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Gross Domestic Product and Gross
National Product

GDP is the market value of all
newly produced final goods and
services produced by resources
located in the United States,
regardless of who owns those
resources
Final and Intermediate Goods and
Services

Final goods and services sold to ultimate,
users


Intermediate goods and services are
purchased for further reprocessing and
resale


Cotton shirts are a final good
Cotton is intermediate good
Keeping final goods and intermediate
goods separate in our thinking allows us
to avoid double counting
Calculating GDP
GDP can be computed in two
ways:


The expenditure approach:
A method of computing GDP
that measures the total
amount spent on all final goods
during a given period.
The income approach:
The Expenditure Approach

The expenditure approach
calculates GDP by adding together
the four components of spending.
In equation form:
GDP  C  I  G  ( EX  IM )
The Circular Flow of Income and
Expenditure
X-M
consumption (C)
Investment (I)
S
Financial
markets
Gov’t (G)
transfer payments
Disposable income
taxes
C+I+G+X-M
aggregate income
= GDP
Categories of Expenditures

Consumption (C)


Investment (I)


Purchases not used for current consumption
(newly built homes,plant, new inventories)
Government Purchases (G)


All household purchases (blue jeans, twinkies,
etc.)
Examples include missile systems and paper
clips
Net Exports (X - M)

Net exports = exports (X) - imports (M)
Personal Consumption
Expenditures

Personal consumption expenditures
(C) are expenditures by consumers
on the following:



Durable goods: Goods that last a
relatively long time, such as cars and
appliances.
Nondurable goods: Goods that are
used up fairly quickly, such as food and
clothing.
Services: Things that do not involve
the production of physical things, such
as legal services, medical services, and
education.
Gross Private Domestic
Investment


Investment refers to the purchase
of new capital.
Total investment by the private
sector is called gross private
domestic investment. It includes
the purchase of new housing,
plants, equipment, and inventory by
the private sector.
Gross Private Domestic
Investment



Nonresidential investment includes
expenditures by firms for machines, tools,
plants, and so on.
Residential investment includes
expenditures by households and firms on
new houses and apartment buildings.
Change in inventories computes the
amount by which firms’ inventories
change during a given period.
Inventories are the goods that firms
produce now but intend to sell later.
Government Consumption
and Gross Investment

Government
consumption and
gross investment (G)
counts expenditures by
federal, state, and local
governments for final
goods and services.
Net Exports

Net exports (EX – IM) is the
difference between exports and
imports. The figure can be positive
or negative.


Exports (EX) are sales to foreigners of
U.S.-produced goods and services.
Imports (IM) are U.S. purchases of
goods and services from abroad).
Classify each of these scenarios








You buy an old house
You buy some marijuana from a friend
You buy stock in GM
A Japanese firm buys City Brewery
The government makes a welfare
payment
You buy a used car
A business fails to sell some of its
inventory
A business buys a new truck
Components of GDP, 2002: The Expenditure Approach
BILLIONS
OF
DOLLARS
Personal consumption expenditures (C)
Durable goods
Nondurable goods
Services
Gross private domestic investment (l)
Nonresidential
Residential
Change in business inventories
Government consumption and gross
investment (G)
Federal
State and local
Net exports (EX – IM)
Exports (EX)
Imports (IM)
Total gross domestic product (GDP)
Note: Numbers may not add exactly because of rounding.
Source: U.S. Department of Commerce, Bureau of Economic Analysis.
PERCENTAGE
OF GDP
7303.7
871.9
2115.0
4316.8
1543.2
1117.4
471.9
3.9
1972.9
69.9
8.3
20.2
41.3
14.8
10.7
4.5
0
18.9
693.7
1279.2
 423.6
1014.9
1438.5
10446.2
6.6
12.2
 4.1
9.8
13.8
100.0
Current and Historical Data

US data (BEA)


Historical US Data


http://www.bea.doc.gov/bea/newsrel/gdp499p
.htm
http://eh.net/hmit/gdp/
International


