Reading 17 LOS's

Question 1

LOS 17a: Calculate and explain gross domestic product (GDP) using expenditure and income approaches

Answer 1

Aggregate output refers to the total value of all the goods and services produces in an economy over a period of time

Aggregate Income refers to the total value of all payments earned by the suppliers of factors of production in an economy over a period of time. Composed of employee compensation, rent, interest, and profits.

• Aggregate Output = Aggregate Income

Aggregate Expenditure refers to the total amount spend on the goods and services produced in the domestic economy over a period of time.

Gross Domestic Product

GDP may be defined in two ways:

1. _Output definition-_GDP is the market value of all final goods and services produced within an economy over a period of time
2. Income Definition GDP is the aggregate income earned by all households, companies, and the government in an economy over a period of time

Based on these two definitions GDP can be calculated using the expenditure approach or the income approach.

In order to ensure consistency in the method used to calculate GDP the following criteria are applied:

• Only goods and services produced during the measurement period are included
  
  • Transfer payments from gov to individuals are excluded
  • Income from capital gains is excluded
• Only goods and services whose value can be determined be being sold in the market are included
• Only the value of final goods and services is included in the calculation of GDP. The value of intermediate goods is excluded.

Question 2

LOS 17b: Compare the sum-of-value-added and value-of-final-output methods of calculating GDP

Answer 2

The sum-of-value-added method would consider the each step of the production process and how it adds to the value. So the farmer sells wheat to a miller for $.30(adding$.30), the miller grinds it and sells it to teh baker for $.85 (adding $.55). The baker bakes and sells the bread to the retailer for $1.45 (adding $.60). and finally the retailer sells the bread to consumer for $2 (adding $.55). So if we were to add all the values added, we would come to $2.

The value of final output method would simply calculate the price of the final good sold, which would be $2.

Both methods arrive to the same conclusion. Value added just taked you through the production process

Question 3

LOS 17c; Compare nominal and real GDP and calculate and interpret the GDP deflator

Answer 3

Nominal GDP refers to the value of goods and services included in GDP measured at current prices

• Nominal GDP = Quantity produced in Year t x Prices in year t

Nominal includes the effect of inflation since it is stated in current prices. Anlaysts will remove this effect by measuring GDP at base-year prices, giving us real GDP.

• Real GDP = Quantity produced in Year t x Base-year Prices

The GDP Deflator broadly measures the aggregate change in prices across the overall economy. Changes in the GDP deflator provide a useful measure of inflation

• GDP deflator = (Nominal GDP / Real GDP) x 100

We can rearrange to look like:

• Real GDP = (Nominal GDP/ GDP deflator) x 100

Therefore we can say that the effects of changes in price can be removed from nominal GDP by dividing it by the GDP deflator

The components of GDP

based on the expenditure approach, GDP can be calculated as:

• GDP = C + I+ G + ( X - IM)

Question 4

LOS 17d: Compare GDP, national income, personal income, and personal disposable income

Answer 4

Expenditure Approach

GDP = the sum of :

• Consumer Spending on goods and services
• Business gross fixed Invesments
• Changes in inventories
• Government spending on goods and services
• Government gross fixed investment
• Exports - Imports
• Statistical discrepancy

Income Approach

GDP = National Income + Capital Consumption allowance + Statistical discrepancy

National Income equals the sum of income received by all factors of production used to generate final output and includes:

• Employee Compensation
• Corporate and government enterprise profits before taxes
• Interest Income
• Rent and unincorproated business net income (proprietor’s income)
• Indirect business taxes less subsidies

The capital consumption allowance (CCA) accounts for the wear and tear or depreciation that occurs in capital stock during the production process. It represents the amount that must be reinvested by the company in the business to maintain current productivity levels.

