R14 Aggregate Output, Prices, and Economic Growth 01

Reading 14 - Aggregate Output, Prices, and Economic Growth

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1. The aggregate output of an economy Is the value of all goods and services produced in a specified period of time
2. 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.
3. What is the relationship between Because the value of the output produced must accrue to the factors of production,
aggregate output and aggregate input? aggregate output and aggregate income within an economy must be equal.
4. Four broad forms of payments (i.e. Compensation of employees, rent, interest, and profits.
income);
5. Compensation of employees includes wages and benefits (primarily employer contributions to private pension plans and health
insurance) that individuals receive in exchange for providing labor.
6. Rent Is payment for the use of property
7. Interest Is payment for lending funds
8. Profit 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.
9. Operating Surplus Sum of rent, interest and profit of the company. It represents the return on all capital used
by the business.
10. Aggregate Expenditure The total amount spent on the goods and services produced in the domestic economy
during the period, must be equal to aggregate output and aggregate income. Some of
this expenditure may come from foreigners in the form of net exports.
11. Gross Domestic Product (GDP) Measures:
- the market value of all final goods and services produced within the economy in a given
period of time (output definition) or equivalently,
- the aggregate income earned by all households, all companies, and the government
within the economy in a given period of time (income definition)

Measures the flow of output and income in the economy.

12. How is GDP calculated using the GDP is calculated as the total amount spent on goods and services produced within the
expenditure approach? economy during a given period.

Value of final output and sum of value added.