http://www.stls.frb.org/publications/iet/
http://www.odci.gov/cia/publications/factbook/
The Keynesian Framework
and the ISLM Model
Determination of Output
Keynesian ISLM Model assumes price level is fixed
Aggregate Expenditures
AE= C + I + G + NX
Equilibrium
Y = AE
Consumption Function
C = a + (mpc  YD)
Investment
1. Fixed investment
2. Inventory investment
Only planned investment is included in AE
NOTE: In many of the Slides Yd in place of AE they are the
same thing.
16
Consumption
Function
17
Keynesian Cross Diagram
AE
Y=AE
AE
Assume G = 0, NX = 0, T = 0
AE= C + I = 200 + .5Y + 300
= 500 + .5Y
Equilibrium:
1. When Y > Y*, Iu > 0  Y 
to Y*
2. When Y < Y*, Iu < 0  Y 
to Y*
18
Expenditure Multiplier
Analysis of Figure 3:
Expenditure Multiplier
I = + 100  Y/I = 200/100 = 2
1
Y = (a + I) 
1 – mpc
A = a + I = autonomous spending
Conclusions:
1. Expenditure multiplier = Y/A = 1/(1 – mpc)
whether change in A is due to change in a or I
2. Animal spirits change A
The Great Depression
and the Collapse of Investment
Role of Government
Analysis of Figure 5:
Role of Government
G = + 400,  T = + 400
1. With no G and T, Yd = C + I = 500 + mpc Y
= 500 + .5Y, Y1 = 1000
2. With G, Y= C + I + G = 900 + .5Y, Y2 =
1800
3. With G and T, Yd = 900 + mpc  Y – mpc T
= 700 + .5Y, Y3 = 1400
Conclusions:
1. G  Y ; T  Y 
2. G = T = + 400, Y  400
Role of International Trade
NX = +100,
Y/NX = 200/100 = 2
= 1/(1 – mpc) = 1/(1 – .5)
Summary:
Factors that
Affect Y
IS Curve
IS curve
1. i  I  NX , Yad
, Y 
Points 1, 2, 3 in
figure
2. Right of IS: Y >
Yad  Y  to IS
Left of IS: Y <
Yad  Y  to IS
26
LM Curve
LM curve
1. Y , Md , i 
Points 1, 2, 3 in figure
2. Right of LM: excess Md, i  to LM
Left of LM : excess Ms, i  to LM
27
ISLM
Model
Point E,
equilibrium where
Y = Yad (IS) and Md
= M s (LM )
At other points like
A, B, C, D, one of
two markets is not
in equilibrium and
arrows mark
movement towards
point E
Monetary and Fiscal Policy in
the ISLM Model
1. C : at given iA, Yad ,
Y   IS shifts right
2. Same reasoning when
I , G , NX , T 
Shift in
the IS
Curve
Shift in the LM Curve from a Rise in Ms
s
1. M : at given YA, i  in panel (b) and (a)  LM shifts to the right
Shift in the LM Curve from a Rise in M
d
1. M : at given YA, i  in panel (b) and (a)  LM shifts to the left
d
Response to an Increase in M
s
s
1. M : i , LM shifts
right  Y  i 
Response to Expansionary Fiscal Policy
ad
1. G  or T : Y , IS
shifts right  Y  i 
Summary:
Factors
that Shift
IS and LM
Curves
Effectiveness
of Monetary
and Fiscal
Policy
d
d
s
1. M is unrelated to i  i , M = M
at same Y  LM vertical
2. Panel (a): G , IS shifts right  i ,
Y stays same (complete crowding
out)
s
d
3. Panel (b): M , Y so M , LM
shifts right  i  Y 
Conclusion: Less interest sensitive is
d
M , more effective is monetary
policy relative to fiscal policy
36
s
M vs. i Targets When IS Unstable
1. IS unstable:
fluctuates from
IS' to IS''
2. i target at i*: Y
fluctuates from
YI' to YI''
3. M target, LM =
LM*: Y
fluctuates from
YM' to YM''
4. Y fluctuation is
less with M
target
Conclusion: If IS
curve is more
unstable than
LM curve, M
target is
preferred
s
M vs. i Targets When LM Unstable
1. LM unstable:
fluctuates from
LM' to LM''
2. i target at i*: Y
= Y*
3. M target: Y
fluctuates from
YM' to YM''
4. Y fluctuation is
less with i
target
Conclusion: If
LM curve is
more unstable
than IS curve, i
target is
preferred
The ISLM Model in the Long Run
Panel (a)
s
1. M , LM right to LM2, go to point 2, i to i2, Y to Y2
2. Because Y2 > Yn, P , M/P , LM back to LM1, go back to point 1
Panel (b)
1. G , IS right to IS2, go to point 2 where i = i2 and Y = Y2
2. Because Y2 > Yn, P , M/P , LM left to LM2, go to point 2', i = i2` and Y = Yn.
Deriving AD Curve
P , M/P , LM shifts in, Y 
Points 1, 2, 3
Shift in AD from Shift in IS
At given PA, IS shifts right: Y  in panel (b)  AD shifts right in panel (a)
Shift in AD from Shift in LM
At given PA, LM shifts right: Y  in panel (b)  AD shifts right in panel (a)
The Aggregate Supply Curve

Aggregate supply is
the total supply of all
goods and services in
the economy.
The Aggregate Supply Curve

The aggregate supply (AS)
curve is a graph that shows
the relationship between the
aggregate quantity of output
supplied by all firms in an
economy and the overall price
level.
The Aggregate Supply Curve:
A Warning

The aggregate supply
curve is not a market
supply curve or the sum
of all the individual supply
curves in the economy.
The Aggregate Supply Curve:
A Warning

Firms do not simply respond to
market-determined prices, but
they actually set prices. Pricesetting firms do not have
individual supply curves
because these firms are
choosing both output and price
at the same time.
The Aggregate Supply Curve:
A Warning


