Part 3. Aggregate Output, Price and Economic Growth

Question 1

GDP

Answer 1

The total market value of goods and services produced in a country within a certain time period.

• Includes only purchases of newly produced goods and services
  i. e. market value of final goods and services not resold or used in production, provided by gov such as policing, roads, value of owner-occupied housing.
• Not include transfer payments i.e. unemployment, retirement, welfare benefits

Question 2

Expenditure approach (GDP)

Answer 2

GDP calculated by summing amounts spent on goods and services produced during the period.

Question 3

Income approach (GDP)

Answer 3

Summing the amounts earned by households and companies during the period, including wage income, interest income and business profits.

Question 4

Value of final output method

Answer 4

= expenditure method to summing the values of all final goods and services produced.

Question 5

Sum of value added method

Answer 5

• GDP calculated by summing the additions to value created at each stage of production and distribution.

Question 6

Nominal GDP

Answer 6

The total value of all goods and services produced by an economy, valued at current market prices.

Since its based on current prices, inflation will increase value even if physical output of goods and services remain constant from 1 year to the next.

Question 7

Real GDP

Answer 7

This measures the output of the economy using prices from a base year, removing the effect of changes in prices so inflation is not counted as economic growth.

Question 8

GDP deflator

Answer 8

A price index that can be used to convert nominal GDP into real GDP taking out effects of changes in overall price level.

Question 9

Per-capita real GDP

Answer 9

The real GDP divided by population and often used as a measure of economic well-being of country’s residents.

Question 10

GDP equation (expenditure approach):

Answer 10

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

or

GDP = (C + Gc) + (I + Gi) + (X-M)

where:
Gc = government consumption
Gi = government investment (capital goods, inventories)

Question 11

GDP equation (income approach):

Answer 11

GDP/GDI = national income + capital consumption allowance + statistical discrepancy

Question 12

Capital consumption allowance (CCA):

Answer 12

This measures the depreciation of physical capital from product of goods and services over a period.

• The amount that would be reinvested to maintain the productivity of physical capital from one period to the next.

Question 13

Statistical discrepancy

Answer 13

An adjustment for the difference between GDP measured under the income approach, and expenditure approach because they use different data.

Question 14

National income

Answer 14

The sum of the income received by all factors of production that go into the creation of final output.

national income = compensation of employees (wages and benefits) + corporate and government enterprise profits before tax + interest income + unincorporated business net income (business owners income) + rent + indirect business taxes - subsidies (taxes and subsidies that are included in final prices).

Question 15

Personal income

Answer 15

A measure of pretax income received by households and is an determinant of consumer purchasing power and consumption.

Includes: all income households receive, including government transfer payments such as unemployment or disability benefits.

Question 16

Household/personal disposable income

Answer 16

This is personal income after tax, measuring household have available to either save or spend on goods and services, and an important indicator of the ability of consumers to spend and save.

Question 17

Total income, which must equal total expenditure is:

Answer 17

GDP = C + S + T

where:
C = consumption spending
S = household and business savings
T = net taxes ( taxes paid minus transfer payments received)

Question 18

Consumption

Answer 18

A function of disposable income, with additional disposable income either consumed or saved.

MPC = proportion of income spent on consumption.
MPS = proportion of income saved.

MPC + MPS must equal 100%

Question 19

Investment

Answer 19

A function of expected profitability (dependent on overall level of economic output) and cost of financing (reflected in real interest rates, approx. nominal interest rates minus expected inflation rate).

Question 20

Government purchases

Answer 20

An independent economic activity to a degree, but tax revenue to the government, hence fiscal balance is a function of economic output.

Question 21

Net exports

Answer 21

A function of domestic disposable incomes (affect imports), foreign disposable incomes (affect exports), and relative prices of goods in foreign and domestic markets.

Question 22

IS curve (income-savings)

Answer 22

The negative relationship between real interest rates and real income for equilibrium in the goods market, the curve being a combination of real interest rates and income for which planned expenditures equal income.

Question 23

LM curve (liquidity-money)

Answer 23

This illustrates the positive relationship between real interest rates and income consistent with equilibrium in money market.

Question 24

Aggregate demand curve

Answer 24

This shows the relationship between the quantity of real output demanded (= real income), and price level, given income is equal to planned expenditures (IS curve) and money demand is equal to money supply (LM curve).

• LM curve meant we held real money supply (M/P) constant, now if we hold nominal money supply (M) constant, changes in real money supply are due to changes in price level (P).
• An increase in price level will decrease real money supply (M/P) and decrease in price level will increase real money supply (M/P).

Question 25

Aggregate supply (AS) curve

Answer 25

This describes the relationship between the price level and the quantity of real GDP supplied, when all other factors are kept constant, representing the amount of output firms will produce at different price levels.

Question 26

Factors that cause AD to shift:

Answer 26

1. Increase in consumer wealth - as the value of household wealth increases (real estate, stocks, other financial securities), the proportion of income saved decreases and spending increases, increasing AD.
2. Business expectations - more optimistic businesses about future sales tend to increase investment in plant, equipment, and inventory, increasing AD.
3. Consumer expectations of future income - if consumers expect higher future incomes due to belief of job stability/rising wage, they save less for future and increase C, thus increase AD.
4. High capacity utilisation - companies produce a high % of capacity, to invest in more plant and equipment, increasing AD.
5. Expansionary monetary policy - rate of growth of money supply is increased, banks have more funds to lend, putting downward pressure on IR, increasing I as a decline in cost of financing investments.
   - Lower IR & greater credit availability also increases C on durables (i.e. automobiles), so overall increases AD.
6. Expansionary fiscal policy - decreasing government budget surplus (or increasing budget deficit) from decreasing tax, increasing G or both.
   - Fall in tax, rises disposable income and C, while increase in G increases AD directly.
7. Exchange rate - a decrease in relative value of country’s currency will increase X and decrease M, increasing domestic AD.
8. Global economic growth - GDP growth in foreign economies increases quantity of imports (dom. exports) foreigners demand, by increasing domestic export demand, this increases AD.

