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The Theor}'of Short-TermEconomicGrowth Economic growth theory states that the potential GDP of an economy is best calculated by what it makes, its aggregate (total) supply (AS). There are two types of aggregate supply. Short-run aggregate supply (SRAS) is all of the goods and services produced in the short-run (SR) (up to one year out) by all of the firms in an economy using the available labor, capital, and technology. The curve is sloped because of the law of supply . . n Increase PL decrease SRAS 2 SRAS 1 SRAS2 P2 Pl Y1 Y2 y RealGDP Page1 Y2 Y1 y RealGDP The Theor}'of Short-TermEconomicGrowth(cont.) SRAS is referred to as a supply-side policy because it deals with the total supply of goods and services in an economy. SRAS assumes that there are fixed costs (FC) that cannot be changed in the short-run (SR), but the variable costs (VC) can be changed. **Variables thatimpactSRAS** 1. resource/input costs for production- wages, salaries, the costs of materials, supplies, equipment, technologies, and facilities 2. inflation expectations 3. subsidies (payments by governments) to producers 4. taxes on producers Page2 The Theor}'of Short-TermEconomicGrowth(cont.) When the level of short-run aggregate supply (SRAS)is the same as aggregated demand (AD), short-run (SR) equilibrium occurs. Short-run equilibrium is a state where aggregate supply (AS) equals aggregate demand (AD) in the short-run (SR) (less than one year). The price level is the measurement of current prices of goods and services produced in the economy in a specific region or country at a specific time. Short -ru n eQui i b r iu m output Pr ce l evel SR.AS p AD O ______ Page3 v_____ o_u-tputRG()P The Theor}'of Short-TermEconomicGrowth(cont.) Expansionary monetary policy increases the price level, but a continual increase in the price level causes inflation. A decrease in the money supply decreases the price level but doesn't change output levels. The equilibrium price level and equilibrium output level are the market price and output where the quantity of goods supplied (Qs) is equal to the quantity of goods demanded (Qd). Short - run equ P · ce l eve l i i br·um output SRAS p AD 0 Page4 y Ou p t The Theor}'of Short-TermEconomicGrowth(cont.) The SRAS curve shifts right (increases) if the stock (worth) of physical capital (trucks, factories) increases. An increase in government expenditures (spending) will also shift the SRAS right as will increased numbers of workers enterring the labor force. A decrease in input resource prices for AS increases SRAS but decreases the price level (prices). Real output will then increase but not inflation until demand itself increases. PL SRAS2 P1 P2 Y1 Y2 y R eal Page5 GDP The Theor}'of Short-TermEconomicGrowth(cont.) An increase in SRAS will lead to increases in income and possibly unemployment because an increase in demand will follow increased supply. Unanticipated increases in SRAS can cause hyperinflation because the excess supply will increase demand. PL SRAS2 P1 P2 AD V1 V2 y Real Page6 GDP The Theor}'of Short-TermEconomicGrowth(cont.) SRAS can also shift left (decrease.) A decrease in labor productivity, and an increase in production costs/per unit costs all decrease SRAS. If SRAS decrease then aggregate demand (AD) increases, the price level will increase. PL SR.AS 2 SRAS 1 PL ---------------P2 P1 ,. ........ . . . ........... ..... ................... ............-:..-............ .. AD \ Y2 -·--·---- Page7 Y1 ___ -r- __ 'f3 - l ----- y Real GDP The Theor}'of Short-TermEconomicGrowth(cont.) When SRAS decreases but AD stays the same, stagflation occurs. When SRAS decreases rapidly but AD increases, like with a natural disaster, the price level goes up and real wages decline. This is referred to as demand-pull inflation. stagflation demand-pull inflation PL SRAS2 SRAS1 PL P2 Pl Y2 Yl y RealGDP Page8 Y2 Yl y RealGDP The Theor>'of Short-TermEconomicGrowth-?s 3. A rightward hift in the hort -run aggregate upply curve will occur when A (B C D (E export exceed impor the money upply increa e the price of imported raw material increa e the tock of phy ical capital incre e union have negotiated a wage increa e for their membet 14. An increa e in which of the following would mo t likely re ult in an increa e in aggregate upply? (A (B (C (D E Page9 The price level Aggregate demand Unemployment