R14 AGGREGATE OUTPUT, PRICES,

AND ECONOMIC GROWTH

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 Introduction
• This reading covers:
• What is gross domestic product, and what are the related measures of domestic output and
income.
• Short-run and long-run aggregate demand and supply curves.
• What causes the shift and movement in these curves.
• Factors that affect the equilibrium price and output.
• Sources and measures of economic growth.

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 Aggregate Output and Income
Aggregate output of an economy: It is the value of all goods and services produced during a period.

Aggregate income of an economy: It is the value of all the payments earned by the suppliers of the
factors used in the production of goods and services. Payments are classified into four categories:
• Compensation of employees – for labor.
• Rent – for use of property.
• Interest - for lending funds.
• Profits – return earned for use of capital.

• Aggregate expenditure: The total amount spent on goods and services produced in an economy
during a given period. Aggregate Expenditure = Aggregate Output = Aggregate Income.

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 Gross Domestic Product
There are two ways of defining GDP:
• 1. The market value of all final goods and services produced within an economy in a given
period of time, or
• 2. The aggregate income earned by all households, all companies, and the government in a
given period of time.

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 Gross Domestic Product
• To ensure consistency across countries and across time, the following criteria are used:
• Only count goods and services produced during the measurement period.
• Count goods and services whose value can be determined by being sold in the market (goods
and services included at imputed prices). Items that are excluded:
• o The value of labor for activities that are not used in production is not included. Ex:
commuting to work.
• o By-products that have no explicit value. Ex: air/water pollution

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 Gross Domestic Product
• Use market value of final goods and services. Final goods are goods that cannot be resold.
Intermediate goods are goods that are resold to produce another good. The value of
intermediate goods is included in the value of final goods. These are not included in GDP to
avoid double counting. For example, a car is a final good, whereas several auto parts used in
the car such as car tires, dashboard, steering wheel, and wiper are intermediate goods. The
value of the car is included when calculating GDP and not that of the parts, or the steel used to
make the car.

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 Gross Domestic Product
• Calculating Gross Domestic Product
• GDP can be calculated using the income approach or the expenditure approach.
• The income approach computes GDP as the total income earned by households, businesses, and
the government in a given period.

• The expenditure approach computes GDP as the total amount spent on goods and services.
• Two methods are used to calculate the total amount spent:
• Sum-of-value-added method: Calculate GDP as the sum of the value added at each stage of
production and distribution.
• Value-of-final-output method: Compute GDP as the sum of the value of all final goods and services
produced during the period.

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 Gross Domestic Product
1. Sum of value-added method; value is added at each stage of production.
2. Value of final output method; value of final goods and services are taken.
• Stages of Production Value of Sales Value-added
• Farmer supplies milk 100 100
• Ice cream maker factory 300 200
• Vendor 500(for case 1) 200
• Total 500(for case 2)
• However, as seen above, in the case of both the methods, the GDP calculated is the same ($500).
• Thus, the value of final goods and services = value of goods at each stage of production

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Nominal GDP measures the value of goods and services at their current prices.
Real GDP measures current-year output using prices from a base year. This eliminates the effect of
inflation.

• Example:
• Consider a country that only produces cotton. In 2010, 1 million tons were produced at Rs100 per
ton. In 2012, 1 million tons were produced at Rs120 per ton. What is the nominal and real GDP in
2012? Assume that 2010 is the base year.

• Nominal GDP = 120 * 1 million = 120 million

• Real GDP = 1 million * 100 = 100 million

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• Inference:
• As you can see, the output has not gone up. The nominal GDP is higher by 20% because of the
inflation effect. To assess the exact change in output, it is judicious to use real GDP as it
eliminates the price effect. Real GDP reflects the actual quantity of output available for
consumption and investment.

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• Used to measure inflation across all sectors of an economy such as consumer, business,
government, exports, and imports. It is reported as a price index number that can be used to
convert nominal GDP into real GDP by removing the effects of changes in prices.

• GDP Deflator = Nominal GDP * 100

Real GDP
• GDP Deflator = Value of Current year Output at current Price * 100
Value of Current year output at base year price

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• The following are the major components of GDP based on the expenditure approach:
• Consumer spending on final goods and services.
• Gross private domestic investment.
• Government spending on final goods and services.
• Net exports (exports – imports).

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• GDP based on expenditure approach = C + I + G + (X – M)
• where:
• C = consumer spending on goods and services
• I = gross private domestic investment
• G = government spending on final goods and services
• X-M = net exports = exports - imports

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Prepared & Presented by Jugal Shah
The Household and Business Sectors (private sector)
Consumption expenditure: C
• Part of income that households pay to firms for consuming goods and services.
Saving: S
• Part of income of households is saved. National savings equals savings by households, businesses,
and government.
Investment: I
• Refers to the purchase of new capital which includes plant, property, equipment, buildings and
inventory. It does not include labor.
• It is financed by household savings and capital flows from the rest of the world.