13. How is GDP calculated using the As the total amount earned by households and companies in the economy.
income approach?
14. To ensure that GDP is measured 1. All goods and services included in the calculation of GDP must be produced during the
consistently over time and across measurement period
countries, the three broad criteria is 2. The only goods and services included in the calculated of GDP are those whose value
used: can be determined by being sold in the market.
3. Only the market value of final goods and services is included in the GDP. Final good
and services are those that are not resold. Intermediate goods are goods that are resold
or used to produce a=another good.
15. Calculating GDP using value added Take the sum of the value added by each stage of production. See pg 121 for details.
method:
16. What are examples of services that are Owner occupied housing and government services. Ex) paying rent
not sold in the marketplace but are still
included in the GDP?
17. Real GDP Indicates what would have been the total expenditures on the outputs of goods and
services if prices were unchanged.
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18. Per Capital Real real GDP divided by the size of population
GDP
Has often been used as a measure of the average standard of living in a country
19. Nominal GDP The value of goods and services measured at current prices.
20. What expression of Investment spending. At the same time, investment spending is the most volatile component of the economy,
the GDP is an and changes in the capital spending, especially spending on inventories, are one of the main factors causing
important short-run economic fluctuations.
determinant of an
economy's long
term growth?
21. Transfer Payments Governments also make transfer payments to households. In general, these are designed to address social
objectives such as maintaining minimum living standards, providing health care, and assisting the unemployed
with retraining and temporary support. They are subtracted from taxes and reflected in net taxes, T. They are not
included in govt expenditures on goods and services (G) because they represent a monetary transfer by the
government of tax revenue back to individuals with no corresponding receipt of goods and services.
22. A balance of trade Means that the domestic economy is spending more on foreign goods and services than foreign economies are
deficit spending on domestic goods and services. Also means that the country is spending more than it produces
because domestic savings is not sufficient to finance domestic investment plus the government's fiscal balance
23. How is a trade By borrowing from the rest of world through the financial markets. The rest of the world is able to provide this
deficit funded? funding because, by definition, it must be running a corresponding trade surplus and is spending less than it
produces.
24. T or F: trade and True. One area's deficit is another's surplus and vice versa.
capital flows
between an
economy and the
rest of the world
must be balanced.
25. Why must Otherwise, goods produced but not yet sold would be left out of GDP.
investment in
business
inventories be
included in
expenditures?
26. Gross Operating Related to corporate profits and includes private corporations, non-profits corporations, and government
Surplus corporations. It is the surplus arising from operations and does not take out charges for rent, interest, or similar
charges on financial assets or natural resources used by the business. Essentially measures the return on capital
used by the business as a whole, rather than the return to owners of the business (profit)
27. Gross Mixed Is the same concept applied to unincorporated business in the economy. Measured in the same way as gross
Income & 3 major operating surplus and has 3 major components:
components
1 - farm income
2 - non-farm income excluding rent
3 - rental income
28. Indirect Business Reflect taxes and subsidies included in the final price of the good or service. It is the (net) portion of national
Taxes Less income that is directly paid to the government.
subsidies
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29. Consumption of Fixed Capital (CFC) Measure of wear and tear (depreciation) of the capital stock that occurs in production
of goods and services. This measure acknowledged the fact that some income/output
must be allocated to the replacement of the existing capital stock as it wears out.
30. Personal Income Is a broad measure of household income and measures the ability of consumers to
make purchases. Includes all income received by households, whether earned or
unearned. Includes compensation of employees plus net mixed income from
unincorporated business plus net property income.
31. Aggregate Demand (AD) Represents the quantity of goods and services that households, businesses, government
and foreign customers want to buy at any given level of prices.
32. Aggregate Supply (AS) Represents the quantity of goods and services producers are willing to supply at any
given level of prices. Also reflects the amount of labor and capital that households are
willing to offer into the market place at given real wage rates and cost of capital.
33. Marginal Propensity to Consume (MPC) Represents the proportion of an additional unit of disposable income that is consumed
or spent.
34. Marginal Propensity to Save (MPS) the amount by which saving changes when disposable income changes
35. High average propensity to consume More sensitivity to changes in disposable household income
indicates.....
36. Gross Investment Total investment, including replacement of worn-out capital
37. Net Investment Reflects only the addition of new capacity.
38. Investment Decisions depends primarily 1. Level of interest rates - reflect cost of financing investments
on two factors 2. Aggregate output/income - Serves as proxy for the expected profitability of new
investments.
39. When economy is underutilizing its the expected return on new investments is low and vice versa
resources, interest rates are typically low
and yet investment spending often
remains dormant because...
40. What does the investment function Availability of new technology
(I=I(r.y)) leave out in terms of important
drivers of important investment
decisions?
41. What does the investment function Cost of funding (represented by real interest rate) and expected profitability of the new
(I=I(r.y)) reflect in terms of investment capital (proxied by the level of aggregate output)
decisions?
42. Exogenous Policy Variable Economists often treat the level of govt spending on goods and services (G). This
means that adjustments required to maintain the balance among aggregate spending,
income, and output must occur primarily within the private sector. Tax spending is often
views as an exogenous policy tool.
43. automatic stabilizers changes in fiscal policy that stimulate aggregate demand when the economy goes into
a recession without policymakers having to take any deliberate action
44. As domestic income rises, net exports fall, some of the additional demand that is induced will be for imported goods,
increased demand for imports. Therefore, net exports will decline. An increase in
income in the rest of the world will lead to an increase in demand for the domestic
country's products and hence an increase net exports.
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45. A decrease in the relative price of domestically produced goods toward these products and hence increase net exports.
and services, perhaps because of a depreciation in currency, will
shift demand.....
46. The slope of the AD curve depends on the relative sensitivities investment, saving, and money demand to income and the
of... interest rate.
47. The AD Curve will be flatter if... - Investment expenditure is highly sensitive to the interest rate;
- Saving is sensitive to income;
- Money demand is insensitive to interest rates;
- Money demand is insensitive to income

The first two imply that income will have to move more to
induce a large enough change in saving to match the change
in investment spending