compen ation Labor-force pa1ticipation rate The minimurn wage The Theor>'of Short-TermEconomicGrowth-?s 3. A rightward hift in the hort -run aggregate upply curve will occur when A (B C • (E export exceed impor the money upply increa e the price of imported raw material increa e the tock of phy ical capital incre e union have negotiated a wage increa e for their membet 14. An increa e in which of the following would mo t likely re ult in an increa e in aggregate upply? (A (B (C (• E Page10 The price level Aggregate demand Unemployment compen ation Labor-force pa1ticipation rate The minimurn wage The Theoryof Short-TermEconomicGrowth-?s 40. An increa e in which of the following i mo t likely to cau e the hort-run aggregate upply curve to hift to the left? A (B C D (E Con umer ' income The money upply Go ernment pending The optimi m of busine firm The per unit co t of production 10. If a reduction in aggregate upply i followed by an increa e in aggregate dernand, which of the following will definitely occur? (A (B (C (D (E Page11 Output will increa e. Output will decrea e. Output will not change . The price le el will increa e. The price le el will decrea e. 1 The Theoryof Short-TermEconomicGrowth-?s 40. An increa e in which of the following i mo t likely to cau e the hort-run aggregate upply curve to hift to the left? A (B C D Con umer ' income The money upply Go ernment pending The optimi m of busine firm (e ) The per unit co t of production 10. If a reduction in aggregate upply i followed by an increa e in aggregate dernand, which of the following will definitely occur? (A Output will increa e. (B Output will decrea e. (C Output will not change . (e The price le el will increa e. (E The price le el will decrea e. 1 Page12 The Theorl'of Short-TermEconomicGrowth-?s 2 1. With an up war d-slopin g hort -run aggrega t e uppl y curve an in crea e in gove rnm en t ex penditur e will mo st lik e ly (A ) redu ce th e price leve l (B ) redu ce th e l eve l of nomin al gro do m e ti c pr odu ct (C ) in crea e rea l gross dome tic pr odu c t (D ) hi f t th e hort -run agg regate uppl y curv e to th e ri ght (E) hi f t both th e agg rega te detna nd cu rve and th e lon g- run agg rega te uppl y curve to th e left 48_ A decr eas e in th e price s of inputs "vill cause w hich of the following to occur in the short run ? (.4~) An increas e in the aggregate demand (B ) (C) (D ) (E) Page13 and an .increase in the pric e leve l A decrease in the aggregate demand and an increas e .in the price level An increas 1e in the short-run aggrega t e supply and a decrease in the price le-vel An increase in the short-run aggregate supply and an increase in the price level A decrease in the short-run aggregate suppl y and a decre ase in the pric e level The Theorl'of Short-TermEconomicGrowth-?s 2 1. With an up war d-slopin g hort -run aggrega t e uppl y curve an in crea e in gove rnm en t ex penditur e will mo st lik e ly (A ) redu ce th e price leve l (B ) redu ce th e l eve l of nomin al gro do m e ti c pr odu ct • in crea e rea l gross dome tic pr odu c t (D ) hi f t th e hort -run agg regate uppl y curv e to th e ri ght (E) hift both th e agg rega te detna nd curve and th e lon g- run agg rega te uppl y curve to th e left 48 _ A decr ease in the price s of inputs will cause which of the foll owing to occur in the short run ? (A) An increa se in the aggregate demand and an increase in the pric e level (B) A decrease in the aggregat.e demand and an increase .in the price level • An increase in the short -run aggregat e supply and a decrease in the price lev el (D ) An increase in the sh ort-run aggregate supply and an increase in the price level (E) A decrease in the short-rnn aggregate suppl y and a decrea se in the pric,e level Page14 Macroeconomics Do-Now Please do this: 1. Assume the U.S. economy is in short-run equilibrium (real GDP is on the potential GDP line). Is there any monetary policy the Fed should take? Why? a. Draw a correctly labeled graph and show each of the following: i. current equilibrium output and price level, labeled OE and PE 2. Assume that the Fed buys more bonds from banks. a. Show the impact on your graph, labeling the new real GDP as 02 and price level as PE2. 