Lecture Economics for investment decision makers: Chapter 5 - CFA In stitute

Chapter 5 - Aggregate output, prices, and economic growth. This chapter calculate and explain gross domestic product (GDP) using expenditure and income approaches, compare the sum-of-value-added and value-of-final-output methods of calculating GDP, compare nominal and real GDP, and calculate and interpret the GDP deflator,....

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1 Introduction

• The focus of this chapter is on macroeconomics, which is the theory and

analysis of a nation’s

- income and output;

- competitive and comparative advantages;

- productivity of the labor force;

- price levels and inflation; and

- government and central bank actions

• Macroeconomics enables understanding of the effect that a nation’s economy, government actions, and economic trends have on industries and companies

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2 Aggregate output and income

• The aggregate output of an economy is the value of all the goods and

services produced in a period of time (e.g., one year or one quarter)

• The aggregate income of an economy is the value of all the payments earned

by the suppliers of factors used in the production of goods and services in a period of time Forms of payment include the following:

1. Compensation to employees

2. Rent (payment for the use of property)

3. Interest (payment of the use of funds)

4. Profit (return for the use of capital and the assumption of risk)

• The aggregate expenditure is the total amount spent on goods and services

in an economy

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Gross domestic Product

• Gross domestic product (GDP) is the market value of all final goods and

services produced within the economy in a period of time

and the government within the economy

• Key elements of GDP:

- Represents all goods and services produced during the period

- Excludes transfer payments from the government (e.g., welfare)

- Excludes capital gains

- Determined by being sold in a market

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Methods of calculating GDP

Sales value Value added

Stage 1: Produce materials

PlasticTextile

$1.50 0.25

Stage 3: Sell to wholesaler $7.00 3.00

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Nominal and real GDP

• Real GDP is GDP calculated as if the price level did not change

- Real GDP per capita is often used as a measure of the standard of living

• Nominal GDP is GDP unadjusted for any price-level change

• Relationships:

Nominal GDPt = Pt × Qt Real GDPt = PB × Qt

where

Pt is the price in year t

PB is the price in the base year B

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GDP deflator

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Components of GDP

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GDP and other income measures

• National income is the income received by all factors of production used in the

generation of final output in an economy less a capital consumption allowance

- Sum of compensation of employees, business and government enterprise profits, interest income, rent, and indirect business taxes less subsidies

- Capital consumption allowance (CCA) is an estimate of the depreciation of

capital stock attributed to the production of goods and services

• Personal income is a measure of household income.

- A measure of the ability of consumers to make purchases

- A measure of national income to households

- Equal to national income less indirect business taxes, corporate income

taxes, and undistributed corporate profits, and plus transfer payments

• Personal disposable income (PDI) is personal income less personal taxes.

- A measure of what is available for spending

• Household saving is PDI less consumption expenditures, interest paid by

consumers to businesses, and personal transfer payments to foreigners

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The Fiscal balance

The fiscal balance is the difference between government expenditures (G) and

taxes (T):

Fiscal balance = G – T

- If G > T, the fiscal balance is a deficit (spending more than taking in).

- If G < T, the fiscal balance is a surplus (taxing more than spending).

The role of automatic stabilizing:

- As income declines, the deficit grows

- As income increases, the deficit shrinks or becomes a surplus

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The trade balance

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The trade balance is the net position in trade with other countries:

Trade balance = Exports – Imports = X – M

• If exports > imports, Exports – Imports = Current account surplus

- This is also referred to as a positive trade balance

• If exports < imports, Imports – Exports = Trade balance deficit

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Aggregate Savings

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Savings and investment

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Aggregate demand, aggregate supply, and

equilibrium

• Aggregate demand represents aggregate income and price level.

• Aggregate expenditures = Aggregate income

- This results in the investment–savings (IS) curve, which is the

relationship between savings less investment (S – I) and income, Y.

- The IS curve represents the demand for money from the goods market

• If we assume that planned expenditures equals actual income,

- there is equilibrium in the money markets, represented by the liquidity–

money supply (LM) curve.

