1. Economics Today Chapter 10
Roger LeRoy Miller
Economics Today
Chapter 10
Real GDP and the Price Level in the Long Run

2. Introduction
In January 1989, a New York Times feature article examined the “P” model developed by the Federal Reserve.
The “new theory” proposed finding a price level, P*, consistent with the economy’s long-run growth rate.

3. 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 the factors that cause the curve to shift 3

4. Learning Objectives
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 4

5. Chapter Outline Output Growth and the Long-Run Aggregate Supply Curve
Spending and Total Expenditures
The Aggregate Demand Curve
Shifts in the Aggregate Demand Curve 5

6. Chapter Outline Long-Run Equilibrium and the Price Level
The Effects of Economic Growth on the Price Level
Causes of Inflation 6

7. Did You Know That...
The Wonderful Wizard of Oz was an allegory about how to achieve long-run price stability?
The story looks at how the money supply affects the price level? 7

8. Output Growth and the Long-Run Aggregate Supply Curve
An amount of real GDP
People have full information and have adjusted
The price level is fixed
Technology does not change
All resources are fully employed
The economy is on its production possibilities curve 8

9. Output Growth and the Long-Run Aggregate Supply Curve
Figure 10-1

10. The 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 10

11. Economic Growth and Long-Run Aggregate Supply
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 11

12. Economic Growth and the Long-Run Aggregate Supply Curve
Figure 10-2, Panels (a) and (b)

13. Economic Growth and Long-Run Aggregate Supply
Figure 10-3

14. Spending and Total Expenditures
Aggregate Demand
The total of all planned expenditures in the economy
Aggregate Supply
The total of all planned production in the economy 14

15. Spending and Total Expenditures
Questions
What determines the total amount that individuals, governments, firms, and foreigners want to spend?
What determines the equilibrium price level? 15

16. The Aggregate Demand Curve
A curve showing planned purchase rates for all goods and services in the economy at various price levels, all other things held constant
Aggregate demand = C + I + G + X

17. The Aggregate Demand CurveAD
As the price level
rises, real GDP
demand declines
140
120
Price Level A
100 6 7 8 9 10 11 12
Real GDP per Year ($ trillions)

18. The Aggregate Demand Curve
140 B
120
Price Level A
100 AD 6 7 8 9 10 11 12
Real GDP per Year ($ trillions)

19. The Aggregate Demand Curve
140 B
120
Price Level A
100 AD 6 7 8 9 10 11 12
Real GDP per Year ($ trillions)
Figure 10-4

20. The Aggregate Demand Curve
What happens when the price level rises?
The Real-Balance Effect (wealth effect)
The Interest Rate Effect
The Open Economy Effect 22

21. The Aggregate Demand Curve
The Real-Balance Effect
The change in the real value of money balances when the price level changes 23

22. The Aggregate Demand Curve
The Interest Rate Effect
Higher price levels indirectly increase the interest rate. 24

23. The Aggregate Demand Curve
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). 25

24. 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. 26

25. 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. 27

26. 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. 28

27. Factors Increasing Aggregate Demand
A drop in the foreign exchange value of the dollar
Increased security about jobs and future income
Improvements in economic conditions in other countries
A reduction in real interest rates (nominal interest rates corrected for inflation) not due to price level changes
Tax decreases
An increase in the amount of money in circulation

28. Shifts in the Aggregate Demand CurveAD
120
GDP Deflator 90 1 2 3 4 5 6 7
Real GDP per Year ($ trillions)

29. Shifts in the Aggregate Demand Curve
120
GDP Deflator 90 AD 1 2 3 4 5 6 7
Real GDP per Year ($ trillions)

30. Shifts in the Aggregate Demand Curve
Increase in aggregate demand
120
GDP Deflator 90
AD1 AD 1 2 3 4 5 6 7
Real GDP per Year ($ trillions)

31. Factors Decreasing Aggregate Demand
A rise in the foreign exchange value of the dollar
Decreased security about jobs and future income
Declines in economic conditions in other countries
A rise in real interest rates (nominal interest rates corrected for inflation) not due to price level changes
Tax increases
A decrease in the amount of money in circulation

32. Shifts in the Aggregate Demand Curve
120
GDP Deflator 90 AD 1 2 3 4 5 6 7
Real GDP per Year ($ trillions)

33. Shifts in the Aggregate Demand Curve
120
GDP Deflator 90 AD 1 2 3 4 5 6 7
Real GDP per Year ($ trillions)

34. Shifts in the Aggregate Demand Curve
Decrease in aggregate demand
120
GDP Deflator 90
AD1 AD 1 2 3 4 5 6 7
Real GDP per Year ($ trillions)

35. The Aggregate Supply Curve
The Long-Run Aggregate Supply Curve
Real output at full employment
A vertical line representing real output based on full information and after full adjustment has occurred 37

36. Long-Run Equilibrium and the Price Level
Figure 10-5 38

37. Long-Run Equilibrium and the Price Level
Long-run equilibrium occurs at the intersection of the LRAS curve and the AD curve
Equilibrium price level is determined
Planned real expenditures for the economy are equal to total planned production along the economy’s trends growth path 39

38. The Effects of Economic Growth on the Price Level
Figure 10-6, Panel (a) 40

39. The Effects of Economic Growth on the Price Level
Figure 10-6, Panel (b) 40

40. The Effects of Economic Growth on the Price Level
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. 41

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

42. Causes of Inflation: Supply-Side Inflation
• 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 (a)

43. Causes of Inflation: Demand-Side Inflation
An increase in AD from AD1 to AD2 causes the price level to rise from 120 to 140. An increase in AD causes inflation.
Figure 10-8, Panel (b)

44. Causes of Inflation: Economic Growth and Inflation
Source: Economic Report of the President; Economic Indicators, various issues
Figure 10-9

45. Policy Example: Is There a Simple Explanation for the Price Level’s Upward Drift?
As you will learn in Chapter 17, a group of economists known as monetarists believe that changes in the quantity of money in circulation are the predominant cause of changes in the position of the aggregate demand curve.

46. Policy Example: Is There a Simple Explanation for the Price Level’s Upward Drift?
Source: Economic Report of the President; Economic Indicators, various issues
Figure 10-10

47. Issues and Applications: What is P* and Why Should We Care?
P* is the equilibrium price level that emerges in the economy’s long-run equilibrium.
If the Fed caused the money supply to grow at the same rate as LRAS then inflation could be avoided. 46

48. Base Drift
Figure 10-11

49. Web Links
The following Web links appear in the margin of this chapter in the textbook:

50. Summary Discussion of Learning Objectives
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 complete adjustment to input and output changes.
Economic growth can be shown by an outward shift of the LRAS curve or of the production possibilities curve.
The aggregate demand curve slopes downward because of the real-balance effect, the interest rate effect, and the open economy effect. 47

51. Summary Discussion of Learning Objectives
Long-run equilibrium for the economy occurs when the price level adjusts until total planned real expenditures equal total planned production.
If the AD curve is stable during a period of economic growth the price level falls.
Because real GDP has been increasing, the most likely factor causing inflation is that AD increases faster than LRAS. 48

52. End of Chapter
Chapter 10
Real GDP and the Price Level in the Long Run