All else equal, the last two implies that a larger change in the
interest rate is required to bring money demand in line with
money supply. This in turn, implies a larger change in
investment spending and a correspondingly larger change in
saving and income.
48. The inverse relationship between GDP and price level is.... the AD Curve
49. The inverse relationship between GDP and interest rate is... the IS curve
50. As the real money supply increases, the interest rate must FALL, INCREASE, RISE, INCREASE
FALL/RISE and/or expenditure must DECREASE/INCREASE in
order to induce households to hold the increased money supply.
With investment spending now more sensitive to the interest rate,
income will have to FALL/RISE by more in order to
DECREASE/INCREASE savings by a corresponding amount.
51. Aggregate Supply Curve The amount of output producers are willing to provide at
various prices. The AS curve represents the level of domestic
output that companies will produce at each price level. Unlike
demand side, must distinguish between SR and LR AS curves,
which differ with respect to how wages and other input prices
respond to changes in final output prices.
52. In business expansion, real GDP is decreasing/increasing, the Increasing, declining, rising.
unemployment rate is declining/increasing, and capacity
utilization is falling/rising.
53. What key factors determine directly or indirectly influence the 1. Household wealth
shift in aggregate demand? 2. Consumer and business expectations
3. Capacity utilization
4. Monetary Policy
5. The Exchange Rate
6. Growth in global economy
7. Fiscal Policy (government spending and taxes)
54. Household Wealth Includes the value of both financial assets (cash, savings
accounts, investment securities, and pensions) and real assets
(e.g. real estate). Households save a portion of their current
income in order to consume in the future. Increase in wealth,
increases spending, and shifts aggregate demand curve right
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55. Wealth Effect The tendency for people to increase their consumption spending when the value of their financial and
real assets rises and to decrease their consumption spending when the value of those assets falls.
56. Capacity utilisation Measure of how fully an economy's production capacity is being used. Companies with excess
capacity have little incentive to invest in new property, plant, equipment.
57. Fiscal Policy The use of taxes and government spending to affect the level of aggregate expenditures. An increase in
govt spending, shifts AD curve right. Taxes affect GDP indirectly through their effect on consumer
spending and business investment.
58. Monetary Policy Actions taken by a nation's central bank to affect aggregate output prices through changes in bank
reserves, reserve requirements, or it's target interest rate.
59. How can the central bank 1) Buying securities from banks
increase money supply? 2) Lowering the required reserve ratio
3) Reducing its target for the interest rate at which banks borrow and lend reserves among themselves
60. What is the impact of the This monetary action is designed to reduce consumption and business investment spending. This will
central bank reducing discourage lending within banking system and increase interest rates. Shifts AD left, lower corporate
bank reserves, resulting in profits as a result lowering equity prices.
a lower money supply?
61. What is the impact of Capacity utilization is a key factor determining the level of investment spending. Shifts AD right. Higher
higher capacity utilization? economic activity will cause upward pressure on interest rates and have a negative impact on fixed
income securities. Higher income/output should increase corporate profits and has positive impact on
equity securities.
62. What is the impact of Expected corporation profits are an important determinant of the level of investment spending. The
corporations having large increase in expected profits will raise the level of investment spending and increase aggregate
increased profits over the demand. This shifts AD right, increasing output and will have a positive impact on equity prices.
last year and forecasting
future profitability
upward?
63. What is the impact if the Fiscal policy uses government spending to influence the level and growth rate of economic activity.
government announces it The announcement indicates an increase in gov't spending, which is a direct component of AD.
will start funding a Therefore, AD curve shifts right. The increase in output and expenditure should be positive for equities.
project? But it will be negative for fixed income investments because higher interest rates will be required to
induce investors to buy and hold the gov't debt issued to fund the new project.
64. What is the impact if A recession in the European economy will decrease demand for foreign exports by European
