Aggregate output, prices and economic growth

Microeconomics is the study of the economic behaviors of individual economic units such as a
household a company or a market for a particular good or service. While Macroeconomics is
the study of the aggregate activities of households, companies and markets

It focuses on national aggregates such as total investments, the amount spent by all businesses
on a plant and equipment; total consumption, the amount spent by all households on goods
and services; the rate of change in the general level of prices; and the overall level interest
rates

Aggregate output and income

The aggregate output of an economy is the value of all goods and services produced in a
specified period of time. The aggregate income is the value of all payments earned by the
suppliers of factors used in the production of goods and services. Both calculations must be
equal

There are four broad forms of income

● Compensation for employees

● Rent: payment for use of property
● Interest: lending of funds
● Profits: is the return that owners of a company receive for the use of their capital and
the assumption of financial risk when making their investments

Gross domestic product measures

● The market value of all final goods and services produced within the economy in a
given period of time or
● The aggregate income earned by all households and the government within the
economy in a given period of time

It measures the flow of output and income in the economy

To ensure consistency

● All goods and services must be produced during the measurement period
● The only goods and services included in the calculation of GDP are those whose value
can be determined by being sold in the market
● Only the market value of final goods and services are included in GDP

Goods and services included at imputed values

Owner-occupied housing and government services are included in the GDP measurement.
Government services are included at their cost

Nominal and real GDP

In order to evaluate n economy´s health, it is often useful to remove the effect of changes in
the general price level on GDP because income driven solely by changes in price levels is not
indicative of higher level of economic activity. Use real GDP. This indicator measures the total
expenditures on output of goods and services if prices were unchanged.
Per capital real GDP: it is measure of the average standard of living and its real GDP/ size of
population

Nominal GDP: value of goods and services measured at current prices

GDP Deflator: (value of current year output at current year prices/ value of current year
output at base year prices)*100

It is a useful gauge of inflation within the economy

GDP components

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

C: consumer spending on final goods and services

I: Gross private domestic investment

G: government spending on final goods and services

X: exports

M: Imports

Household and business sectors

Households spend part of their income on consumption and save a part of their income for
future consumption. Current consumption flows through the goods market to the business
sector and saving flows into the financial markets where it provides funding for businesses that
need to borrow or raise equity capital

Government sector:

It collects taxes from households and businesses. It purchases goods and services from the
business sector. Transfer to households are netted from collected taxes

When G>T we have a fiscal deficit and must borrow in the financial market. Thus, it competes
with businesses in the financial markets for the funds generated by household saving.

External sector:

Trade deficit: it means that domestic economy is spending more on foreign goods and services
than foreign economies are spending on domestic goods and services. It must be funded by
borrowing from the rest of the world through the financial markets. The rest of world is able to
provide financing as it must be running a corresponding trade surplus

Financing term to fund deficit could be not attractive

GDP= National income + Capital consumption allowance + Statistical discrepancy

National income: is the income received by all factors of production used in the generation of
final output: compensation of employees+corporate and government profits+interest
income+rent+indirect business taxes + unincorporated business net income

Capital consumption allowance: is a measure of the wear and tear of the capital stock that
occurs in the production of goods and services. It is the amount that must be earned and
reinvested just to maintain the existing productivity of capital
Personal income: is a broad measure of household income and measure the ability of
consumers to make purchases

Personal income: national income- indirect business taxes-corporate income taxes-

undistributed corporate profits + transfer payments

Personal disposable income: is equal to personal income – personal taxes

Household saving: personal disposable income- consumption expenditures – interest paid by

consumers to businesses and personal transfer payments to foreigners

Aggregate demand, aggregate supply and equilibrium

Aggregate demand: represents the quantity of goods and services that households, businesses
and government and foreign consumers want to buy at any given level of price. Aggregate
supply: represents the quantity of goods and services producers are willing to supply at any
given level of prices

The aggregate demand is downward sloping

Equally of planned expenditures and actual income/output gives rise to what is called IS curve.
Second condition equilibrium in the money market is embodied in what is called LM Curve

IS curve

S= I + (G-T) + (X-M)

This equation shows that domestic private saving is used in one three ways

● Investment spending
● Financing government deficits
● Building up financial claims against overseas economies

Marginal propensity to consume: represents the proportion of an additional unit of disposable

income that is consumed or spent. The amount that is not spent is saved, the marginal
propensity to save= 1-MPC

S-I= (G-T) + (X-M) the right hand of the equation declines with income increases and the left
hand increases as income rises

S= Y-C-T
Equilibrating income and expenditure entails an inverse relationship between income and real
interest rate

Equilibrium in the money market

IS curve tells us what level of income is consistent with a given level of the real interest rate
but doesn’t address the appropriate level of interest rates nor does it depend on the price
level

MV=PY

M: money supply

P Price level

Y real income/expenditure

V: velocity of money, the average rate at which money circulates through the economy to
facilitate expenditure

M/P=kY

K: 1/V reflect how much money people want to hold for every currency unit of real income

The demand for real money is inversely on the interest rate because a higher interest rate
investors shift their assets out of money into higher yielding securities

