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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 nations
- 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 nations 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


Stage 1: Produce materials
Plastic $1.50
Textile 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


Total value added $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 currentyear output
at currentyear prices
GDP deflator = 100
Value of currentyear output
at baseyear prices

Nominal GDP
Real GDP =
GDP deflator
100

Nominal GDP = Real GDP GDP deflator100

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




GDP = Consumer + Gross private + Government + Exports Imports
spending domestic spending
on goods investment on goods
and services and services

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
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


= + +
S I GT (X M)

National savings = Private savings + Government savings

Government Transfer Interest on


Government savings = Taxes
spending payments government debt

Transfer Interest on
Personal savings = GDP + + Taxes Consumption
payments government debt

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SAVINGS AND INVESTMENT
Rearrange the GDP equation to equate expenditures and income:
Savings Investment Fiscal balance Net exports
= +
( )
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 investmentsavings (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 LM1


rate (r) LM2
r1
r2
IS

Y1 Y2 Income (Y)

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).
SRAS
LRAS
Price level

VSRAS

Output
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SHIFTS IN AGGREGATE DEMAND AND
AGGREGATE SUPPLY CURVES
Shifts in aggregate demand result Shifts in aggregate supply result from
from changes in the following: changes in the following:
Household wealth Supply of labor
Consumer and business Human capital (quality of labor)
expectations Supply of natural resources
Capacity utilization Supply of physical capital
Monetary policy (reserves and Productivity and technology
interest rates)
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 LRAS
level 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 LRAS
level SRAS

P1
P2

AD1
AD2
Y2 Y1 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 Income, Output, Y
Y2

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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 Income, Output, Y

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EFFECTS OF A SHIFT IN AGGREGATE SUPPLY
AND AGGREGATE DEMAND ON THE ECONOMY:
SUMMARY

Change Change in Unemployment Aggregate price


GDP rate 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
Technology
Capital

Capacity
Labor to Supply Natural
Supply Goods and Resources
Services

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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
Longterm growth Longterm labor
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:

= ,
and divide each side by 1/L:

= 1,

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,
= , ,
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 + +
in labor in capital

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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 economys 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 economys 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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