Other GDP-Related Measures

Personal Income measures the ability of households to make purchases and includes all income received by households, regardless of whether it is earned or unearned. It differs from national income by:

• National income includes income that goes to businesses and government, whereas personal income does not
• National income does not include household income that is not earned (transfer payments)

Personal Income = National Income - Indirect business tax - corporate income tax- undistributed corporate profits + transfer payments

Personal Disposable income measures the amount of income that households have left to spend or save after paying taxes

• PDI = Personal Income - Personal Taxes
• PDI = Household consumption + household saving

Question 5

LOS 17e: Explain the fundamental relationship among saving, investment, the fiscal balance, and the trade balance

Answer 5

The equality of expenditure and income

• S = I + (G -T) + (X - IM)

Based on this equation we can say that domestic private saving ( S) can be used for:

• Investment spending (I)
• Financing government deficits (G-T)
• Building up financial claims against overseas economies by financing their trade deficits (X - M)
  
  • If an economy has a negative trade balance, foreign savings will supplement domestic savings and foreigners will build up financial claims against the domestic economy
  • IF they government runs a fiscal surplus, the surplus will add to domestic saving

We can also evaluate the effects of government deficits and surpluses by rearranging the equation:

• (G-T) = (S-I) - (X - M)

A fiscal deficit occurs when government expenditures exceed net taxes. In order to finance a fiscal deficit:

• The private sector must save more than it invests (S>I)
• or The country’s imports must exceed its exports with a corresponding inflow of foreign saving

Question 6

LOS 17f: Explain the IS and LM curves and how they combine to generate the aggregate demand curve

Answer 6

The aggregate demand (AD) curve shows the combinations of aggregate income and price level at which the following conditions are satisfied:

• Planned expenditures equal actual income/output
• There is equilibrium in the money market

the first condition gives rise to the IS curve, while the second gives rise to the LM Curve. We can combine the two curves to make the AD curve

The IS Curve ( Relationship between Income and the Real Interest Rate)

In order to derive the relationship, lets consider the components of AD.

First let consider consumption, which is a function of income and taxes.

When household receive a unit of disposable income, they spend a portion and save the rest:

• The marginal propensity to consume (MPC) is the portion that is consumed
• the marginal propensity to save (MPS) is the portion of additional unit that is saved

Generally speaking consumption spending in an economy will increase when there is an increase in real income or a decrease in taxes

Consumption varies positively with income and negatively with taxes.

The two most important determinates of investment spending are:

1. The level of interest rates
2. the current level of aggregate output/income

Investment expenditure varies positively with income and negatively with real interest rates

Government expenditure does not vary with income. Taxes vary positively with income. Therefore, the government’s fiscal balance varies negatively with income.This is known as an automatic stabilizer as it reduces the fluctuations in aggregate output.

The two most important factors that affect net exports are:

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

Net exports vary negatively with income and negatively with domestic price levels.

So examining equality of expenditure and income equation:

• S- I = (G-T) + (X-M)

we see the right-hand side of this equation represents government’s fiscal balance (G-T) and the trade balance (X-M). An increase in aggregate income results in:

• Higher net taxes (lower fiscal balance)
• Higher imports (lowering the trade balance)

Therefore the right hand side declines as income rises. This results in a downward sloping line.

As for the left-hand side, we assume that the direct effect of an increase in income on saving is greater than its impact on investment. Therefore this side of the equation increases with income. This results in an upward sloping line

The point of intersection between these two lines defines the point where aggregate expenditure and aggregate income are eqaul.

• At higher levels of income, the saving-investment differential is greater than fiscal and trade balances combined, which implies excess saving or insufficient expenditure
• At lower levels of income, the saving-investment differential is smaller than the fiscal and trade balances combined, which implies that expenditure exceeds income/output

Changes in the level of real interest rates cause shifts in the line representing the saving-investment differential

• If real investment rates were to fall, investment expenditure would rise. To maintain the saving - investment differential at the same level, there would need to be a similar increase in saving.

Equilibrating income and expenditure implies an inverse relationship between income and the real interest rate. This relationship is referred to as the IS curve because investment and saving are the main components taht adjust to maintain a balance between aggregate expenditure and income.

The LM Curve

The LM curve shows the combinations of interest rates and real income for which the money market is in equilibrium.

The quantity theory of money described the relationship between money suplpy (M), the price level (P),real income/expenditure (Y), and Velocity of circulation (V) , which is the number of times a unit of currency changes hands annualy to purchase goods and services, to make this equation:

• MV = PY

Holding velocity constant, the quantity theory of money then implies that money supply determines the value of nominal output (PY).

