Economics Today The Macro 17th Edition by

Roger LeRoy Miller ISBN 0132948893

9780132948890
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Chapter 10
Real GDP and the Price Level
in the Long Run

◼ Overview
This chapter introduces the concepts of aggregate demand (AD) and long-run aggregate supply (LRAS).
It shows how economic growth can be illustrated by the use of the LRAS. Both LRAS and AD are used
extensively in later chapters. Aggregate demand and long-run aggregate supply curves are derived. They
are used to identify the long-run equilibrium price level and equilibrium real GDP. Why each curve shifts
is then discussed, and the effect of these shifts on macroeconomic equilibrium is shown. Finally, the model
is used to explain both inflation and deflation.

◼ Learning Objectives
After studying this chapter, students should be able to
• 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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• Discuss the meaning of long-run equilibrium for the economy as a whole.

• Evaluate why economic growth can cause deflation.
• Evaluate the likely reasons for persistent inflation in recent decades.

◼ Outline
I. Output Growth and the Long-Run Aggregate Supply Curve: The total of all planned production
for the entire economy is referred to as the aggregate supply of real output.
A. The Long-Run Aggregate Supply Curve: The long-run aggregate supply curve (LRAS) is
some amount of output of real goods and services in a world in which technology is constant,
the price level has not changed, labor productivity has not changed, all resources are fully
employed, and people have fully adjusted to all the information they have. The curve is a
vertical line relating full employment real GDP to the price level. (See Figure 10-1.)
B. Economic Growth and Long-Run Aggregate Supply: Economic growth is shown by the
outward shifting of the production possibilities curve or as the LRAS curve shifting to the
right over time. A long-run growth or trend path can be derived showing real GDP at full
employment over time. (See Figures 10-2 and 10-3.)
II. Total Expenditures and Aggregate Demand: The spending decisions of individuals, firms,
governments, and foreigners determine the total value of nominal GDP. There are two issues
that need to be addressed. The first issue is what determines the total amount that individuals,
governments, businesses, and foreigners want to spend? Second, what determines the equilibrium
price level and the rate of inflation? The total of all planned expenditures in the entire economy is
called aggregate demand.
A. The Aggregate Demand Curve: The aggregate demand curve shows planned purchase rates
for all final goods and services in the economy at various price levels, other things held constant.
(See Figure 10-4.)
B. What Happens When the Price Level Rises?:
1. The Real-Balance Effect: The change in expenditures resulting from the real value of
money balances when the price level changes. A rise in the price level decreases the real
value of a given amount of money; balances and planned spending will decrease.
2. The Interest Rate Effect: Higher prices result in a rising interest rate. Households spend
less on consumer durables, businesses spend less on capital investments, and the aggregate
quantity of goods and services demanded decreases.
3. The Open Economy Effect: The Substitution of Foreign Goods: An increase in the price
level in the United States makes U.S. goods relatively more expensive compared with
foreign produced goods. Planned purchases of domestically produced goods will fall and
planned purchases of foreign produced goods (imports) will rise. Foreigners will no longer
want to purchase as much U.S. production as before and U.S. exports will fall. The aggregate
quantity of U.S. produced goods and services demanded falls.
C. What Happens When the Price Level Falls?: There are the same three effects when the price
level falls as when it rises; they just have the reverse effect on the aggregate quantity of goods
and services demanded.
D. Demand for All Goods and Services versus Demand for a Single Good or Service: When
the aggregate demand curve is derived, the entire economic system is viewed. The aggregate
demand curve differs from an individual demand curve because it shows the circular flow of
income and product constructed as AD.

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 Chapter 10 Real GDP and the Price Level in the Long Run 95

III. Shifts in the Aggregate Demand Curve: When non-price level determinants of aggregate demand
change, a shift in the aggregate demand curve occurs. 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. (See Table 10-1.)

IV. Long-Run Equilibrium and the Price Level: Long-run equilibrium occurs at the intersection of the
aggregate demand and the long-run aggregate supply curve. At this point, planned real expenditures
for the entire economy equal actual full employment real GDP produced by firms. (See Figure 10-5.)
A. The Long-Run Equilibrium Price Level: The economy’s long-run equilibrium price level
occurs at the point at which the aggregate demand curve crosses the long-run aggregate supply
curve. (See Figure 10-5.)
1. Economic Growth and Secular Deflation: If all factors that affect total planned real
expenditure are unchanged so that the aggregate demand curve does not move during a
10-year interval, then economic growth as shown by an outward shifting long-run aggregate
supply curve results in deflation. (See Figure 10-6.)
2. Secular Deflation in the United States: Between 1872 and 1895, the price level in the
United States fell. Founders of populism wanted the U.S. government to issue new money
backed by silver. The effect would have been to increase aggregate demand. The movement
was not successful in getting the money supply growing fast enough.

