Download Chapter 5Aggregate Output, Prices, and Economic Growth

CHAPTER 5
AGGREGATE OUTPUT, PRICES, AND
ECONOMIC GROWTH
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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.
- Expenditures approach: The amount spent for all goods and services
- Income approach: Aggregate income earned by all households, companies,
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
- Includes only final goods, not intermediate (i.e., items to be resold)
• Measurement alternatives (for an example, see Exhibit 5-2)
- Receipts from the final customer
- Value added at each stage of production to customer
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METHODS OF CALCULATING GDP
Consider the manufacture and sale of a doll using both the expenditures
method and the value-added method of measuring gross domestic product.
Sales value
Value added
$1.50
0.25
$1.75
$1.75
Stage 2: Assemble dolls
$4.00
2.25
Stage 3: Sell to wholesaler
$7.00
3.00
Stage 4: Sell to retailer
$10.00
3.00
Total expenditures
$10.00
Stage 1: Produce materials
Plastic
Textile
Total value added
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$10.00
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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
Qt is the quantity in year t
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GDP DEFLATOR
The GDP deflator or the implicit price deflator reflects the amount of the GDP that
is associated with the change in the price level:
Value of current−year output
at current−year prices
GDP deflator =
× 100
Value of current−year output
at base−year prices
Real GDP =
Nominal GDP
GDP deflator
100
Nominal GDP = Real GDP × GDP deflator 100
Example: If nominal GDP is 16,988.3 billion and the GDP deflator is 106.775, what is
real GDP?
16,988.3 billion
Real GDP =
= 15,910.37 billion
106.775
100
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COMPONENTS OF GDP
𝐻𝑜𝑢𝑠𝑒ℎ𝑜𝑙𝑑
𝐵𝑢𝑠𝑖𝑛𝑒𝑠𝑠
𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝑜𝑟 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙
𝑆𝑒𝑐𝑡𝑜𝑟
𝑆𝑒𝑐𝑡𝑜𝑟
𝑆𝑒𝑐𝑡𝑜𝑟
𝑆𝑒𝑐𝑡𝑜𝑟
↓
↓
↓
↓
GDP = Consumer + Gross private + Government + Exports − Imports
spending
spending
domestic
on goods
on goods
investment
and services
and services
GDP = 𝐶 + 𝐼 + 𝐺 + (𝑋 − 𝑀)
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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
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
Aggregate savings (AS) = National savings + Current account surplus = I
Savings Investment Fiscal balance Net exports
=
+
+
G–T
(X – M)
I
S
National savings = Private savings + Government savings
Government savings = Taxes –
Personal savings = GDP +
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Interest on
Government Transfer
–
–
spending
payments government debt
Interest on
Transfer
+
− Taxes − Consumption
payments government debt
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SAVINGS AND INVESTMENT
• Rearrange the GDP equation to equate expenditures and income:
Fiscal balance Net exports
Savings
Investment
−
=
+
(𝑋 – 𝑀)
𝐺– 𝑇
𝐼
𝑆
• As income increases, the fiscal balance and net exports decline.
- If the effect of income on savings is greater than the effect on investment, the
net savings (S – I) increases.
• Dealing with an imbalance:
- If (S – I) > (G – T) + (X – M), there is excess savings.
- If (S – I) < (G – T) + (X – M), there is excess planned investment.
- The balance between expenditure and income is the result of a changing real
interest rate:
- If there is excess savings, the real rate will decline.
- If there is excess planned investment, the real rate will increase.
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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
where
M = money supply
V = velocity of money
P = price level
Y = income
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THE IS AND LM CURVES
The IS and LM curves illustrate the relationship between the real interest rate,
r, and income, Y.
LM with an
increase in M
Real Interest
LM
Rate (r)
IS with an
increase in G
IS
Income (Y)
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IS, LM, AND AGGREGATE DEMAND
Real interest
rate (r)
r1
LM1
LM2
r2
IS
Y1
Income (Y)
Y2
Price
level
P1
P2
AD
Y1
Y2
Income (Y)
Effects when the central bank increases the money supply
→ increased aggregate demand
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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).
Price level
LRAS
SRAS
VSRAS
Output
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SHIFTS IN AGGREGATE DEMAND AND
AGGREGATE SUPPLY CURVES
Shifts in aggregate demand result
from changes in the following:
Shifts in aggregate supply result from
changes in the following:
• Household wealth
• Supply of labor
• Consumer and business
expectations
• Human capital (quality of labor)
• Capacity utilization
• Supply of physical capital
• Monetary policy (reserves and
interest rates)
• Productivity and technology
• Supply of natural resources
• Exchange rate
• Growth in global economy
• Fiscal policy (taxes and government
spending)
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EFFECTS OF A SHIFT IN AGGREGATE DEMAND AND
AGGREGATE SUPPLY ON BUSINESS CYCLES
• 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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EFFECTS OF A SHIFT IN AGGREGATE DEMAND AND
AGGREGATE SUPPLY ON BUSINESS CYCLES
At long-run full employment, the economy is at potential GDP, and equilibrium
output is at an equilibrium where LRAS = SRAS = AD
Price
level
LRAS
SRAS
P1
AD
Income, Output, Y
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EFFECTS OF A SHIFT IN AGGREGATE DEMAND AND
AGGREGATE SUPPLY ON BUSINESS CYCLES
A short-run recessionary gap exists when the economy is in a recession and
equilibrium output is less than potential GDP.