The quantity theory can also be written as:

• M/P and M_D/P = kY
• where:
• k= I/V
• M= nominal money supply
• M_D= Nominal money demand
• M_D/P is referred to as real money demand and M/P is real money supply. Equilibrium in the money market requires these two to be equal

Demand for real money is a positive function of real income and a negative function of interest rates.

• The quantity theory eqaution suggests that real money demand increases with real income (Y)
• Households choose to hold less money in favor of investing it in higher-yielding securities when interest rates rise. Therefore, demand for real money varies inversely with interest rates (r)

If real money supply is held constant, we can infer a positive relationship between real income (Y) and the real interest rate (r), which is illustrated by the LM curve.

If real money supply increases (decreases) the LM curve would shift to the right (left).

The point where the IS and LM curve intersect defines the combination of real interest rates and real income where:

• PLanned expenditures equals actual (or realized) income/output
• There is equilibrium in the money market, that is, the available real money suppl is equal to the demand for real money.

The Aggregate Demand Curve

If money supply is held constant, then the only thing that affects real money supply is the price level. If prices increase, then the real money supply will decrease, pushing the LM curve up the IS curve, where there is lower income and higher interest rates. The inverse relationship between the price level and the real income is captured by the aggregate demand curve.

Other factors that explain this negative curve are:

• Higher prices reduce the purchasing power of those whose incomes are fixed in nominal terms
• Higher prices reduce the real value of assets and decrease real wealth

In order to ensure that aggregate expenditure equals aggregate income, any change in investment must be matched by a similar change in private saving

• As the price level increases, real money supply falls
• To bring about an equivalent reduction in real money demand, the real interest rate must rise and income must fall
• The higher the interest rate results in a decrease in investment spending, while a lower income results in a decrease in household saving
• Therefore, the steepness of the slope of the AD curve depends on the relative sensitivities of investment, saving, and money demand to income and real interest rates

The AD curve will be flatter if:

• Investment expenditure is highly sensitive to the interest rate- increase in interest rates would bring about a significant decrease in investment spending and in quantity demanded
• Saving is sensititve to income - A decrease in investment must be matched by an equivalent decrease in saving. In order to bring about the fall in saving, the decrease in income required would be greater the more insensitive saving is to income
• Money demand is insensitive to interest rates- If money demand is insensitive to interest rates, the increase in interest rates required to decrease money demand wil be higher. The higher interest rate would decrease investment and reduce aggregate demand significantly
• Money demand is insensitive to income - If this is the case, the decrease in income requried to reduce real money demand will be higher

IMPORTANT

• The inverse relationship between the price level and GDP is the AD curve
• The inverse relationship between GDP and the interest rate is the IS curve

Question 7

LOS 17g: Explain the aggregate supply curve in the short run and long run

Answer 7

Aggregate supply (AS) represents the quantities of goods and services that domestic producers are willing and able to supply at various price levels.

The very short-run is defined as the time period over which companies can only change output levels to a limited extent without changing prices. The very short-run aggregate supply (VSRAS) curve is therefore represented by a horizontal line

The short-run is defined as the time period over which some more costs become variable. However, wages and prices of other inputs remain constant in the short run. Therefore, as prices increase companies can increase profits by raising output. This is represented by the upward sloping short-run aggregate supply curve (SRAS)

The long-run- is defined as the time period over which wages and prices of other inputs are also variable. As prices increase over the long run, wages and other input prices also increase proportionately, so the higher price level has no effect on quantity supplied. This is shown by the vertical long-run aggregate supply (LRAS) curve. The LRAS curve basically defines the potential output of the economy. The economy’s ability to produce goods and services is limited not by price level, but by the output level where all its resources are fully employed.

When an economy operates at its potential output level, all its resources are fully employed and it is said to be working at full employment. At this output level, unemployment is at its natural rate.

• Structural unemployment results from structural changes in the economy, which make some skills obsolete and leave previously employed people jobless
• Cyclical unemployment is the unemployment generated as an economy goes through the phases of a business cycle

Question 8

LOS 17h: explain causes of movements along and shifts in aggregate demand and supply curves

Answer 8

• The point of intersection of the AD curve and the LRAS curve defines the economy’s long-run equilibrium position. At this point, actual real GDP equals potential GDP
• The point of intersection of the AD curve and the SRAS curve defines the economy’s short-run equilibrium position. Short-run fluctuations in equilibrium real GDP may occur due to shifts in either or both the AD and SRAS curves. Short run equilibrium may be established at, below, or above potential output. Deviations of short-run equilibrium from potential output result in business cycles.
  