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B. The Effects of Economic Growth on the Price Level: If LRAS increased over time and
aggregate demand stayed constant, the price level would fall and there would be secular
deflation. If aggregate demand increased at the same rate as LRAS, the price level would remain
constant. (See Figure 10-6.)
1. Economic Growth and Secular Deflation: From 1872 to 1894, the price level fell. To
counter the deflation, a group of populists called for an increase in the money supply by
having the government issue new currency backed by silver. The effect would have been
to increase aggregate demand and stop the deflation.
2. Secular Deflation in the United States: In 1890, the experiment with silver backed money
began. In 1893, there was a financial panic and the experiment ended with the repeal of the
Silver Purchase Act.

V. Causes of Inflation
A. Supply-Side Inflation?: Inflation could be caused by a decrease in aggregate supply with a
given aggregate demand curve. This cannot be the explanation of inflation for the persistent or
secular inflation because of the long-run increase in population, productivity, and real GDP,
i.e., the aggregate supply curve has shifted to the right. (See Figure 10-8(a).)
B. Demand-Side Inflation: If the aggregate demand curve shifts rightward over time at a pace
faster than the rightward progression of aggregate supply, then persistent or secular inflation
will occur. (See Figures 10-8(b) and 10-9.)

◼ Points to Emphasize
Planned Values versus Actual Values
It is important to emphasize that aggregate demand represents total planned expenditures in the economy
on domestically produced goods at different price levels and that aggregate supply is total planned production
in the economy at different price levels. Without a firm understanding of aggregate demand and supply as
behavioral concepts, the idea of macroeconomic equilibrium as a realization of plans (i.e., planned production
equals planned expenditures) is a difficult concept to grasp. Actual real production and actual real expenditure
will always be equal by definition.

Real Balance Effect

This effect of a change in the price level on planned expenditures through the decline in the purchasing
power of money is similar to the income effect associated with a price change in the model of demand.

Changes in the Price Level/Changes in Non-Price-Level Factors

The idea of moving along a curve and a shift of the curve is often difficult for students to grasp. Emphasize
the difference between an increase in planned expenditures that occurs because the price level falls
(a movement down a given AD curve) and an increase in planned expenditures at each price level
(a rightward shift of the AD curve). Spend a little extra time on this distinction, perhaps jumping ahead a
little and explaining how an increase in the money supply can shift the curve to the right. For those who
want to stress theory, comparing the difference between the effect on planned expenditures when there is a
change in the price level with the nominal money supply fixed, and no change in the price level with a
change in the nominal money supply is easy at this point, since the real balance effect has already been
introduced.

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 Chapter 10 Real GDP and the Price Level in the Long Run 97

Long-Run Aggregate Supply

The long-run aggregate supply concept is easy for students to grasp when it is presented simply as full
employment real GDP with no other conditions or explanation given. The idea of long-run aggregate
supply as the level of real GDP that exists in the stationary state after all adjustments to any disturbances
in the economy have taken place is difficult for them to grasp at this point in the text. This is because they
have not been introduced to the types of adjustments that do take place in response to a change in the price
level, or the money supply, or other types of disturbances in the short run. Also, the stationary state itself is
a very abstract concept for those who are just being introduced to economics. Spending some extra time
with this concept now can make it easier for students to pick up on discussions of adjustments that occur
because of adaptive expectations versus rational expectations that are presented later.

◼ For Those Who Wish to Stress Theory

The Real Balance Effect
In order to explain the negatively sloped aggregate demand curve via the real balance effect, try the
following approach. Suppose a person owns $100 worth of real estate, a $100 corporate (not U.S.) bond,
and a $100 bill. What happens if the price level falls to one-thousandth of its previous value? Assume that
all prices fall at the same rate, which is how this analysis is usually conducted.

1. The value of his real estate falls to one-thousandth of its previous value, but a person is not poorer
because all prices have fallen at the same rate.

2. The person is better off because a bond is a monetary asset; the coupon payment on the bond is
denominated in nominal dollars, therefore one can now buy more goods and services with the bond’s
fixed nominal dollar interest payment. But the bond issuer is correspondingly worse off; therefore,
net wealth for the community is unchanged.

3. The $100 bill is now worth $100,000. A person is better off because he or she can now buy $100,000
worth of goods and services instead of $100 worth, and it is generally agreed, no one else is worse
off. The net effect, therefore, is that the community is richer, and there will be an increase in the
quantity of real GDP demanded. Therefore, the aggregate demand curve is negatively sloped.

