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

2. Chapter Overview Aggregate Demand (AD)
Long Run Aggregate Supply (LRAS)
Long Run Equilibrium
Price Level
Real GDP
Inflation / Deflation
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3. Aggregates What is an economic aggregate? An abstraction
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4. Output Growth and the Long-Run Aggregate Supply Curve
The total of all planned production for the economy
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5. Output Growth and the Long-Run Aggregate Supply Curve (cont'd)
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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6. Figure 10-1 The Production Possibilities and the Economy’s Long-Run Aggregate Supply Curve
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7. 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
Growth in labor-force participation rate
Capital accumulation
Improvements in technology
Increase in resource base
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8. Figure 10-2 The Long-Run Aggregate Supply Curve and Shifts in It
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9. Total Expenditures and Aggregate Demand
The total of all planned expenditures in the entire economy
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10. 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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11. The 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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12. Figure 10-4 The Aggregate Demand Curve
As the price level rises, real GDP declines
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13. The Aggregate Demand Curve (cont'd)
What happens when the price level changes?
The real-balance effect (or wealth effect)
The interest rate effect
The open economy effect
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14. The Aggregate Demand Curve (cont'd)
The Real-Balance Effect (The Wealth Effect)
Purchasing Power of cash balances
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15. The Aggregate Demand Curve (cont'd)
The Interest Rate Effect
Lower price levels indirectly decrease the interest rate, which in turn causes an increase in borrowing and spending.
↓ Price level  ↓ demand for loans  ↓ i-rate
↓ Price Level  ↓ i-rate  ↑ Investment
↑ Consumption
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16. 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).
↑ P-level  ↓ goods purchased
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17. 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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18. 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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19. 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)
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20. Shifts in the Aggregate Demand Curve (cont'd)
Decrease in aggregate demand
120
GDP Deflator
100
AD1 AD 9 10 11 12 13 14 15
Real GDP per Year ($ trillions)
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21. Non Price Determinants of Aggregate Demand (AD)
Government Spending
Tax Policy
Expectations
Money Supply
Population
Foreign exchange rate
Economic Conditions in other countries
Interest Rate
Fiscal Policy
Monetary Policy
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22. 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).
Equilibrium = Stability
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23. Figure 10-5 Long-Run Economywide Equilibrium
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24. 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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25. 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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26. Secular Deflation versus Long-Run Price Stability in a Growing Economy
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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27. Figure 10-6 Secular Deflation versus Long-Run Price Stability in a Growing Economy, Panel (a)
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28. Figure 10-6 Secular Deflation versus Long-Run Price Stability in a Growing Economy, Panel (b)
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29. 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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30. Secular Inflation
A persistent rise in prices resulting from Aggregate Demand (AD) increasing faster that aggregate supply
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31. Supply Side Inflation
• 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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32. Demand Side Inflation
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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33. Figure 10-7 Inflation Rates in the United States
Source: Economic Report of the President; Economic Indicators, various issues
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