  • In an expansion, real GDP is increasing, the unemployment rate is falling, and capacity utilization is rising. Further, inflation tends to rise during expansion
  • In a contraction, real GDP is decreasing, the unemployment rate is rising, and capacity utilization is falling. Further, inflation tends to fall during a contraction.

Shifts in Aggregate Demand

• Household Wealth - An increase in wealth will lead to an increase in AD (wealth effect)
• Consumer and business confidence- when people are optomistic, there will be an increase in AD
• Capacity utilization- companies operating close to full capacity will need to increase investment expenditure which will increase AD
• Fiscal Policy - An increase in Gov expenditure will increase AD, while higher taxes will decrease AD
• Monetary Policy- an increase in the money supply will increase AD
• Exchange rate- An appreciating domestic currency will reduce aggregate demand
• Growth in the Global Economy- Growth in foreign countries will increase AD, while rapid domestic growth will increase demand for imports and lower AD

Interest Rates and Aggregate Demand

• If the increase in aggregate demand is caused by an increase in money supply, interest rates fall. The increase in income results in an increase in saving, so rates must fall to stimulate a corresponding increase in investment
• If the increase in aggregate demand is caused by any other factor mentioned above, interest rates will rise. The increase in income implies that there must be a corresponding increase in the velocity of circulation.

Shifts in Short-Run Aggregate Supply

• Nominal (money) wages: recall that in the short run, wages and other input prices were assumed constant. Therefore, an increase in nominal wages increases cost of production and results in a fall in SRAS. The impact of labor costs on SRAS can be measured by calculating the change in unit labor cost
  
  • %Change in unit labor cost = % Change in nominal wages - % change in productivity
• Input Prices _ Higher (lower) prices of raw materials increase (decrease) costs of production resulting in a decrease (an increase) in SRAS
• Expectations about future prices- If a company expects the price of its output to increase relative to the general price level in the economy, it will increase supply in anticipation of higher profit magrins in the future, increasing SRAS
• Business Taxes and Subsidies - Higher business taxes increase production costs and result in a decrease in SRAS. Subsidies reduce production costs leading to an increase in SRAS
• The exchange rate- An appreciating domestic currency will make imports of raw materials cheaper for domestic producers and increase SRAS
• The SRAS curve will also shift if the LRAS curve shifts

Shifts in Long-Run Aggregate Supply

• Supply of Labor- as supply increase, economy can output more
• Supply of Natural Resources- an increase in the availability of natural resources results in an increase in the economy’s potential output.
• Supply of physical capital- An increase in the supply or quality of physical capital increases labor productivity and increases potential output
• Labor productivity and technology- An increase in labor productivity increases potential output

Question 9

LOS 17i: Describe how fluctuations in aggregate demand and aggregate supply cause short-run changes in the economy and business cycle

LOS 17j: Distinguish between the following types of macroeconomic equilibria: long-run full employment, short-run recessionary gap, short-run inflationary gap, and short-run stagflation

LOS 17k: Explain how a short-run macroeconomic equilibrium may occur at a level above or below full employment

LOS 17l: Analyze the effect of combined changes in aggregate supply and demand on the economy

Answer 9

Short-Run Equilibrium

Is established at the point where aggregate demand equals short-run aggregate supply. It is important to remember that we construct the short-run aggregate supply curve with the assumption that money wages are constant. In the short-run there is no adjustment of money wages to achieve full employment. Therefore an economy can operate at a level below, above, or at full employment inthe short run

Long-Run Full Employment Equilibrium

Is achieved when the intersection of the AD curve and SRAS curve occurs at a point on the LRAS curve. At this point, actual real GDP equals potential GDP or full employment GDP.

In reality the real GDP rarely equals potential GDP as the AD and SRAS curves are constantly shifting. Therefore observations of real GDP cannot be used to estimate potential GDP with precision. Further, estimates of potential GDP based on production capacity estimate of all the economy’s available resources tend to be inaccurate

Business Cycles

Fluctuations in AD and AS in the short-run that cause deviations of real GDP from potential GDP are caused by the business cycle.