The fact is that all monetary assets are corresponding liabilities for others. This is true for money itself,
which is a liability of the Federal Reserve (or the Treasury). Apparently, there is a Pigou effect because the
Federal Reserve is not like an individual or a business, i.e., it does not have a budget constraint and need
not react to this increase in the real value of its liabilities.

Secular Inflation
Secular inflation can only occur if aggregate demand increases faster than aggregate supply in an economy
in which the resource base is growing and technology is improving. Since the private sector cannot sustain
increases in aggregate demand over very long periods of time without changes in the money supply, inflation
must have as its source, increases in the money supply. Given a constant money supply, increases in aggregate
demand would result in increases in the demand for money, causing interest rates to rise. Eventually, higher
and higher interest rates would choke off investment spending and those parts of consumption financed by
borrowing. Aggregate demand would begin growing more slowly and would eventually stop growing, thus
bringing inflation to an end.

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98 Miller • Economics Today, Seventeenth Edition

Secular Deflation
Secular deflation brings its own problems to the economy. As the value of money rises, the real cost of
paying off debt increases, and there is a transfer of wealth from debtors to creditors. The groups most
harmed would be homebuyers, small businesspersons, and corporate borrowers. Groups that would benefit
would be creditors, e.g., persons who held bonds, lending institutions, and retired persons on fixed
pensions or annuities.

◼ Further Questions for Class Discussion

1. As the price level rises, the aggregate quantity of real goods and services demanded declines due to
the open economy effect. Ask students why the AD curve slopes downward in this case. After all,
while foreigners buy fewer U.S. produced goods, Americans buy more foreign goods, so that total
spending by the various sectors of the U.S. economy on all goods and services might rise, fall, or
remain the same. While it is true that total spending on goods and services might not change,
spending on domestically produced goods and services will certainly fall because exports will fall
and some foreign produced goods will be substituted for domestically produced ones. The AD curve
is not about the amount spent on foreign and domestically produced goods; rather, it is about the
amount of spending on domestically produced goods and services.

2. What kinds of government policies could discourage economic growth by reducing the rate at which
the LRAS curve shifts to the right? Since the LRAS curve depends on the quantity of resources and the
level of technology, higher marginal tax rates would discourage people from working as many hours
and would effectively decrease the supply of labor. Increasing marginal tax rates on the return
(income from) saving would decrease the amount of funds and resources available for capital
creation. Government could reduce subsidies of basic research, especially in the public domain via
decreasing grants to universities, would reduce the rate of growth of technological progress. Increases
in the amount of government welfare benefits and/or the length of time that they can be paid to any
one person would effectively decrease the labor force. Reducing spending on education, especially
higher education, would cause the rate of growth of productivity of the labor force to decrease.

3. Why is a stable price level likely to increase the rate of economic growth? A stable price level tends
to create more certainty about the future and thus reduces risk in the economy. Long-term contracts
can be signed, bonds can be purchased, and saving requirements for retirement can be estimated in
money terms with a fair degree of accuracy. A stable price level will therefore contribute to a climate
that fosters saving and investment. Also, purchasing power is not altered capriciously by unanticipated
changes in the price level.

4. In what ways might deflation affect an individual’s well-being? For persons who are creditors,
deflation means an increase in the real value of the debts owed to them, as well as increases in the
purchasing power of the interest payments. For example, a retired person with certificates of deposit
and shares in a bond mutual fund should experience a net increase in both wealth and his or her
standard of living. Debtors will find that they are worse off because they will have to pay off debts in
dollars that are worth more in purchasing power terms than the ones they borrowed. In a practical
sense, the debt repayments will be made from a lower dollar income for the average debtor since a
falling price level means lower dollar incomes on the average. So, someone paying off a car loan over
a five-year period would find him- or herself giving up increasing amounts of purchasing power over
the term of the loan.

5. Inflation has been a macroeconomic issue since the 1950s. It has varied from year to year, but the
overall trend of the price level has been up for every year since 1950. What has likely been the cause

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 Chapter 10 Real GDP and the Price Level in the Long Run 99

of this long-term (secular) inflation? Increases in the money supply has caused aggregate demand to
increase faster than aggregate supply. Only the government through the Federal Reserve can increase
the quantity of money and cause secular inflation in a growing economy.

6. By 2008, the foreign exchange rate of the dollar had dropped against almost every major currency in
the world. Despite a financial crisis and a crash in the U.S. housing market (a major decrease in
housing construction would cause a decrease in AD) in late 2007, which worsened in 2008 and 2009,
the price level began to increase. Explain in terms of the aggregate demand (AD) and aggregate
supply (AS) model how this would have been possible if LRAS had remained unchanged. Answer: A
drop in the foreign exchange rate of the dollar increases AD as exports increase and imports decrease.
The increase in AD from this effect must have been larger than the decrease in AD caused by the
housing market crash.