Money demand increases with income

Given the real money supply, an increase in real income must be accompanied by an increase
in the interest rate to keep the demand for real money balances equal to the supply
Graph (145)

The aggregate demand will be flatter if

● Investment expenditure is highly sensitive to interest rate

● Saving is insensitive to income
● Money demand is insensitive to interest rates
● Money demand is insensitive to income

Aggregate supply

Short run cost varies inflexible

Long run upward sloping

Shift to aggregate demand

Household wealth an increase increases consumer spending and shifts demand to the right

Consumer and business expectations when consumers are confident about their future income
and stability of their jobs tend to spend a higher portion of their disposable income

Capacity utilization when companies are operating at near or full capacity, they will need to
increase investment spending in order to expand production

Monetary policy affect aggregate output and prices through changes in bank reserves, reserve
requirements or its target interest rate, an increase in money supply move demand to the right

Exchange rate: lower exchange rate move demand to the right

Growth in global economy: higher exports and move demand to the right

Fiscal policy: lower taxes will increase the proportion of personal income and corporate pre-tax
profits that consumers and business have available to spend

Shift in short run aggregate supply

Nominal wages An increase in nominal wages reduce production but check productivity

Input prices lower input prices increase production and supply

Expectations about future output prices: higher produce more or relative to general prices,
increase production

Business taxes and subsidies more taxes produce less

Exchange rate: lower cost of materials and produce more

Shifts in long run aggregate supply

Potential GPD: measures the productive capacity of the economy and is the level of real GDP
that can be fully produced at full employment. Any factor increasing the resource base of an
economy causes the LRAS to the right

Supply of labor and quality forces: the larger the more output the economy can produce or
increase quality

Supply of natural resources: more availability more output

Supply of physical capital: investment in new capital more output

Productivity and technology: advances in technology more output

Equilibrium GDP and Prices

Long run equilibrium: occurs where the AD curve intercepts the SRAS and LRAS. In the long
run equilibrium GDP is equal to potential GDP

Recessionary gap: occurs when the AD intersects the short run AS at a short run equilibrium
level of GDP below potential

Recession the following condition will likely to occur

● Corporate profits will decline

● Commodity prices will decline
● Interest rates will decline
● Demand for credit line will decline

Following investment strategies

● Reduce investment in cyclical companies

● Reduce investment in commodities or commodities oriented companies
● Increase investment in defensive companies
● Increase investment in government issued fixed incomes as interest rates will decline
● Increase investment in the long term because prices will be more responsive to
interest rate declines
● Reduce investments in speculative equity securities

Inflationary gap: if expansion drives the economy beyond its production capacity inflation will
occur, cut above potential GDP

Expansion this will occurs

● Corporate profits will rise

● Commodity prices will increase
● Interest rates will rise
● Inflationary pressures will build

Following investment strategies

● Increase investment in cyclical companies

 ● Increase investment in commodities or commodities oriented companies
● Decrease investment in defensive companies
● Decrease investment in the long term because prices will be more responsive to
interest rate rises
● Increases investments in speculative equity securities as default probabilities will be
reduced

Stagflation

Declines in AS bring stagflation, high unemployment and increased inflation

Reduce in AS do the following

● Reducing investment in fixed income because rising output prices put upward pressure
on nominal interest rates
● Reduce investments in most equity securities because profit margins are squeezed and
output declines
● Increase investment on commodities because prices will increases

Economic growth and sustainability

It is calculated as annual percentage change in real GDP or the annual change in real per capita
GDP

Sustainable rate of economic growth: is measured by the rate of increase in the potential GDP

Solow growth model the potential GDP increase for two reasons

Accumulation of such inputs as capital, labor and raw materials used in production

Discovery and application of new technology that make the inputs in the production process
more productive it is based on a production function that provides the quantitative link
between the level of output that the economy can produce and the input used in the
production process

Two assumptions, production function has constant returns to scale and the production
exhibits diminishing marginal probability with respect to any individual input

Long term growth cannot rely solely on capital deepening investment that increases the stock
of capital relative to labor

Growth of developing countries greater than that of developed countries

Delta GDP= Growth in tech+ WL growth in labor + Wc growth in capital WL and WC relative to
GDP

Sources of economic growth

Labor: labor force is the portion of the working age population that is employed or available
for work but not working

Human capital

Physical capital net investment is always positive

Tech: overcome limits imposed by diminishing marginal returns

Natural resources

Measures of sustainable growth

Labor productivity: real GDP/Aggregate hours

Look also for growth in this area

Potential GDP: Aggregate hours worked*labor productivity

Potential growth rate: Long term growth rate of labor force+ Long term labor productivity
growth rate

National income GDP-Capital consumption allowance

Questions

1) B
2) C
3) C
4) A
5) B
6) B
7) A
8) B
9) C it is A me falto volverla annual
10) B
11) B
12) C
13) B it is A S=I+G-T+X-M
14) C but increase G-T fiscal deficit
15) A
16) B
17) C
18) B
19) A
20) A It is C
21) C
22) B
23) B
24) A it is B
25) C
26) B
27) C it is A
28) A it is B
29) A
30) B
31) B
32) B
33) B
34) C
35) B