Reading 14: Aggregate Output, Prices, and Economic Growth

Question 1

Give the equations used to calculate the equality of expenditure and income. Once equality of expenditure and income is calculated, what can domestic private saving be used for?

Answer 1

S = I + (G−T) + (X−M)

What can domestic private saving be used for:

Investment spending (I)
Financing government deficits (G – T)
Building up financial claims against overseas economies by financing their trade deficits (lending the domestic economy's trade surplus, X − M)

Question 2

Distinguish between structural unemployment and cyclical unemployment.

Answer 2

Structural unemployment results from changes that make some skills obsolete and leave previously employed people jobless.

Cyclical unemployment occurs as an economy goes through the phases of a business cycle.

Question 3

Identify the factors that explain the negative slope of the aggregate demand curve.

Answer 3

Higher prices reduce the purchasing power of those whose incomes are fixed in nominal terms.

Higher prices reduce the real and nominal value of assets and decrease real wealth.

Higher prices make foreign goods more competitive, so imports rise and exports fall.

Question 4

Describe the growth accounting equation.

Answer 4

Potential output grows as a function of technology and the weighted average of labor and capital growth:

Growth in potential GDP = Growth in technology + WL(growth in labor) + WK(growth in capital)

Question 5

Describe how GDP is calculated and define gross domestic product (GDP) using the output and income definition.

Answer 5

GDP is calculated as the amount spent on goods and services produced in the economy or total amount earned by households and companies in the economy. Total income must equal total expenditure; GDP can be calculated using either of these approaches.

GDP using output is the market value of all final goods and services produced within an economy during a period.

GDP using the income definition is the aggregate income earned by all households, companies, and the government in an economy during a period.

Question 6

Describe the framework the Solow (neoclassical) growth model provides.

Answer 6

The model is based on the production function and identifies underlying sources of economic growth.

Note: The mathematical representation of the production function is below:

Y = AF(L, K)

Y = Aggregate output
L = Quantity of labor
K = Quantity of capital
A = Technological knowledge; that is, total factor productivity (TFP)

Question 7

Describe how changes in the level of real interest rates (r) cause shifts in the S – I line.

Answer 7

If real interest rates fall, investment expenditure rises. A similar increase in saving can only occur if income rises (the S – I curve shifts to the right).

Question 8

Identify the two most important determinants of investment spending (I) in an economy.

Answer 8

1. The higher the cost of obtaining funds (interest rate), the lower the level of investment in an economy.
2. Higher aggregate output/income leads to higher expected return and encourages new investments.

Question 9

Describe the point where the IS and LM curves intersect and define the combination of real interest rates and real income.

Answer 9

Planned expenditures equal actual (or realized) income/output.

There is equilibrium in the money market; that is, the available real money supply is equal to the demand for real money.

Question 10

Describe the implications of diminishing marginal returns to capital on the growth rate.

Answer 10

For long-term sustainable economic growth, countries cannot rely solely on increasing the quantity of capital relative to labor. Eventually incomes across developed and developing countries should converge.

Question 11

Explain aggregate output, aggregate income, and aggregate expenditure.

Answer 11

Aggregate output refers to the total value of all the goods and services produced in an economy during a period.

Aggregate income refers to the total value of payments earned by the suppliers of factors of production during a period.

Aggregate expenditure refers to the total amount spent on the goods and services produced in the domestic economy during a period.

Question 12

What happens when AD increases? What should an investor do in this situation?

Answer 12

Corporate profits, interest rates, and commodity prices all increase.

Inflationary pressures build.

An investor should do the following:

Increase investments in cyclical, commodities, and commodity-oriented companies.
Reduce investments in defensive companies, and fixed-income securities.
Increase investments in junk bonds, however, as default risk should fall in an expansion.

Question 13

Graphically, when is long-run full employment equilibrium achieved?

Answer 13

When the aggregate demand curve and the short-run aggregate supply curve intersect at a point on the long-run aggregate supply curve. At this point, actual real GDP equals potential GDP or full employment GDP.

Question 14

Identify what may cause shifts in the AD curve.

Answer 14

Changes in household wealth, consumer and business confidence, capacity utilization, fiscal/monetary policy, exchange rates, growth in the global economy.

Question 15

Define total factor productivity (TFP).

Answer 15

A scale factor that accounts for the portion of economic growth that is not explained by capital and labor quantities. The main influence on TFP is technological change.

Question 16

List the factors that have an impact on the resource base of an economy and will cause a shift in LRAS (and SRAS).

Answer 16

Supply of labor (and quality of labor or human capital), supply of natural resources, supply of physical capital, and labor productivity and technology

Question 17

Give the formula to calculate GDP using the expenditure approach.

Answer 17

GDP = C + I + G + (X−M)

C = Consumer spending

I = Gross private domestic investment (capital goods and changes in inventory)

G = Government spending

X = Exports, M = Imports

Question 18

Describe the two most important factors that affect net exports (X – M).

Answer 18

1. Relative incomes in the domestic country and in the rest of the world.
2. Relative prices of domestic and foreign goods and services.

Note: An increase in aggregate income results in (1) higher net taxes (lowering the fiscal balance); and (2) higher imports (lowering the trade balance).

Question 19

Differentiate between GDP and GNP.

Answer 19

GDP accounts for all production within a country’s borders, whether owned domestically or by foreigners. GNP measures output produced by domestically owned factors of production, whether produced within the economy’s boundaries or outside.

Question 20

Give the quantity theory equation.

Answer 20

MV = PY; M/P = MD/P = kY

k = 1/V, the proportion of income held as currency

M = Nominal money supply; MD = Nominal money demand

MD/P is referred to as real money demand, RMD, and M/P is real money supply

Question 21

Explain how economic growth may be calculated.

Answer 21

The annual percentage change in real GDP, which measures overall economic activity.

The annual change in real per capita GDP; that is, total real GDP divided by total population. It indicates standard of living in a country.

Question 22

What happens to GDP in an expansion and in a contraction?

Answer 22

In an expansion, real GDP increases, the unemployment rate falls, and capacity utilization rises. Inflation rises.

In a contraction, real GDP decreases, unemployment rises, and capacity utilization falls. Inflation falls.

Question 23

Describe the importance of labor productivity and mathematically define it.

Answer 23

The higher the productivity of labor, the more goods and services the economy can produce given the number of workers. Labor productivity depends on the stock of human and physical capital and state of technology.

Labor Productivity = Real GDP / Aggregate hours

The growth rate of labor productivity is the percentage increase in productivity over a year. Rapid productivity growth means the same number of labor units can produce more and more goods and services, which allows companies to pay higher wages and still make high profits.