◼ Answers to Questions for Critical Analysis

Shrinking Rightward Shifts in the U.S. LRAS Curve? (p. 213)
As the rightward shift of the U.S. long-run aggregate supply curve has slowed down, the U.S. production
possibilities curve has shifted outward at a slower pace.

The Consumer Confidence Index and Aggregate Demand (p. 218)

A substantial increase in the Consumer Confidence Index suggests that U.S. households feel more secure
about their future employment and income status. Consumer spending will likely increase as a result,
meaning that the position of the aggregate demand curve will shift rightward.

Will Slowed Growth of Potential U.S. Real GDP Fuel Inflation? (pp. 222-223)
The lower growth of long-run aggregate supply in the 2000s means that the long-run aggregate supply
curve was shifting rightward at a slower pace during that period. As aggregate demand continued to
increased, the slower growth of long-run aggregate supply could account for the higher average inflation
rate in the 2000s than in the 1990s.

◼ You Are There

A Nation Confronts a Leftward-Shifting LRAS Curve (p. 223)
1. As Portugal’s long-run aggregate supply curve is shifting leftward over time, the nation’s production
possibilities curve is shifting leftward as well.

2. Given that Portugal’s long-run supply curve is shifting leftward, the nation will likely experience
supply-side inflation in the coming years unless aggregate demand will reduce substantially to offset
the effect of the leftward shift of the long-run supply curve.

◼ Issues and Applications

Will Arctic Assets Unfreeze Long-Run Aggregate Supply? (pp. 223–224)
1. In contrast to governments, private firms in privately accessible Arctic areas have incentives to
extract available resource endowments through the use of specialized tanker ships and platforms.

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100 Miller • Economics Today, Seventeenth Edition

2. The opportunity costs of opening Arctic lands to private extraction of as-yet unavailable resource
endowments include possible damage to the environment and the effect of global warming due to
over-extraction of resources in the Arctic Circle.

◼ Answers to Even-Numbered Problems

10-2. $13.04 trillion

10-4. b, d, and e

10-6. The LRAS curve has shifted rightward, and the consequent decline of the equilibrium price level is
secular deflation.

10-8. a, d, and e

10-10. If there is full information and rapid adjustment of input prices to the rise in the price level, then
firms do not change their production plans. The increase in the price level leads to no change in
real GDP. This is an upward movement along the vertical long-run aggregate supply curve.

10-12. a. An increase in the capital stock causes real planned production to rise at any given price level,
so the LRAS curve shifts rightward.
b. An increase in the quantity of money causes the aggregate demand to shift rightward, which
generates a movement upward along the LRAS curve.
c. This reduction in the capital stock, which also will lead to higher energy prices, causes real
planned production to decline at any given price level, so the LRAS curve shifts leftward.
d. When the price level rises with inflation, there is a movement of the AD curve upward along
the LRAS curve.

10-14. b and c

10-16. a. B: Productivity improvements cause the LRAS curve to shift rightward, from LRAS1 to LRAS2,
and the increase in the quantity of money in circulation causes the AD curve to shift rightward,
from AD1 to AD2.
b. C: The reduction in the usable portion of the capital stock reduces the economy’s long-run
productive capabilities, so the LRAS curve shifts leftward, from LRAS1 to LRAS3. The increase
in taxes imposed on households induces them to reduce their expenditures, so the AD curve
shifts leftward, from AD1 to AD3.
c. E: The technological improvement shifts the LRAS curve rightward, from LRAS1 to LRAS2,
and the reduction in government spending shifts the AD curve leftward, from AD1 to AD3.

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 Chapter 10 Real GDP and the Price Level in the Long Run 101

◼ Selected References
Barro, Robert J., Macroeconomics, 2nd ed., New York: John Wiley and Sons, 1987.
Dornbush, Rudiger and Stanley Fischer, Macroeconomics, 4th ed., New York: McGraw-Hill, 1987.
Friedman, Milton, “Nobel Lecture: Inflation and Unemployment,” Journal of Political Economy,
Vol. 85, 1977, pp. 451–471.
Lombra, Raymond E., James B. Herendeen, and Raymond G. Torto, Money and the Financial System,
New York: McGraw-Hill, 1980.
Miller, Roger L. and Robert Pulsinelli, Macroeconomics, New York: Harper and Row, 1986.

©2014 Pearson Education, Inc.