When actual real GDP is lower than potential GDP, the output gap is known as a deflationary gap, recessionary gap, or an Okun gap.

When actual real GDP is higher than potential GDP, the output gap is known as an inflationary gap or expansionary gap.

LR Adjustment to an Inflationary Gap

Assume the government increases its expenditure which shifts the AD curve out on the SRAS, keeping it in short-run equilibrium but out of long run equilibrium. This consequently increases the price level and an inflationary gap is made. Since the economy is operating above potential, the unemployment rate is below the natural rate

The increase in price level reduces real wages, so workers demand an increase in their money wages. Producers who are already operatin above capacity give in. This increase in the money wages and costs of production reduces SRAS down the AD curve, until long run equilibrium is restored, when LRAS intersects the SRAS and the AD curve. Equilibrium is restored at a higher price

Investment Applications of an Increase in AD Resulting in an Inflationary Gap

If data suggests that the economy is undergoing an expansion caused by an increase in AD, going forward:

• Corporate profits will be expected to rise
• Commodity prices will be expected to increase
• Interest rates will be expected to rise
• Inflationary pressures will build in the economy

Therefore investors should:

• Increase investments in cyclical companies as their earnings would rise
• Increase investments in commodities and/ or commodity-oriented companies
• Reduce investments in defensive companies, as their profits would not rise as much as cyclicals
• Reduce investments in fixed-income securites, as their values would falls as interest rates go up
• Increase investment in junk bonds, as their default risk should fall

LR Adjustment to a Deflationary Gap

A reduction in Gov expenditure would decrease AD, sliding it down the SRAS curve, keeping it in short-run equilibrium, but out of long-run equilibrium. This will lower the price level, and cause a deflationary gap. Since the economy is operating below potential, the unemployment rate will be higher than the natural rate.

The lower price rate will increase real wages. Producers that are suffering from low prices, will have to negotiate worker prices down ( and will be able to do so do to the increased supply of unemployed). Lower wages will reduce costs of production and shift the SRAS curve back to long run equilibrium, at a now lower price level.

Investment Applications of a Decrease in AD Resulting in a Delationary Gap

If data suggests a recession caused by decrease in AD, going forward:

• Corporate profits will be expected to fall
• Commodity prices wil be expected to decline
• Interest rates will be expected to fall
• Demand for credit will decrease

Therefore, investors should:

• Reduce investments in cyclical companies
• Reduce investments in commodities and/or commodity- oriented companies
• Increase investments in defensive companies, as their profits would decline less
• Increase investments in investment grade or government fixed-income
• Decrease investments in junk

Stagflation

A decrease in SRAS causes stagflation, while an increase in SRAS brings about economic growth and low inflation

A shift in of the SRAS curve leads to a decline in output, while the price level increases. Over time, wages and input prices may be expected to fall, which would shift the SRAS curve outward and restore equilibrium. However this process can be very slow so the government may step in using expansionary fiscal or monetary policy. This will increase AD and shift the AD curve to the right, to bring the economy back to its full potential. However this does come at the cost of a higher price level

Investment Applications of a Shift in SRAS

• Reduce investment in fixed-income because increasing output prices may put upward pressure on nominal interest rates
• Reduce exposure to equities in anticipation of a decline in output and profit margins coming under pressure
• Increase investments in commodities and/or commodity-oriented companies because their prices and profits are likely to rise

Question 10

LOS 17m: Describe sources, measurement, and sustainability of economic growth

LOS 17n: Describe the production function approach to analyzing the sources of economic growth.