- The LM curve illustrates the supply of money/funds available for investing (that is, equilibrium in the money market):

MV = PY

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The IS and LM Curves

The IS and LM curves illustrate the relationship between the real interest rate,

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IS, LM, and aggregate demand

Income (Y)

Real interest

rate (r)

Price level

LM1

LM2

IS

P1 P2

r1 r2

AD

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Aggregate Supply

• The aggregate supply (AS) curve represents the level of domestic output that

companies produce at each price

• In the short run,

- Suppliers can change the supply at the current price in the very short term (very short-run aggregate supply, or VSRAS)

- Suppliers can increase profits by increasing supply in the short run if they are covering their variable costs (short-run aggregate supply, or SRAS)

• The long-run aggregate supply curve is vertical (long-run aggregate supply, or LRAS)

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Price level

VSRAS

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Shifts in Aggregate demand and aggregate supply

curves

Shifts in aggregate demand result from

changes in the following:

• Growth in global economy

Shifts in aggregate supply result from changes in the following:

• Supply of labor

• Human capital (quality of labor)

• Supply of natural resources

• Supply of physical capital

• Productivity and technology

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Effects of a shift in aggregate demand and

Aggregate supply on business cycles

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• Equilibrium is the price level and output at which the aggregate demand and

aggregate supply curves intersect

• A business cycle consists of expansion and contraction.

- Shifts in aggregate demand and aggregate supply determine changes in the economy

• A recession is an economic situation in which the growth in GDP is negative.

- Typical definition: two or more quarters of negative GDP growth

• Sensitivity of investments to the economy:

- A cyclical company is one in which the earnings are likely to decline in the

event of an economic slowdown

- A defensive company is one in which earnings may increase during an

economic slowdown

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At long-run full employment, the economy is at potential GDP, and equilibrium

output is at an equilibrium where LRAS = SRAS = AD

Price

LRAS

P1

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Aggregate Supply on business cycles

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A short-run recessionary gap exists when the economy is in a recession and

equilibrium output is less than potential GDP

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A short-run inflationary gap exists when the economy drives GDP beyond the

potential GDP When price levels increase, short-run supply increases and the economy returns to the long-run equilibrium

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Short-run stagflation occurs when there is high unemployment and increased

inflation brought on by a drop in aggregate supply The downward pressure on wages and input prices eventually brings long-run full employment

Income, Output, Y

SRAS

AD1

P1 P2

Y1 Y2

LRAS

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Effects of a shift in aggregate supply and aggregate

demand on the economy: Summary

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4 Economic growth and sustainability

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Sources of Economic growth

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Sources and Measures of

Economic growth

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Sustainability of Economic growth

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Production Function and Growth

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Input growth and the growth of

total factor productivity

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Conclusions and Summary

• GDP is the market value of all final, newly produced goods and services within

a country in a given time period; valued by looking at either the total amount spent on goods and services produced in the economy or the income

generated in producing those goods and services

- Nominal GDP is the value of production using the prices of the current year

- Real GDP measures production using the constant prices of a base year

• Households earn income in exchange for providing the factors of production (labor, capital, and natural resources, including land)

• Businesses produce most of the economy’s output/income and invest to

maintain and expand productive capacity

• The government sector collects taxes from households and businesses and purchases goods and services from the private business sector

• Capital markets provide a link between saving and investing in the economy

• From the expenditure side, GDP includes personal consumption, gross private domestic investment, government spending, and net exports

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• National income is income received by all factors of production used in the

generation of final output: GDP minus the capital consumption allowance

• Personal income reflects pretax income received by households, whereas

personal disposable income equals personal income minus personal taxes

• Consumption spending is a function of disposable income, whereas investment spending depends on the average interest rate and the level of aggregate

income

• Aggregate demand and aggregate supply determine the level of real GDP and the price level

• The aggregate supply curve is the relationship between the quantity of real

GDP supplied and the price level, keeping all other factors constant

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• The long-run aggregate supply curve shifts because of changes in labor supply, the supply of physical and human capital, and productivity/technology

• The short-run supply curve shifts because of changes in potential GDP,

nominal wages, input prices, expectations about future prices, business taxes and subsidies, and the exchange rate

• The business cycle and short-term fluctuations in GDP are caused by shifts in aggregate demand and aggregate supply

- Stagflation, a combination of high inflation and weak economic growth, is

caused by a decline in short-run aggregate supply

• The sustainable rate of economic growth is measured by the rate of increase in the economy’s productive capacity or potential GDP

• Growth in real GDP measures how rapidly the total economy is expanding

• The sources of economic growth include the supply of labor, the supply of

physical and human capital, raw materials, and technological knowledge

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