Question 27

Short run aggregate supply (SRAS) curve:

Answer 27

This reflects the relationship between output and the price level when wages and other input prices are held constant (or are slow to adjust to higher output prices).

The curve shows the level of output, that businesses are willing to supply at different price levels, and the number of factors affect level of output and cause SRAS to shift.

Question 28

Factors that cause SRAS curve to shift to the right:

Answer 28

1. Labour productivity - holding wage rate constant, an increase in labour productivity will decrease unit costs to producers, they will increases output, increasing SRAS.
2. Input prices - a decrease in nominal wages or prices of other important productive inputs will decrease production costs, and cause forms to increase production, increasing SRAS; wages are often the largest contributor to producers’ costs and have the greatest impact on SRAS.
3. Expectations of future output prices - when businesses expect the price of their output to increase in the future, they will expand production increasing SRAS.
4. Taxes and government subsidies - a decrease in business taxes or increase in government subsidies for a product will decrease the costs of production; firms will output, increasing SRAS.
5. Exchange rates - appreciation of countries’ currency in foreign exchange will decrease the cost of imports, to the extent productive inputs are purchased from foreign countries, causing a decrease in production costs will cause firms to increase output, thus SRAS.

Question 29

Long Run Aggregate Supply

Answer 29

A vertical (perfectly inelastic) at potential (full-employment) level of real GDP.

Question 30

Factors will shift the LRAS curve:

Answer 30

1. Increase in supply and quality of labour - LRAS reflects output at full employment, an increase in the labour force will increase full-employment output and LRAS; an increase in skills of the workforce through training and education will increase the productivity of labour force of given size, increasing real output and increasing LRAS.
2. Increase in supply of natural resources - increase in available amounts of other important productive inputs will increase potential real GDP and LRAS.
3. Increase in the stock of physical capital - for labour force of given size, an increase in an economy’s accumulated stock of capital equipment will increase potential output and LRAS.
4. Technology - improvements in technology increase labour productivity (output per unit of labour), thereby an increase in real output produced from a given amount of productive inputs, increasing LRAS.
   - Tech does not really retreat (i.e. decrease LRAS), but law prohibiting the use of an improved technology could decrease LRAS.

Question 31

Recession

Answer 31

A period of declining GDP and rising unemployment.

Question 32

Stagflation

Answer 32

The combination of declining economic putput and higher prices, compared to initial long term equilbrium.

Question 33

When AD and AS both increase OR decrease:

Answer 33

Real GDP increases OR decreases, but the effect of price level depends on the relative magnitude of the changes, as price effects are in opposite directions.

Question 34

When AD increases/decreases and AS decreases/increases:

Answer 34

The price level will increase/decrease, but effect on real GDP depends on relative magnitudes of changes as their effect on economic output are in opposite directions.

Question 35

Sources of economic growth:

Answer 35

1. Labor supply
   - the labor force is the number of people over the age of 16 working or available for work but currently unemployed, affected by population growth, net immigration and labor force participation rate.
2. Human capital
   - The education and skill level of countries labor force, where skilled and well-educated (possess more human capital) are more productive, and better able to take advantage of advances in technology.
3. Physical capital stock
   - From higher rate of investment, where larger capital stock increases labor productivity and potential GDP.
4. Technology
   - Improvements in tech increases productivity and potential GDP.
5. Natural resources
   - raw material inputs such as oil, land are necessary to produce economic output, these may be renewable (forests), non-renewable, with countries having abundant amounts achieving greater economic growth rates.

Question 36

Potential GDP formula:

Answer 36

potential GDP = aggregate hours worked x labor productivity

Question 37

Growth in potential GDP formula:

Answer 37

Growth in potential GDP = growth in labor force + growth in labor productivity

Question 38

Sustainable rate of economic growth

Answer 38

The rate of increase in the economy’s productive capacity (potential GDP), where long term equity returns are highly dependent on economic growth over time.

Question 39

Production function

Answer 39

THe relationship of output to the size of the labor force, the capital stock and productivity.

Y = A x f(L, K)

where:

Y = aggregate economic output
L = size of labor force
K = amount of capital available]
A = total factor productivity

Question 40

Total factor productivity (A)

Answer 40

A multiplier which quantifies the amount of output growth not explained by increases in the size of the labor force and capital

• This cannot be observed directly, and must be inferred based on other factors.

Question 41

Production function (on a per worker basis):

Answer 41

Y/L = A x f(K/L)

where:

Y/L = output per worker (labor productivity)
K/L = physical capital per worker

• where labor productivity can be increased by either improving technology or increasing physical capital per worker.

Question 42

Diminishing marginal productivity

Answer 42

For each individual input, meaning the amount of additional output produced by each additional unit of input declines (holding the quantities of other inputs constant).

i.e. capital deepening investment cannot necessarily create sustainable long term growth, but rather increasing physical capital per worker over time.