3. Now assume something has increased production costs in the country. a. Show the impact on your graph, labeling the new output of production 03 and price level as PE3. Page15 Macroecono . \f\~ ~\)'d WICS Do-Now :z.,~ {\::,;} s~s' Page16 I I I I I I I I I I I I I I I I I I I I I I I I I I The Theor}'of T,ong-TermEconomicGrowth Long-run aggregate supply (LRAS) is all of the goods and services produced in the long-run (LR- four to five years out) by all of the firms in an economy using the available labor, capital, and technology . The curve is perfectly vertical because it reflects economists' belief that changes in aggregate demand (AD) have only a temporary change on the economy's total output and because it indicates immediate adjustments between wages and the price level as they fluctuate over time. The LRAS curve is determined by all of the factors of production since none are fixed in the LR. fC'ic.e..le"al PL 1. full employment level 2. full output level 3. natural rate of unemployment P1 AD Y:1. Page17 2 The Theor}'of T,ong-TermEconomicGrowth(cont.) Long-run equilibrium is a state where long-run aggregate supply (LRAS) equals aggregate demand (AD) in the long-run (LR) (four to five years and beyond). Long-run equilibrium is where real GDP (Y) equals potential GDP. When both the LRAS and AD shift right (increase), output increases but the new price level is unknown at first. This is known as a double-shift. ~, Price Level ~Q L \<..C?,.. \ \Jl"l \ Long~un Aggregate Sup p ly Output Page18 LRAS LRAS 2 ~ 1. full employment level 2. full output level 3. natural rate of unemployment AD2 _-'=:=:::-~ ~n~ ...:!ll ~v2~= =--; v RealGDP The Theor}'of T,ong-TermEconomicGrowth(cont.) The LRAS curve represents an economy where all inputs: land, labor and capital, are used to full efficiency. The LRAS curve indicates where full employment and full output are in an economy and also the natural rate of unemployment occur. If there was an increase in investment, growth in size of a skilled labor force, a right shift in the production possibilities curve/frontier, or consumer confidence in the economy grows, LRAS shifts to the right. When LRAS shifts to the right, it's an indicator of positive eE) ~mic growth. \<-.e. 1. full employment level 2. full output level 3. natural rate of unemployment \ "e.\ 2 LR As LR AS P1 AD2 Y1 Y2 Y Real Page19 GDP The Theor}'of T,ong-TermEconomicGrowth(cont.) The LRAS also shows wages over time shifting to the prevailing price level. Classical economists believe that the close alignment of wages and the price level allow a country to naturally return to long-run equilibrium, even when unemployment or inflation occurs. --• - RecessionaryGa,p lnffatlonaryGap LRAS LRAS 0... 1. full employment ~ level ~ 2. full output ~ S·RAS1 level 3. natural rate of unemploy- ment ~ea GDP Page20 YF >y 1 Real GDP The Theor}'of T,ong-TermEconomicGrowth(cont.) Long-run aggregate supply (LRAS) can be impacted by changes in input or output costs, taxes, subsidies, government regulations, and the production of capital goods (goods created in order to produce other goods, like a robot for a car factory) and consumer goods (goods created for consumer purchase, like twinkies ). Labor is the total number of hours that workers are available to work in producing real GDP. Capital is the total number of factories, machines, computers, human workers, etc., available. Technology is the total amount of know-how available. Page21 The Theorl'of T,ong-Term EconomicGrowth-?s 27. The hort -run aggregate upply curve would be vertical if (A) nominal wage adjust immediately to change in the price level (B ) nominal wage adjust lowly when there is unemployment (C) both nominal wage and prices adju t lowly to change in aggregate demand (D ) the pendin g rnultiplier i very low (E) investment demand i very re pon ive to change in intere t rates 43. An increase in con umer confidence will re ult in which of the following in the short run? (A) A rightward shift of the long -run aggregate supply curve (B) A rightward hift of the hort -run aggregate supply curve (C) A leftward shift of the hort-run aggregate supply curve (D) A rightward shift of the aggregate demand curve (E) .t-\ leftward hift of the aggregate demand curve Page22 The Theorl'of T,ong-Term EconomicGrowth-?s 27. The hort -run aggregate upply curve would be vertical if ce nominal wage adjust immediately to change in the price level (B ) nominal wage adjust lowly when there is unemployment (C) both nominal wage and prices adju t lowly to change in aggregate demand (D ) the