3 1 reading 16 aggregate output, prices, and economic growth pdf

LOS LOS Explain the IS and LM curves and how they combine to generate the aggregate demand curve IS-LM curve is a macro tool that illustrates the relationship between interest rates an

LOS

Economics

• Topics in Demand and Supply Analysis

• The Firm and Market Structures

• Aggregate Output, Prices, And Economic Growth

• Understanding Business Cycles

• Monetary and Fiscal Policy

• International Trade and Capital Flows

• Currency Exchange Rates

LOS LOS Calculate and explain gross domestic product (GDP) using

expenditure and income approaches

GDP is intended to measure total size of a given economy

• It is used for calculating the size and growth of countries

• There are 2 ways to calculate it:

1 The Income Approach; and

2 The Expenditure Approach

 Both methods should arrive at same value

LOS LOS Calculate and explain gross domestic product (GDP) using

expenditure and income approaches

1 Income Approach

• It is the aggregate income earned by all households, companies, and the government of a given economy during a specified time period:

GDP = Total National Income

+ Sales Tax + Depreciation + Net Foreign Factor Income

 Equal to the sum of all wages plus rents plus interest and profits

LOS LOS Calculate and explain gross domestic product (GDP) using

expenditure and income approaches

2 Expenditure Approach

• It is the total amount spent on goods and services produced in the economy within a given period of time:

GDP = Gross Private Consumption Expenditures

+ Gross Private Investment + Government Purchases + Exports

- Imports

• Limiting criteria:

i Only include goods and services produced during the period

being measured

ii Transfer payments not included

iii Only include goods and services whose value can be

calculated through selling in the market

LOS LOS Compare the sum-of-value-added and value-of-final-output

methods of calculating GDP

There are 2 methods for the Expenditure Approach:

• Sum-of-Value-Added: captures value at each stage of production

• Value-of-Final-Output: captures value only at final sale

 Both methods have to equal the same final value

 The Sum-of-Value-Added has more granular details

Value Captured

Sum-of-Value-Added

Output

Value-of-Final-Farmer sells wheat to miller - $0.40 $0.40

Miller sells flour to baker - $0.90 $0.90-0.40=0.50

Baker sells bread to store - $1.10 $1.10-0.90=0.20

Store Sells bread to customer - $1.40 $1.40-1.10=0.30 $1.40

Total Value: $1.40 $1.40

LOS LOS Compare nominal and real GDP and calculate and interpret

the GDP deflator

• Nominal GDP represents the market value of goods and services at current prices:

Uses the actual prices paid at any point in time

• Real GDP represents the market value if prices did not change over time:

Holds prices constant to separate actual growth from inflation

Example >>

LOS LOS Compare nominal and real GDP and calculate and interpret

the GDP deflator

Example

• Last year, automakers sold 1,000 cars at $20,745 each on average

• This year, automakers sold 1,000 cars at $21,175 each on average What is the DGP Deflator?

Solution

• Nominal GDP (last year): $20,745,000

• Nominal GDP (this year): $21,175,000

• Real GDP (last year): $20,745,000

• Real GDP (this year): $20,745,000

• Capture impact of inflation using the GDP Deflator:

𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑮𝑫𝑷𝑹𝒆𝒂𝒍 𝑮𝑫𝑷 × 𝟏𝟎𝟎 =

𝟐𝟏, 𝟏𝟕𝟓, 𝟎𝟎𝟎

𝟐𝟎, 𝟕𝟒𝟓, 𝟎𝟎𝟎 × 𝟏𝟎𝟎 = 𝟏𝟎𝟐 𝟎𝟕

LOS LOS Compare nominal and real GDP and calculate and interpret

the GDP deflator

Example

• Last year, automakers sold 1,000 cars at $20,745 each on average

• This year, automakers sold 1,000 cars at $21,175 each on average What is the DGP Deflator?

Solution

• Nominal GDP (last year): $20,745,000

• Nominal GDP (this year): $21,175,000

• Real GDP (last year): $20,745,000

• Real GDP (this year): $20,745,000

• Capture impact of inflation using the GDP Deflator:

𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑮𝑫𝑷𝑹𝒆𝒂𝒍 𝑮𝑫𝑷 × 𝟏𝟎𝟎 =

𝟐𝟏, 𝟏𝟕𝟓, 𝟎𝟎𝟎

𝟐𝟎, 𝟕𝟒𝟓, 𝟎𝟎𝟎 × 𝟏𝟎𝟎 = 𝟏𝟎𝟐 𝟎𝟕

LOS LOS Compare nominal and real GDP and calculate and interpret

the GDP deflator

• In nominal terms, we see 2.07% GDP growth in the previous

example

Nominal GDP increase from $20,745,000 to $21,175,000

• In real terms, there was 0% GDP growth

Real GDP is still 1,000 cars sold

 That 2.07% is the inflation in the economy

LOS LOS Compare GDP, national income, personal income, and

personal disposable income

GDP measures:

• the value of all goods and services sold in an economy; and also

• measures the total income earned by everyone in an economy

These must always somewhat be equal

1 GDP Expenditure Formula:

GDP = Consumer spending on goods and services

+ Business Gross Fixed Investment + Change in Inventories

+ Government Spending on Goods and Services + Government Gross Fixed Investment

+ Exports

- Imports + Statistical Discrepancy

LOS LOS Compare GDP, national income, personal income, and

personal disposable income

National Income = Compensation of Employees

+ Corporate and Govt Enterprise Profits Before Taxes + Interest Income

+ Unincorporated Net Income of Businesses + Rent

+ Indirect Business Taxes -Subsidies

LOS LOS Compare GDP, national income, personal income, and

personal disposable income

Personal Income is a measure of all household income in an

economy

It represents the purchasing power of consumers

Personal Income = National Income

– Indirect Business Taxes – Corporate Income Taxes – Undistributed Corporate Profits + Transfer Payments

LOS LOS Compare GDP, national income, personal income, and

personal disposable income

Personal Disposable Income is all personal income minus personal

Household Savings is Personal Disposable Income minus

consumption expenditures, interest paid to businesses, and personal transfer payments

LOS LOS Explain the fundamental relationship among saving,

investment, the fiscal balance, and the trade balance

Savings and Investment are inversely related

• You can’t save your money and invest it, too

• Therefore, Investment is a form of spending

• The formula is:

GDP = C + I + G + (X - M)

Where C= Consumer spending

I= Business Investment G= Government Spending X= Exports

M= Imports

 Money saved does not flow into this equation, not part of GDP growth

LOS LOS Explain the fundamental relationship among saving,

investment, the fiscal balance, and the trade balance

Three ways to absorb savings:

• Can go into Investment spending (I)

• Can finance govt deficits (G-T)

T=Taxes

• Can finance trade deficits (X-M)

The Savings equation is:

LOS LOS Explain the IS and LM curves and how they combine to

generate the aggregate demand curve

IS-LM curve is a macro tool that illustrates the relationship between interest rates and asset prices:

• IS = Investment-Saving

• LM = Liquidity-Money

(Also known as the Hicks-Hansen Model)

• Used to model general equilibrium of price levels

There are two interpretations of IS-LM:

i Explains the changes that occur in National Income when term price levels are fixed; and

short-ii Explains the causes of a shift in the aggregate demand curve

LOS LOS Explain the IS and LM curves and how they combine to

generate the aggregate demand curve

• The IS curve represents the

goods market

• The LM curve represents the

money market

• The intersection generates the

aggregate demand curve

Where I = Nominal Interest Rate; and

Y = Real GDP

LOS LOS Explain the IS and LM curves and how they combine to

generate the aggregate demand curve

The IS Curve

• The interest rate is independent variable and level of income is the dependent variable

• The curve is downward sloping

• The curve shows where total income is equal to total spending The general formula is:

LOS LOS Explain the IS and LM curves and how they combine to

generate the aggregate demand curve

The LM Curve

• Income is the independent variable and interest rates are the dependent variable

• It represents the equilibrium of the money market

• It also represents the points of equilibrium between demand for money and money supply

 Model studies short run with

fixed price assumptions for each

point on the curve

 Aggregate demand occurs at the

intersection of the curves at a

particular price

 At a higher price level, money

supply will be lower and a lower

aggregate demand will result

LOS LOS Explain the aggregate supply curve in the short run and

long run

• Aggregate Supply represents the total amount of goods and

services available in the economy at a given price level

• The Aggregate Supply Curve represents the amount producers are willing to produce at each price level

Components of Aggregate Supply:

1 Consumer Goods: goods and services supplied by private firms

Items like clothes or food; services like car repair

2 Trade Goods: goods and services for export

Items like industrial chemicals

3 Capital Goods: goods supplied to firms to serve as investment

goods

Items like factory machinery

4 Public and Merit Goods: goods and services produced by private

firms for use by governments

LOS LOS Explain the aggregate supply curve in the short run and

long run

Long Run Aggregate Supply (LRAS)

• Assumes no fixed factors of production

• Supply levels will change in response to expected economic profits and losses

• Is a static value

• Shift in LRAS requires changes in factors of production

Things like increase in available labor hours or change in Total Productivity Factor over long-run

LOS LOS Explain the aggregate supply curve in the short run and

long run

Short Run Aggregate Supply (SRAS)