private sector economists households and businesses and shift the AD curve to the left. The resulting decline in income and
project that the European downward pressure on prices will be positive for fixed-income securities but negative for equities.
economy will enter a
recession in the next year?
65. Factors that change the 1. Nominal wages
cost of production or 2. Input prices, including the price of natural resources
expected profit margins 3. Expectations about future output prices and the overall price level
will cause the SRAS curve 4. Business taxes and subsidies
to shift. These factors 5. Exchange rate
include:
66. Changes in nominal supply It shifts the SRAS curve because wages are often the largest component of a company's costs. An
- Why does it shift the increase in wages raises production costs, resulting in a decrease in AS and a leftward shift in the SRAS
SRAS curve? how does this curve. Lower wages shift the AS curve to the right. Changes in the nominal wages have no impact on
shift SRAS and LRAS the LRAS curve.
curve?
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67. Changing in Input Prices Lower input prices reduce the cost of production, which in turn, makes companies willing to produce
more at any output price (right ward of the SRAS curve). And vice versa.
68. Changes in Expectations In aggregate, companies can neither raise or lower their price relative to the general price level.
about Future Prices Hence, shifts in the SRAS driven by such price expectations are likely to be modest and temporary.
Also, considering future prices is expected to be higher, companies may decide to produce more
today in order to expand inventory available for future sales.
69. Change in Business Taxes Higher business taxes increase production costs per unit and shift the short run AS curve to the left.
and Subsidies Business subsidies are payment from the government to the producer, lowers production costs and
shift the SRAS curve right.
70. Change in Exchange Rate Changes in exchange rate can affect the cost of production and therefore, aggregate supply.
71. Potential GDP Measures the productive capacity of the economy and is the level of real GDP that can be produced
at full employment.
72. What factors can shift the 1. Supply of Labor
LRAS curve? 2. Supply of Natural Resources
3. Supply Physical Capital
4. Productivity and Technology
73. Supply of Labor The larger the supply of labor, the more output the economy can produce. The labor supply depends
on growth in the population, the labor force participation rate (the percentage of the population
working or looking for work), and net immigration. Increases in labor supply shifts the LRAS curve to
the right. Decreases shift the curve to the left.
74. Supply of Natural Are essential inputs to the production process and include everything from available land to oil and
Resources water. Increased availability of natural resources shifts the LRAS curve to the right.
75. Supply of Physical Capital Investment in new property, plant, equipment and software is an essential ingredient for growth. Better
equipment = efficiency = more output. Strong investment = increase in supply of physical capital =
Shifts LRAS right
76. Supply of Human Capital Improvement in quality of the labor force shifts the LRAS curve to the right
77. Labor Productivity and How efficient labor is in transforming inputs into final goods and services. Productivity measures the
Technology efficiency of labor and is the amount of output produced by workers in a given period of time.
Advances in technology shift the LRAS curve to the right.
78. Four types of 1. LR full employment
macroeconomic equilibrium: 2. SR recession gap
3. SR Inflationary Gap
4. SR Stagflation
79. How does the economy go Tightening of monetary policy, higher taxes, more pessimistic consumers and businesses, and lower
into recession? equity and housing prices, etc. A decline in AD or a leftward shift in the AD curve results in lower
prices, leading to economic contractions. And if such declines drive GDP below potential GDP,
economy is in recession. Companies reduce their workforce, employment rises.
80. How does the economy Some economists argue that an automatic, self correcting mechanism will push economy back to its
return to full employment? potential, without the need for government action.Workers will accept lower wages because prices
are low. As an alternative, government can use fiscal and monetary policy to push AD back right.
81. If statistics suggest that a 1. Corporate profits
recession caused by 2. Interest Rates
decline in AD will occur, 3. Commodity Prices
what 4 conditions will 4. Demand for credit
decline?
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82. Investment Strategies when Reduce investments in cyclical companies (companies with sales and profits that regularly expand
there is a decrease in AD: and contract with the business cycle or state of economy) because their earnings are likely to decline
the most in an economic slowdown