Price
level
LRAS
SRAS
P1
P2
AD2
Y2 Y1
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AD1
Income, Output, Y
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EFFECTS OF A SHIFT IN AGGREGATE DEMAND AND
AGGREGATE SUPPLY ON BUSINESS CYCLES
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.
LRAS
SRAS
P2
P1
AD2
AD1
Y1
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Y2
Income, Output, Y
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EFFECTS OF A SHIFT IN AGGREGATE DEMAND AND
AGGREGATE SUPPLY ON BUSINESS CYCLES
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.
LRAS
SRAS
P2
P1
AD1
Y2 Y1
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Income, Output, Y
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EFFECTS OF A SHIFT IN AGGREGATE SUPPLY
AND AGGREGATE DEMAND ON THE ECONOMY:
SUMMARY
Change Change in
GDP
Unemployment
rate
Aggregate price
level
↑ AD
↓ AD
↑
↓
↓
↑
↑
↓
↑ AS
↓ AS
↑
↓
↓
↑
↓
↑
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4. ECONOMIC GROWTH AND SUSTAINABILITY
• The production function indicates the relationship between output and the
inputs of technology, labor, and capital:
Y = A × F L,K
where
Y is the level of aggregate output
A is the technological knowledge
F indicates a functional relationship
L is the quantity of labor
K is the capital stock (that is, property, plant, equipment, and land) used
to produce goods and services
• We use the production function to link output in an economy to the inputs.
• A is the total factor productivity (TFP), which is the growth in output not
attributed to K or L.
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SOURCES OF ECONOMIC GROWTH
Physical
Capital
Human
Capital
Labor
Supply
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Technology
Capacity
to Supply
Goods and
Services
Natural
Resources
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SOURCES AND MEASURES OF
ECONOMIC GROWTH
• The labor force is the portion of the working age population (that is, above age
16) that is employed or available for work.
- Human capital reflects the education, training, and life experience of the
labor force.
• Labor productivity is the quantity of goods and services that a worker can
produce in one hour of work:
Real GDP
Labor productivity =
Aggregate hours
• Labor productivity is affected by
- education and skill of workers,
- investments in physical capital, and
- improvements in technology.
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SUSTAINABILITY OF ECONOMIC GROWTH
• Sustainable growth is the rate of growth that is achievable given the
resources (labor and capital); it depends on productivity and the size of the
labor force:
Potential growth
Long−term labor
Long−term growth
rate of GD
=
+
productivity growth rate
(adjusted for inflation) rate of labor force
Example: If the labor force of a nation is expected to grow at a rate of 4% per
year and the labor productivity is expected to grow at a rate of 1% per year, the
expected rate of growth in potential GDP = 4% + 1% = 5%.
• We can derive the degree of slack in an economy by comparing actual growth
in GDP with potential growth in GDP:
- If actual growth > potential growth → inflationary pressures
- If actual growth < potential growth → resource slack and low inflationary
pressure
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PRODUCTION FUNCTION AND GROWTH
• Economic growth depends on labor productivity.
• We can see the relation between production in an economy and labor
productivity by starting with the production function:
𝑌 = 𝐴 × 𝐹 𝐿, 𝐾
and divide each side by 1/L:
𝑌
𝐾
=
𝐴
×
𝐹
1,
𝐿
𝐿
• Therefore, the productivity relative to labor depends on the level of the labor
force, the level of capital investment, and the mix of labor and capital.
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INPUT GROWTH AND THE GROWTH OF
TOTAL FACTOR PRODUCTIVITY
• Referring back to the production function,
𝑌 = 𝐴 × 𝐹 𝐿, 𝐾 ,
we see that any growth in the output (that is, Y) depends on the inputs, but
also the scale factor, A.
- A captures technology or total factor productivity (TFP), which is sometimes
referred to as an index of the output per unit input.
- TFP is often viewed as the growth in GDP that is not explained by the growth
in labor or capital.
• Therefore, growth in Y may come from growth in the inputs (K and L) but also
from growth in TFP:
Growth
Growth
Growth potential in GDP = TFP growth + 𝑊𝐿
+ 𝑊𝐶
in capital
in labor
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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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CONCLUSIONS AND SUMMARY
• 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.
Movements along the supply curve reflect the impact of price on supply.
• The long-run aggregate supply curve is vertical because input costs adjust to
changes in output prices, leaving the optimal level of output unchanged.
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CONCLUSIONS AND SUMMARY
• 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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