of prices in a base year
The various resources in an economy, including both physical resources and such resources as ingenuity and management skills
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
Improvements in technology
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.
The total of all planned expenditures in the entire economy
What determines the total amount that individuals, governments, firms, and foreigners want to spend?
What determines the equilibrium price level?
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
As the price level rises, real GDP declines
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 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 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 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.
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
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
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.
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)
The effects of economic growth on the price level
Economic growth and 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
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
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 10-8 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
• 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 (b)
If aggregate demand increases for a given level of long-run aggregate supply, the price level must increase
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
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.
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.
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.
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
Shown by an outward shift of the LRAS curve or of the production possibilities curve
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
Long-run equilibrium for the economy
Occurs when the price level adjusts until total planned real expenditures equal actual real GDP
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