Increase investment in defensive (are companies with sales and profits that have little sensitivity to
the business cycle or state of economy) because they are likely to experience only modest earnings
declines in an economic slow down
83. Inflation Increases in AD lead to economic expansions as real GDP and employment increase. If the
expansion drives the economy beyond its production capacity, inflation occurs. If aggregate supply
does not increase to match the increase in AD, a rise in overall level of prices result.
84. How can the inflationary GDP cannot remain at Y2 for long because the economy is over utilizing its resources (extra shift of
gap be resolved? workers, equipment is being used at their max. capacity). Eventually workers become tired and plant
and equipment wear out. The increase in the general level of price and input prices will set in motion
the process of returning the economy back to potential GDP. Higher wages and input prices shift the
SRAS to the left, moving economy to point C

A nation's government/central bank can attempt to use the tools of fiscal and monetary policy to
control inflation by shifting the AD curve to the left, so that the return to full employment occurs
without the price increase. Fiscal - raise taxes or cut gov't spending. Monetary - central bank can
reduce bank reserves, resulting in a decrease in the growth of the money supply and higher interest
rates.
85. Stagflation Declines in aggregate supply - high unemployment and increased inflation. Increases in aggregate
supply conversely give rise to high economic growth and low inflation.
86. Sustainable Rate of Is measured by the rate of increase in the economy's productive capacity or potential GDP.
Economic Growth
87. Neoclassical/Solow Growth Framework used to determine the underlying sources of growth of an economy.
Model
88. The Neoclassical/Solow 1. Accumulation of such inputs as capital, labor, and raw materials used in production
Growth model shows that 2. Discovery and application of new technologies that make the inputs in the production process
the economy's productive more productive - that is, able to produce more goods and services for the same amount of input.
capacity and potential GDP
increases for 2 reasons:
89. Production Function Provides the quantitative link between the levels of output that the economy can produce and the
inputs used in the production process, given the state of technology. The more technologically
advanced an economy is, the more output it is able to produce from a given amount of inputs.
90. Total Factor Productivity Is a scale factor that reflects the portion of growth that is not accounted for by the capital and labor
(TFP) inputs. The main factor influencing TFP is technological change. Like potential GDP, it is estimated
and not directly observed.
91. 2 Assumptions about the 1. We assume that the production function has constant returns to scale. This means that if all the
production function: inputs in production process are increased by the same percentage, then output will rise by that
percentage. Thus, double all inputs would be doubling outputs.
2. We assume that the production function exhibits diminishing marginal productivity (at some point,
the extra output obtained from each additional unit of input will decline) with respect to any
individual input.
92. Tradition Growth Theory As the population and labor force grew, the additional output produced by an additional worker
(Thomas Malthus) would decline essentially to zero and there would be no long-term economic growth. For example, if
capital grows faster than fix labor, capital will become less productive, resulting in slower and
slower growth.
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93. 2 major implications for 1. Long term sustainable growth cannot rely solely on capital deepening investment that
potential GDP that diminishing increases the stock of capital relative to labor. Will lead to diminishing returns
marginal productivity has: 2. Given the relative scarcity and hence high productivity of capital in developing countries, the
growth rate of developing countries should exceed those of developed countries. As a result,
there should be a convergence of incomes between developed and developing countries over
time.
94. Because of diminishing returns technological change or growth in total factor productivity.
to capital, the only way to
sustain growth in potential GDP
per capita is through:
95. 5 Sources of Economic Growth 1. Labor Supply
2. Human Capital
3. Physical Capital
4. Technology
5. Natural Resources
96. Human Capital The quality of the labor force is important. It is the accumulated knowledge and skill that the
workers acquired from education, training, and life experience. Better educated and skilled
workers will be more productive and more adaptable to changes in technology.
97. Physical Capital Stock Accumulated amount of buildings, machinery, and equipment used to produce goods and
services. Increases from year to year as long as net investment (gross investment less
depreciation of capital)is positive. Countries with higher rate of investment should have a
growing physical capital stock and higher rate of GDP growth.
98. Technology Most important factor affecting economic growth, especially within developed countries.
Technological advances are discoveries that make it possible to produce more or higher-quality
goods and services with the same resources or inputs. Allows an economy to overcome the
limits imposed by diminishing marginal returns.
99. One of the key drivers of IT (information technology)
growth in developing countries
over the last decade has been....
100. Labor Productivity The quantity goods and services (real GDP) that a worker can produce in one hour of work.
101. This is reading 15: 4 Phases of a trough, expansion, peak, contraction
Business Cycle
102. the lowest point in the business trough
cycle
103. Highest point in the business peak
cycle
104. T or F: Trough is often called FALSE. Contraction
recession or depression
105. When does contraction occur? After peak and before trough.
106. Boom and what phase of the When an economy's expansion is well established. It is an expansionary phase.
business cycle does it
represent?
107. Variables to consider when Unemployment, GDP growth, industrial production, and inflation
identifying peaks and troughs of
a country's business cycle are:
108. Inventory ...