Chapter 10 Powerpoint

Chapter 10
Real GDP and
the Price Level
in the Long Run

Copyright ©2014 Pearson Education, Inc. All rights reserved. 10-2
Introduction
Economic growth has trended steadily downward during the
past four decades in nations with northern borders lying
within the Arctic Circle, such as Canada, Russia, and the
United States.
Yet, there is evidence to suggest that resources lying within
the Arctic zone could employed to boost the economic
growth rate of these countries.
In Chapter 10, we will look at how the overall performance of
an economy is affected by the use of new resources.

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 ...
• In Venezuela, the president has used his
parliamentary powers to impose laws that prevent
prices from increasing?
• This was an attempt to make inflation illegal.
• Few countries resort to such dramatic measures to
prevent inflation.
• What causes inflation?

Output Growth and the Long-Run
Aggregate Supply Curve
• Aggregate Supply
– The total of all planned production for the
economy

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

Policy Example: Shrinking Rightward
Shifts in the U.S. LRAS Curve
• Between 2000 and 2007, U.S. real GDP grew at an
annual average rate of 2.6 percent.
– This translated into an increase of about $250 billion per
year in long-run aggregate supply.
• Since 2007, the annual growth of GDP has fallen to
0.5 percent.
– Consequently, the annual increase in long-run aggregate
supply has been reduced to about $70 billion per year.

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

(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

(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

(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

(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.

(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
• 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

Policy Example: The Consumer Confidence Index
and Aggregate Demand
• The Consumer Confidence Index (CCI) is a
measure of the degree of security that U.S.
households have about their future employment
and income.
• Variations in the CCI normally provide an indication
of changes in U.S. aggregate demand.
• Between late 2007 and early 2008, the CCI lost
nearly half of its value.
• Immediately following this drop in consumer
confidence, U.S. aggregate demand decreased by
$350 billion.

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
– An increase in LRAS will, ceteris paribus, result
in a decrease in the price level

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 (b)

Figure 10-7 Inflation Rates in the United
States
Sources: Economic Report of the President; Economic Indicators, various issues.

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)

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 10-9 Real GDP and the Price Level in the
United States, 1970 to the Present
Sources: Economic Report of the President; Economic Indicators, various issues; author’s estimates.

What If . . . There was a sustained increase in the
amount of money in circulation intended to
increase GDP?
• A sustained increase in the quantity of money
would cause persistent rightward shifts in the
position of the aggregate demand curve.
• Because the long-run aggregate supply curve is
vertical, increases in aggregate demand cannot
influence the equilibrium level of real GDP.
• Increases in aggregate demand can, however,
raise the price level.
• So the consequence of an increase in the money
supply would be sustained inflation.

Example: Will Slowed Growth of Potential
U.S. Real GDP Fuel Inflation?
• Economists measure the growth of potential
real GDP as a way of determining the rate of
which long-run aggregate supply shifts
outward.
– The growth rate was about 3.5 percent in the
1940s and above 4 percent in the 1960s.
– Between the 1970s and the 1990s, however, the
growth rate dropped to around 3 percent.
– By the early 2010s, potential GDP growth had
fallen to a rate of somewhere between 1.0 and
1.5 percent.

Example: Will Slowed Growth of Potential U.S.
Real GDP Fuel Inflation? (cont’d)
• This is the slowest expansion of long-run
aggregate supply in more than 80 years.
• If aggregate demand continues to grow at
the same pace as it has in the past, inflation
will necessarily increase.

You Are There: A Nation Confronts a
Leftward-Shifting LRAS Curve
• Since 2007, Portugal’s real GDP has been
shrinking at an average pace of 1 percent
per year.
• Thus, the long-run aggregate supply curve
for Portugal has been shifting leftward.
• The cause of this decline is the lack of
investment in productive capital goods.
• Portuguese manufacturing resources have
been wearing out and haven’t been
replaced.

Issues & Applications: Will Arctic Assets
Unfreeze Long-Run Aggregate Supply?
• The Arctic Circle contains only about 4 percent of
the earth’s surface area.
• Yet, nearby areas stretching southward to 45
degrees latitude encompass another 11 percent of
the earth’s surface and an additional 25 percent of
its land mass.
• These lands contain significant endowments of
untapped natural resources.

Issues & Applications: Will Arctic Assets
Unfreeze Long-Run Aggregate Supply? (cont’d)
• There are three reasons for the meager use of
Arctic resources:
– The region is not a hospitable environment for people
– Large tracts of land are covered with thick permafrost and
glaciers.
– Much of land in the region is publicly owned. Governments
have little incentive to extract the productive resources
deposited there.
• By placing these lands in private hands, the
adjacent nations would experience an increase in
economic growth.

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 and the long-run
aggregate supply curve
– Shown by an outward shift of the LRAS curve or
of the production possibilities curve

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

Objectives (cont'd)
• Long-run equilibrium for the economy
– Occurs when the price level adjusts until total
planned real expenditures equal actual real GDP

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

Chapter 10 Powerpoint

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