LOS 17o: Distinguish between input growth and growth of total factor producitivity as components of economic growth

Answer 10

Economic growth may be calculated as:

• The annual percentage change in real GDP, which tells us how rapidly the economy is expanding as a whole or;
• The annual change in real per capita GDP: real GDP per capita is calculated as total real GDP divided by total population. It is a useful indicator of the standard of living in a country

A small increase in the growth rate of per capita GDP can have a large impact on an economy’s standard of living if sustained over time. Rapid growth can lead to inflation and is not always sustainable, therefore countries aim to make economic growth sustainable. Sustainable Economig growth comes from an economy constantly adding to its productive capacity and enhancing its potential GDP

The Production Function and Potential GDP

The Solow (neoclassical) growth model provides a framework for identifying the underlying sources of growth in an economy. The model is based on the production function. We will consider the two-factor production function:

• Y = AF (L,K)
• Where
• Y= aggregate output
• L= quantity of labor
• K= quantity of capital
• A= technological knowledge of total factor productivity (TFP)

TFP is a scale factor that accounts for the portion of economic growth that is not explained by capital and labor quantities.

The production function assets that in increase in an economy’s potential GDP can be caused by:

• An increase in the quantity of inputs used in the production process
• An increase in the productivity of these inputs with the application of better technology.

In defining an economy’s production function we assum the following:

• There are constant returns to scale. If the quantities of labor and capital are doubled, output would also double
• Production inputs exhibit diminishing marginal productivity

If capital were to grow at a rate faster than labor, the productivity of capital would decline, resulting in slower growth. This has the following implications:

• For long-term sustainable economic growth, countries cannot rely soley on increasing the quantity of capital relative to labor
• Given that the marginal productivity of capital is higher in developing countries due to the lower quantities of capital used in those countries, growth in developing nations should outpace growth in developed nations. Therefore, eventually there should be a convergence in incomes across developed and developing countries

Because of diminishing marginal returns to labor and capital, the only way to “sustain” growth in potential GDP is growth in TFP.

The growth accounting equation shows that the rate of growth of potential GDP equals the growth in technology plus the weighted average growth rate of capital and labor based on their relative shares in national income

• Growth in potential GDP = Growth in tech + W_L(Growth in Labor) +
• W_K(growth in capital)
• The weight of capital equals the sum of corporate profits, net interest income, net rental income, and depreciation, divided by total GDP
• the weight of labor equals employee compensation divided by total GDP

This equation highlights the fact that the contribution of labor and capital to GDP growth depends on their relative shares in national income. In the US. labor outweighs capital 70% to 30%, so changes in labor have greater effect on GDP

Since standard of living is measured on a per capita basis, we can gain a deeper insight into the contribution of various sources of GDP to per capita GDP growth by expressing the growth equation in per captia terms:

• Growth in per capital potential GDP = Growth in tech +W_K (growth in capital-labor ratio)

The capital-labor ratio measures the quantity of capital per unit of labor in the economy.

Sources of Economic Growth

• Growth in Labor supply- the potential quantity of labor in an economy is measured in terms of total hours worked:
  
  • Total hours worked = Labor force x Average hours worked per worker
  • the labor force is defined as the portion of the working age population that is employed or available for work
• Improvements in quality of human capital- Human capital refers to the accumulated knowledge and skill that workers acquire from education, training, and experience
• Growth in Physical Capital stock-
• Improvements in technology
• Availability of natural resources

Measures of Sustainable Growth

Economists focus on labor productivity to measure growth, an area where more reliable information is readily available.

Labor productivity refers to the quantity of goods and services that a worker can produce in one hour of work

• Labor productivity = Real GDP / Aggregate Hours

Dividing the production function by L, the number of workers in an economy allows us to identify factors that drive labor productivity:

• Y/L = A F( 1, K/L)

Y/L equals outpute per worker. The equation above implies that labor productivity depends on:

• Physical capital per worker (K/L) or the mix of inputs
• Total factor productivity or technology

Labor productivity can explain differences in living standards and long-term sustainable growth rates across countries.

• Level of Labor productivity: the higher the productivity, the more goods and services the economy can produce given the number of workers. It tends to be higher in developed countries
• Growth Rate of Labor Productivity: This is the percentage increase in productivity over a year and tends to be higher in developing countries. Rapid growth rate is a positive for stock prices as more can be produced with same number of units. A slow growth is associated with flat or declining stock prices
• Measuring Sustainable growth: Potential GDP is a combination of aggregate hours and productivity of labor
  
  • Potential GDP = Aggregate Hours x Labor Productivity
• This equation can be expressed in terms of growth rates as:
  
  • Potential GDP Growth Rate = Long-term growth rate of labor force +
  • Long-term labor productivity growth rate