pendin g rnultiplier i very low (E) investment demand i very re pon ive to change in intere t rates 43. An increase in con umer confidence will re ult in which of the following in the short run? (A) A rightward shift of the long -run aggregate supply curve (B) A rightward hift of the hort -run aggregate supply curve (C) A leftward shift of the hort-run aggregate supply curve (. A rightward shift of the aggregate demand curve (E) .t-\ leftward hift of the aggregate demand curve Page23 Macroeconomics Do-Now Please do this: 1. Assume the U.S. economy is in long-run equilibrium. Is there any monetary policy the Fed should take? Why? a. Draw a correctly labeled graph and show each of the following: i. current equilibrium output- 0 and price level- P 2. Assume that the government starts to spend more money on defense. a. Show the impact on your graph, labeling the new real GDP as 02 and price level as P2. 3. Based on what you graphed above, is the U.S. economy in contraction or expansion? Explain? 4. Based on what you decided in 3, draw an economic fluctuations model on a potential GDP line and also a production possibilities curve, both showing where the economy currently is. Page24 Macroeconomics Do-Now AO~ l~':J 1. full employment level 2. full output level 3. natural rate of unemployment Page25 sRAS AggregateDemandandEconomicFluctuations The theory of economic fluctuations emphasizes fluctuations in the total demand for goods and services as the reason for the ups and downs in the economy. Because the focus is on the total of the demand for all goods and services in the economy and not just one industry, like when we learned about demand (D) in microeconomics, we use the term aggregate demand (AD). More precisely, aggregate demand is the total amount that consumers (C), businesses (J), the government (G), and foreigners (net exports-imports) (X) spend on all goods and services in an economy. AD is referred to as a demand-side policy because it deals with the total demand of goods and services in an economy. Any change in AD can impact the wealth in a society. Page26 AggregateDemandand EconomicFluctuations(cont.) The inflation rate is not the only thing that affects aggregate demand (AD). Changes in government purchases, monetary policy, foreign demand for U.S. exports, taxes, and consumer confidence can affect aggregate demand and cause a shift in • th e AD ltne. Th e AD cur\'e is shifted to th e right I NFLAT ION HAT E by: l) 2) :~) 4) 5) a n inc.:rease in government pur chases a clec·rca.scin taxes an ups hift in for e ig n de mand an UJ> s hift in co n sump tion a mo netary poli cy shift to a highe r inflati o n targ et. Three AD curves Th e AO cur, ·c is s hift e d to the left by: I) a clrcrc ase in governm e nl pur ch ,U:CS 2) an inc reas ' in taxe s :3) a dmvns hirt in fore ign demand ,l) a down hift in con ·umpt ion 6) a monetar y polic;y shift to a lower i nnation target. R F'.A t Page27 GDP AggregateDemandand EconomicFluctuations(cont.) According to the economic fluctuations theory, the increases in real GDP over potential GDP are caused by increases in aggregate demand and decreases in real GDP (Y) below potential GDP during recessions are caused by declines in aggregate demand (AD). Government military spending during (increased) and after (decreased) the Cold War is an example of both. Increases in C, 1, G, or X can cause increase in real GDP (Y) and a rightward shift. B.1.U(l~~cn· 1()021~• 1,l.\k >. V.fi>Or Panel (a) ---------- An increase i n aggregate d emand 1.20 Panel (b) An decre ase in agg regate demand AA~ 1.20 0 q 1.18 ~ Bu.1.1 0-.~r,r L91i200I.L\lll! ~ 1.16 1.16 C'O ~ ll](l r ~ j,1)1.111~ ~ li.OIIOI C'O .::; .o:io- - -------- 1.12 <ii ~ 1.12 QJ u 1.10 &: $11,600 11,800 12,000 12,200 12,400 12,600 Page28 -+-- 8 4,1'.00 :JJ)O{I 1.14 1.10 $11,600 11,800 12,000 12,200 12,400 12,600 AggregateDemandand EconomicFluctuations(cont.) An increase in AD increases the price level. When income taxes decrease, AD increases. A decrease in the money supply can decrease AD. If a decrease in AD creates a recession, the price level and real output will both decrease. Unemployment will also increase and the inflation rate will decrease if AD decreases and price and wages don't quickly adjust to the change. Panel {a) Panel (b) An increase in aggrega te An decrease demand 1.20 1.18 in aggregate d emand 1.20 AAS 0 SRAs 1.18 ~ ,-- ~ 1.16 1.16 