10-2 copyright © 2011 pearson education, inc. all rights...

Copyright ©2011 by Pearson Education, Inc.All rights reserved.

Chapter 10

Real GDP and the Price Level in the Long Run

10-2Copyright © 2011 Pearson Education, Inc. All rights reserved.

Introduction

From the 1930’s until the early 1960’s, the annual rate of U.S. real GDP growth steadily increased, but it generally trended downward in the 1970’s and 1980’s

During the 1990’s annual real GDP growth recovered slightly

During the 2000’s there has been yet another decline

In this chapter, you will learn what factors determine variations in real GDP growth rates over long periods of time


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...

• Several times during the period known as the “Roaring Twenties,” the price level declined in the United States?

• In the meantime, average prices of shares of stock more than doubled, and real GDP increased

• Why did the United States experience deflation even as the nation experienced economic growth in the 1920s?


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



• 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)



• 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



• 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


International Example: Will a “Brain Drain” Flatten Germany’s Trend Growth Path?

• A nation’s economic growth slows as it experiences a brain drain, which is an outflow of human capital

• Its long-run aggregate supply curve shifts rightward at a slower pace, and its long-run real GDP growth path becomes less steeply sloped

• Germany has been experiencing a brain drain since the early 2000s


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 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

• 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


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


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


Long-Run Equilibrium and the Price Level (cont’d)

• 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


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)


International Example: For Greenland, a Warming Climate is Good Economic News

• Today, more than 80% of the country is covered in ice

• The average temperature has risen by 2.7 degrees Fahrenheit over the past 30 years. Some climatologists predict another 10 degree increase by the end of the century

• Warmer days allow greater productivity and shifted Greenland’s long-run aggregate supply curve rightward


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 several

factors: • 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 long-run aggregate supply, the price level must increase


Figure 10-8 Explaining Persistent Inflation, Panel (b)

An increase in AD from AD1to AD2 causes the price level to rise from 120 to 140, and an increase in ADcauses inflation


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


Example: Does Sustained Low Inflation Depress Real GDP?

• Economists agree that inflation imposes two fundamental types of costs that can reduce real GDP:

– People have an incentive to divert resources away producing goods and services to more carefully managing their financial assets

– Inflation hinders efforts to distinguish temporary variations in prices of goods and services from permanent price changes, which complicates firms’ efforts to determine profitable rates of production of goods and services


Example: Does Sustained Low Inflation Depress Real GDP? (cont'd)

• These resource costs of inflation are higher at higher inflation rates

• Some recent estimates, however, take into account a third cost of inflation: taxation, which is not indexed to inflation

• What does the government have to gain from failing to index its tax to inflation?


Issues and Applications: Is U.S. Long-Run Real GDP Growth Declining?

• Since the 1930’s, real GDP has increased in all but a few years

• To gauge the speed of growth of long-run aggregate supply, economists utilize a concept known as potential real GDP

• The rate at which potential real GDP increases each year, indicates how fast the long-run aggregate supply curve shifts rightward over time


Issues and Applications: Is U.S. Long-Run Real GDP Growth Declining? (cont'd)

• To estimate the potential annual rate of real GDP growth, economists must develop projections of long-run growth paths for three key factors: the capital stock, labor employment, and productivity of labor and capital

• Based on such projections, economists agree that potential GDP growth in the U.S. rose from about 3.5% per year in the 1930’s and 1940’s to just above 4% in the early 1960’s


Issues and Applications: Is U.S. Long-Run Real GDP Growth Declining? (cont'd)

• Most estimates indicate that from the early 1960’s to the early 1990’s, potential annual rates of real GDP steadily declined to between 2.8 and 2.9%

• Since 2000, estimated potential annual rates of real GDP growth have been steadily declining again

• If the rate at which the long-run aggregate supply curve shifts rightward decreases but aggregate demand continues increasing at the same rate, what must happen to the rate of change in the long-run equilibrium price level?


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



• 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

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