When we draw a firm’s supply
curve, we assume that input
prices are constant. In
macroeconomics, an increase
in the overall price level means
that at least some input prices
will be rising as well.
The outputs of some firms are
the inputs of other firms.
The Aggregate Supply Curve:
A Warning

Rather than an aggregate supply
curve, what does exist is a
“price/output response” curve — a
curve that traces out the price and
output decisions of all the markets
and firms in the economy under a
given set of circumstances.
Aggregate Supply in the Short Run

In the short run,
the aggregate
supply curve (the
price/output
response curve)
has a positive
slope.
Aggregate Supply in the Short Run

At low levels of
aggregate output,
the curve is fairly
flat. As the
economy
approaches
capacity, the curve
becomes nearly
vertical. At
capacity, the curve
is vertical.
Aggregate Supply in the Short Run


Macroeconomists focus on whether
or not the economy as a whole is
operating at full capacity.
As the economy approaches
maximum capacity, firms respond to
further increases in demand only by
raising prices.
Output Levels and
Price/Output Responses

When the economy is operating at
low levels of output, an increase in
aggregate demand is likely to result
in an increase in output with little or
no increase in the overall price
level.
The Response of Input Prices to
Changes in the Overall Price Level

There must be a lag
between changes in input
prices and changes in
output prices, otherwise
the aggregate supply
(price/output response)
curve would be vertical.
The Response of Input Prices to
Changes in the Overall Price Level

Wage rates may increase
at exactly the same rate
as the overall price level if
the price-level increase is
fully anticipated. Most
input prices, however,
tend to lag increases in
output prices.
Shifts of the Short-Run
Aggregate Supply Curve

A cost shock, or supply shock, is a
change in costs that shifts the aggregate
supply (AS) curve.
Shifts of the Short-Run
Aggregate Supply Curve
Factors That Shift the Aggregate Supply Curve
Shifts to the Right
Increases in Aggregate Supply
Shifts to the Left
Decreases in Aggregate Supply
Lower costs
lower input prices
lower wage rates
Higher costs
higher input prices
higher wage rates
Economic growth
more capital
more labor
technological change
Stagnation
capital deterioration
Public policy
supply-side policies
tax cuts
deregulation
Public policy
waste and inefficiency
over-regulation
Good weather
Bad weather, natural
disasters, destruction
from wars
The Equilibrium Price Level

The equilibrium
price level is the
point at which the
aggregate demand
and aggregate
supply curves
intersect.
The Equilibrium Price Level

P0 and Y0
correspond to
equilibrium in the
goods market and
the money market
and a set of
price/output
decisions on the
part of all the firms
in the economy.
The Long-Run
Aggregate Supply Curve

Costs lag behind
price-level changes
in the short run,
resulting in an
upward-sloping AS
curve.
• Costs and the price level
move in tandem in the long
run, and the AS curve is
vertical.
The Long-Run
Aggregate Supply Curve

Output can be
pushed above
potential GDP by
higher aggregate
demand. The
aggregate price
level also rises.
The Long-Run
Aggregate Supply Curve

When output is pushed
above potential, there
is upward pressure on
costs, and this causes
the short-run AS curve
to the left.
• Costs ultimately increase
by the same percentage as
the price level, and the
quantity supplied ends up
back at Y0.
The Long-Run
Aggregate Supply Curve

Y0 represents the
level of output that
can be sustained in
the long run without
inflation. It is also
called potential
output or
potential GDP.
Aggregate Demand, Aggregate
Supply, and Monetary and Fiscal Policy
• AD can shift to the right for
a number of reasons,
including an increase in the
money supply, a tax cut, or
an increase in government
spending.

Expansionary policy works
well when the economy is on
the flat portion of the AS
curve, causing little change
in P relative to the output
increase.
Aggregate Demand, Aggregate
Supply, and Monetary and Fiscal Policy
• On the steep portion of the
AS curve, expansionary
policy does not work well.
The multiplier is close to
zero.

When the economy is
operating near full
capacity, an increase in
AD will result in an
increase in the price
level with little increase
in output.
Long-Run Aggregate
Supply and Policy Effects

If the AS curve is
vertical in the long run,
neither monetary policy
nor fiscal policy has
any effect on aggregate
output.
• In the long run, the
multiplier effect of a change
in government spending or
taxes on aggregate output
is zero.
The Simple “Keynesian”
Aggregate Supply Curve


The output of the
economy cannot exceed
the maximum output of
Y F.
The difference between
planned aggregate
expenditure and
aggregate output at full
capacity is sometimes
referred to as an
inflationary gap.
Causes of Inflation


Inflation is an increase in
the overall price level.
Sustained inflation
occurs when the overall
price level continues to
rise over some fairly long
period of time.
Causes of Inflation

Demand-pull inflation
is inflation initiated by an
increase in aggregate
demand.
• Cost-push, or supply-side,
inflation is inflation caused by
an increase in costs.