re, QJ >. ~ 1.14 re, 1.14 - ..0 <ii 1.12 > 1.12 QJ QJ u ~ 1.10 1.10 $ 1 1,600 1 1,800 12,000 12 ,200 12,400 12,600 Page29 A0 1 S1 1,600 1 1,800 12,000 12,200 12,400 12 ,600 AggregateDemandand EconomicFluctuations-?s 35. Following a decrease in aggregate demand , an increase in unemployment will result if (A) prices increase and real wages decrease (B) the aggregate supply curve is vertical (C) price s and wage s quickly adjust to equilibrium levels (D) short-run aggregate supply also increases (E) prices and nominal wages are slow to adju t in the short run 12. An increa e in the price of a key input will cau e the aggregate demand curve and the hort -run aggregate upply curve to change in which of the following ways? Aggregate Demand Curve (A (B (C) (D Shift to the right Shift to the left Shift to the left No change (E No change Page30 Aggregate Supply Curve Shift to the Shift to the No change Shift to the Shift to the right left left right AggregateDemandand EconomicFluctuations-?s 35. Following a decrease in aggregate demand , an increase in unemployment will result if (A) prices increase and real wages decrease (B) the aggregate supply curve is vertical (C) price s and wage s quickly adjust to equilibrium levels (D) short-run aggregate supply also increases (e ) prices and nominal wages are slow to adju t in the short run 12. An increa e in the price of a key input will cau e the aggregate demand curve and the hort -run aggregate upply curve to change in which of the following ways? Aggregate Demand Curve (A (B (C) (. ) Shift to the right Shift to the left Shift to the left No change (E No change Page31 Aggregate Supply Curve Shift to the Shift to the No change Shift to the Shift to the right left left right AggregateDemandand EconomicFluctuations-?s 41. An unanticipated decrea e in aggregate demand will rno t likely cause the unemployment rate and the inflation rate to change in which of the following ways? (A) (B) (C) (D) (E) Unemployment Rate Increa e Increa e Increa e Decrease Decrea se Inflation Rate Increa e Decrease No change Increa e Decrease 48. The aggregate demand curve as ume that (A) as the price of a good or ervice increase s nominal wage decrease (B) as the dome tic price level increa e consumer ubstitute domestic good for foreign goods (C) all price and total con umer income are con tant (D) changes in the price level affect real wealth (E) nominal intere t rate increa e as the price level decrea e Page32 AggregateDemandand EconomicFluctuations-?s 41. An unanticipated decrea e in aggregate demand will rno t likely cause the unemployment rate and the inflation rate to change in which of the following ways? (A) • (C) (D) (E) Unemployment Rate Increa e Increa e Increa e Decrease Decrea se Inflation Rate Increa e Decrease No change Increa e Decrease 48. The aggregate demand curve as ume that (A) as the price of a good or ervice increase s nominal wage decrease (B) as the dome tic price level increa e consumer ubstitute domestic good for foreign goods (C) all price and total con umer income are con tant • changes in the price level affect real wealth (E) nominal intere t rate increa e as the price level decrea e Page33 AggregateDemandand EconomicFluctuations-?s Long-run Aggregate Supply (LRAS ) Short -run Aggregate Supply (SRAS) Aggregate Demand (AD ) Yr OUTPUT 57 . Accordin g to the graph above whi ch of the followin g statements about the eco nomy i Uue? (A) The econom y is in long-run equilibrium . (B) The LRAS cu rve will automatically shift to the right restoring long-run equilibrium . (C) In the short run, if wages are sticky the SRAS will shift to the right lowering price . (D) The economy is in a reces ion , requirin g decreases in pending to re tore full emplo yment. (E) Wages will eventuall y decrease, restoring full employm ent in the long run . Page34 AggregateDemandand EconomicFluctuations-?s Long-run Aggregate Supply (LRAS ) Short -run Aggregate Supply (SRAS) Aggregate Demand (AD ) Yr OUTPUT 57 . Accordin g to the graph above whi ch of the followin g statements about the eco nomy i Uue? (A) The econom y is in long-run equilibrium . (B) The LRAS cu rve will automatically shift to the right restoring long-run equilibrium . (C) In the short run, if wages are sticky the SRAS will shift to the right lowering price . (D) The economy is in a reces ion , requirin g decreases in pending to re tore full emplo