• Quantity supplied increases as prices rise

• Rising prices imply higher profits that justify expansion of output

• Firms increase wages and pay for more labor hours in order to produce more

LOS LOS Explain the aggregate supply curve in the short run and

long run

Long-Run and Short-Run

Aggregate Supply graphed

• LRAS is vertical line because

it is static value

• SRAS can move in response

to increased prices

• Increases in wages and raw

materials spending shifts

SRAS to the left

LOS LOS Explain causes of movements along and shifts in aggregate

demand and supply curves

Movement along the Aggregate Demand or Aggregate Supply Curves are mainly caused by prices:

Aggregate Demand Curve: Aggregate Supply Curve:

Price level increases Price level increases

→ Real money supply declines → Business profits increase

→ Rates increase → Businesses increase

LOS LOS Explain causes of movements along and shifts in aggregate

demand and supply curves

Causes of Shifts in Aggregate Demand Curve:

• Household wealth

 Increased wealth leads to increased spending, which shifts demand curve to the right (known as the Wealth Effect)

• Consumer and Business Expectation

 Increased confidence among consumers leads to increased

consumption, which shifts the demand curve to the right

• Capacity Utilization

 Companies almost at full capacity increase their investment

spending, which shifts the demand curve to the right

LOS LOS Explain causes of movements along and shifts in aggregate

demand and supply curves

Causes of Shifts in Aggregate Supply Curve:

• Taxes and Subsidies

 Increased taxes or reduced subsidies decreases production, which shifts the supply curve to the left

• Productivity and Technology

 High productivity and technology innovation increase production and shift the supply curve to the right

LOS LOS Describe how fluctuations in aggregate demand and

aggregate supply cause short-run changes in the economy and the business cycle

Shifts in aggregate supply and demand levels cause fluctuations in

GDP and business cycles

• Business cycle results from changes in short-run value of GDP

Expansion: GDP increasing, unemployment rate falling, capacity utilization increasing

Contraction: GDP decreasing, rising unemployment, capacity

utilization decreasing

LOS LOS Describe how fluctuations in aggregate demand and

aggregate supply cause short-run changes in the economy and the business cycle

Types of cyclical changes in GDP caused by fluctuations in

aggregate demand and supply:

• GDP and price levels fall

• Corporate profits, employment, commodity prices, interest rates, and demand for credit decline

LOS LOS Describe how fluctuations in aggregate demand and

aggregate supply cause short-run changes in the economy and the business cycle

2 Inflationary Gap:

• Aggregate Demand increases more quickly than Aggregate Supply

• Increased govt spending, declining taxes, and increase in money supply can shift Aggregate Demand curve to the right

• Increasing prices leads to increased employment and production

• Corporate profits, employment, commodity prices, interest rates, and inflation all rise

3 Stagflation:

• Combination of stagnation and inflation

• Sharp declines in Aggregate Supply can cause prices to increase and economic growth to slow at the same time

• Price levels increase, but production and employment decrease

• Very costly and difficult to address

LOS LOS Distinguish between the following types of macroeconomic

equilibria: long-run full employment, short-run recessionary gap, short-run inflationary gap, and short-run stagflation

Types of macroeconomic equilibria:

1 Long-Run Full Employment

• When Aggregate Demand curve intersects Short-Run Aggregate Supply Curve at a point along the Long-Run Aggregate Supply

Curve

• Capital and labor are fully utilized

• Over long term, potential GPD and equilibrium GDP are equal

LOS LOS Distinguish between the following types of macroeconomic

equilibria: long-run full employment, short-run recessionary gap, short-run inflationary gap, and short-run stagflation

2 Short-Run Recessionary Gap

• Leftward shift of Aggregate Demand Curve

• Price levels decrease

• Companies reduce production and employment

3 Short-Run Inflationary Gap

• Rightward shift of Aggregate Demand Curve

• Price levels rise

• Companies increase production and employment

4 Short-Run Stagflation

• Leftward shift of Aggregate Supply curve

• Price levels increase and employment falls

• Economic growth slows down while inflation increases

LOS LOS Explain how a short-run macroeconomic equilibrium may

occur at a level above or below full employment

Short-run macroeconomic equilibrium occurs when Aggregate Demand Curve intersects with Short-Run Aggregate Supply Curve

1 Decrease in Aggregate Demand

• Price levels fall, unemployment decreases

• Aggregate Supply falls

• Input prices fall, which increases supply again

• New equilibrium has same output but lower prices

2 Increase in Aggregate Demand

• Output level becomes greater than normal price levels during full employment

• Employment increases above normal levels

• Inflation increases

LOS LOS Explain how a short-run macroeconomic equilibrium may

occur at a level above or below full employment

3 Decrease in Short-Run Aggregate Supply

• Prices increase as supply decreases

• Output levels fall as input prices go up

4 Increase in Short-Run Aggregate Supply

• Unexpected increase in supply shifts curve to the right

• Output and income increase beyond normal full employment levels