Transcript Chapter 10 - The Citadel

Chapter 10
Real GDP and
the Price Level
in the Long Run
Introduction
After a tsunami hit the Indian Ocean region in
2004, observers predicted it might also deal a
mortal blow to the regional economies.
Yet inflation rates in most nations hit by the
tsunami rose only slightly in 2005 and levels of
GDP increased by at least 4%.
In this chapter, you will learn why positive
long-run real GDP and price level trends can
overwhelm even a tsunami.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
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 key
factors that cause this curve to shift
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10-3
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
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10-4
Chapter Outline
• Output Growth and the Long-Run
Aggregate Supply Curve
• Total Expenditures and
Aggregate Demand
• The Aggregate Demand Curve
• Shifts in the Aggregate Demand Curve
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10-5
Chapter Outline (cont'd)
• Long-Run Equilibrium and the
Price Level
• The Effects of Economic Growth
on the Price Level
• Causes of Inflation
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10-6
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?
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10-7
Output Growth and the Long-Run
Aggregate Supply Curve
• Aggregate Supply
 The total of all planned production for
the economy
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10-8
Output Growth and the Long-Run
Aggregate Supply Curve (cont'd)
• Long-Run Aggregate Supply Curve
 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
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10-9
Figure 10-1 The Production Possibilities
and the Economy’s Long-Run Aggregate
Supply Curve
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10-10
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)
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10-11
Output Growth and the Long-Run
Aggregate Supply Curve (cont'd)
• Endowments
 The various resources in an economy,
including both physical resources and
such resources as ingenuity and
management skills
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10-12
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
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10-13
Figure 10-2 The Long-Run Aggregate
Supply Curve and Shifts in It
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10-14
Figure 10-3 A Sample Long-Run
Growth Path for Real GDP
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10-15
Total Expenditures
and Aggregate Demand
• Aggregate Demand
 The total of all planned expenditures in the
entire economy
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10-16
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?
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10-17
The Aggregate Demand Curve
• Aggregate Demand Curve
 A curve showing planned purchase rates
for all final goods and services in the
economy at various price levels, all other
things held constant
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10-18
Figure 10-4
The Aggregate Demand Curve
As the price
level rises, real
GDP declines
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10-19
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
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10-20
The Aggregate Demand
Curve (cont'd)
• The Real-Balance Effect
 The change in the real value of money
balances when the price level changes
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10-21
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.
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10-22
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).
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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.
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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.
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10-25
Table 10-1 Determinants of
Aggregate Demand
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10-26
GDP Deflator
Shifts in the Aggregate
Demand Curve (cont'd)
120
90
AD
0
1
2
3
4
5
Real GDP per Year
($ trillions)
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6
7
10-27
GDP Deflator
Shifts in the Aggregate
Demand Curve (cont'd)
120
90
AD
0
1
2
3
4
5
Real GDP per Year
($ trillions)
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6
7
10-28
Shifts in the Aggregate
Demand Curve (cont'd)
GDP Deflator
Increase in aggregate demand
120
90
AD
0
1
2
3
4
5
Real GDP per Year
($ trillions)
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6
AD1
7
10-29
Shifts in the Aggregate
Demand Curve (cont'd)
GDP Deflator
Decrease in aggregate demand
120
100
0
9
10
11
12
AD1
AD
13
14
Real GDP per Year
($ trillions)
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15
10-30
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).
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10-31
Figure 10-5 Long-Run
Economywide Equilibrium
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10-32
Long-Run Equilibrium
and the Price Level (cont'd)
• The effects of economic growth on the
price level
 Economic growth and secular deflation
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10-33
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
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10-34
Secular Deflation versus Long-Run
Price Stability in a Growing Economy
• 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.
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10-35
Figure 10-6 Secular Deflation versus
Long-Run Price Stability in a Growing
Economy, Panel (a)
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10-36
Figure 10-6 Secular Deflation versus
Long-Run Price Stability in a Growing
Economy, Panel (b)
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10-37
International Example:
Deflation is the Norm in Japan
• Since 1998, Japan’s real GDP has
increased every year except 2002.
• As the LRAS curve shifted rightward,
the price level gradually declined.
• Consequently Japan experienced
deflation.
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10-38
Figure 10-7 Inflation Rates
in the United States
Source: Economic Report of the President; Economic Indicators, various issues
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10-39
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
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10-40
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
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10-41
Figure 10-9 Real GDP and
the Price Level in the United States,
1970 to the Present
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10-42
International Policy Example:
The People’s Bank of China Rediscovers
How to Create Inflation
• LRAS has been increasing rapidly in
China.
• Real GDP has risen at least 7% per
year since 1998.
• Recently the price level has increased.
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10-43
International Policy Example:
The People’s Bank of China Rediscovers
How to Create Inflation (cont'd)
• Money supply growth caused aggregate
demand to shift rightward.
• AD shifted at a faster pace than the
rightward shift in the LRAS curve.
• The end result was an increase in the
price level.
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10-44
Issues and Applications:
Why the 2004 Tsunami Did Not Swamp
Asian Economies
• The estimated death toll from the
tsunami of 2004 exceeded all others
since the year 1556.
• In spite of this huge toll, most of the
regional economies stayed on their
long-run growth paths.
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10-45
Issues and Applications:
Why the 2004 Tsunami Did Not Swamp
Asian Economies (cont'd)
• Observers were concerned that…
 LRAS would decrease, causing price
levels to jump, resulting in sudden inflation
and then real GDP would drop, leading
to recession.
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10-46
Issues and Applications:
Why the 2004 Tsunami Did Not Swamp
Asian Economies (cont'd)
• Yet tourism drop-off generated a decline
in AD, which helped reduce price
increases.
• Inflation rates dropped back to levels
consistent with long-term trends.
• Real GDP grew in 2005 in all
four nations.
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10-47
Table 10-2 Inflation Rates
and Real GDP Growth Rates
in Selected Southeast Asian Nations
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10-48
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
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10-49
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
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10-50
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
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10-51
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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10-52
End of
Chapter 10
Real GDP and
the Price Level
in the Long Run