yment. • Wages will eventuall y decrease, restoring full employm ent in the long run . Page35 AggregateDemandandEconomicFluctuations-?s ...J u.l > u.l ~ u~ c2 Cl.. AD 1 0 REA GROSS DOMESTIC PRODUCT 17. The graph above show two aggregate demand curves AD 1 and AD 2 and an aggregate upply curve AS. The shift in the aggregate demand curve from AD 1 to AD 2 could be caused by (A) (B) (C) (D) (E) Page36 a decrease in taxe a decrease in the money upply an increase in government pending an increase in con umption spending an increase in the price level AggregateDemandandEconomicFluctuations-?s ...J u.l > u.l ~ u~ c2 Cl.. AD 1 0 REA GROSS DOMESTIC PRODUCT 17. The graph above show two aggregate demand curves AD 1 and AD 2 and an aggregate upply curve AS. The shift in the aggregate demand curve from AD 1 to AD 2 could be caused by (A) • (C) (D) (E) Page37 a decrease in taxe a decrease in the money upply an increase in government pending an increase in con umption spending an increase in the price level AggregateDemandand EconomicFluctuations-?s 19. Which of the fallowing will cau e an increa e in aggregate demand? (A) An increa e in the price level (B) A decrease in income taxe (C An increa e in the demand for money (D) A decrea e in the supply of money (E) A decrea e in government transfer payments 60 . Which of the following will hift the aggregate demand curve to the right? (A) A report that corporate earning were lower than expected (B) An increa e in intere t rate cau ed by a tightening of monetary policy (C) Increased import caused by appreciation of the dollar (D) Increased pending by bu ine e on computers (E) An increa e in the government budget urplu Page38 AggregateDemandand EconomicFluctuations-?s 19. Which of the fallowing will cau e an increa e in aggregate demand? (A) An increa e in the price level (. ) A decrease in income taxe (C An increa e in the demand for money (D) A decrea e in the supply of money (E) A decrea e in government transfer payments 60 . Which of the following will hift the aggregate demand curve to the right? (A) A report that corporate earning were lower than expected (B) An increa e in intere t rate cau ed by a tightening of monetary policy (C) Increased import caused by appreciation of the dollar (e ) Increased pending by bu ine e on computers (E) An increa e in the government budget urplu Page39 AggregateSupplyand DemandTogether As seen below, the difference between potential GDP and real GDP (I) is called the recessionary gap (potential GDP minus real GDP) because real GDP in a country is lower than potential GDP at the full employment level. Classical economists feel that the economy will work itself out: wages and the price level will drop and the economy will get back to full employment in the long-run (LR). Reces5lonary Gap 1. full employment > LRAS __, u level SRAS 2. full output level 3. natural rate of unemployment 0.... Q) Q) Q) ·c: 0.. AD ~ea GDP Page40 AggregateSupplyand DemandTogether(cont.) The difference between potential GDP and real GDP (I) is called the inflationary gap (real GDP minus potential GDP) because real GDP in a country is higher than potential GDP at the full employment level. When GDP increases over two years disproportionately, the price level and GDP are increasing. Inflationary Gap - CL LRAS Q.) 1. full employment level 2. full output level 3. natural rate of unemployment u ~ P2 SRAS _____ ,_ .,. _ pi ___ ___ _,_ , AD I > Y(F) Y 1 Page41 Rea l GDP Macroeconomics Do-Now Please do this: 1. Draw two graphs. a. one showing an economy in contraction/recession b. one showing an economy in expansion/inflation (hint: both start with an economy in long-run equilibrium, (the long-run aggregate supply curve) Page42 Macroeconomics Do-Now ~L contraction/recession expansion/inflation fi~ L~P\~ t;,'f..A.S fiO Page43 Lfl.A$ s~S The ProductionFunction We can summarize the relationship between the three determinants and aggregate supply (AS) of real GDP as: real GDP= F(labor +capital+ technology) The function F means that there is a general relationship between the three variables in the parentheses. It is safe to assume that the higher the variables, the higher the real GDP, and vice versa. We call this relationship the production function because it tells us how much production (real GDP) of goods and services can be obtained from a certain amount of labor, capital, and technology inputs. Page44