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Flow between the factor market
• Labor, capital and land flow from households to firms.
• Income flows from firms to households as compensation for labor, interest, rent and profits.
Income is spent in three ways:
• Consumption (C)
• Savings (S) part of which later goes to financial markets.
• Taxes (T)

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Flow between financial market
• Part of the savings from households flows to firms that need to raise capital. Firms raise
money to invest in inventory and PPE (plants, property and equipment): I
Flow between goods market
• Consumption expenditure flows to the business sector. Investment (I) from firms flows
through goods back to firms.

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Flow between financial market
• Part of the savings from households flows to firms that need to raise capital. Firms raise
money to invest in inventory and PPE (plants, property and equipment): I
Flow between goods market
• Consumption expenditure flows to the business sector. Investment (I) from firms flows
through goods back to firms.

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The Government Sector
Flow between households and businesses
• Taxes (T): Government collects taxes from households and businesses. This is the
government’s revenue.
• Transfer payments: The government makes transfer payments to the unemployed, for health
care, etc. This is not included in government expenditure (G) because this is a monetary
transfer and nothing is received in return.
• Net taxes = T = taxes – transfer payments

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The Government Sector
Flow between goods market
• Expenditure (G): Government purchases goods and services from businesses to build roads,
schools, and other goods; spends on military, fire protection, security, and other services. This
is denoted by G.

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The Government Sector
Fiscal deficit
• If G > T, then the government has a fiscal deficit and must borrow from financial markets to
fund its spending.
How government purchases (G) differs from government transfer payments?
• Transfer payments are just a flow of money for social welfare. Whereas, G (expenditure)
involves actual spending on goods or services.

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The External Sector
Exports: X
• Value of goods and services sold to foreigners.
Imports: M
• Portion of domestic consumption (C), government expenditure (G), and investment (I) spent
on purchasing goods and services from the rest of the world.

Net exports X-M

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Trade deficit
• If domestic saving is less than domestic investment plus government fiscal balance, then there
is a deficit. It also foreign countries are spending on domestic goods and services. means that
the economy is spending more on imports than

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• There are two approaches to calculate GDP: expenditure approach and the income approach.

• Ideally, both the approaches should give the same estimate, but they differ because different
data sources are used for each method. The numerical difference between the GDP using the
expenditure approach and GDP using the income approach is accounted for as a statistical
discrepancy.

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• GDP based on expenditure
approach

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• GDP based on Income Approach

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National Income =
Compensation of employees (wages paid by businesses to employees)
+ Corporate profits before taxes
+ Interest income (interest paid by businesses to households)
+ Unincorporated business net income (profits on entities not incorporated)
+ Rent
+ Indirect business tax
- Subsidies included in final prices

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• Capital consumption allowance (CCA)

• A measure of depreciation. It is the decrease in capital stock because

of wear and tear during the production of goods and services. This is
also the amount to be spent on replacing the depreciated stock and
adding new capital stock.

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• Personal Income =
National Income
- Indirect business taxes
- Corporate income taxes
- Undistributed corporate profits (retained earnings)
+ Transfer payments (ex: unemployment benefits paid by governments to households)

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• Personal income measures the
consumers’ ability to make purchases.

Personal disposable income =

Personal income – Personal taxes

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• Example
• What is the GDP and national income given the following data for 2012?
• Account Name Amount
• Consumption 300
• Statistical discrepancy 10
• CCA 30
• Government spending 76
• Imports 34
• Gross private domestic investment 80
• Exports 30

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• GDP for 2012 = C + G + I + (X - M) = 300 + 76 + 80 + (30 - 34) = 452

• NI = GDP – CCA – SD = 452 - 30 - 10 = 412

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Under Total Expenditures
• GDP = C + I + G + (X – M).

Total Income
• GDP = C + S + T
• where:
• C = consumer spending on final goods and services
• S = household and business savings
• T = net taxes (taxes paid minus transfer payments received)

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• Since, total income = total expenditures,
• C + I + G + (X – M) = C + S + T
• Thus, S = I + (G – T) + (X – M)
• (G – T) = Fiscal balance
• (X – M) = Trade balance
• (G – T) = (S – I) – (X – M)
• In this case of a Fiscal deficit (G – T)

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It must be financed by:
1. NEGATIVE trade balance and/or
2. POSITIVE private saving

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It must be financed by:
1. NEGATIVE trade balance and/or
2. POSITIVE private saving

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• Looks like the ordinary demand curves that we encounter in
microeconomics: quantity demanded increases as the price level declines.

• But our intuitive understanding of that relationship—lower price allows us

to buy more of a good with a given level of income—does not apply here
because income is not fixed. Instead, aggregate income/expenditure (GDP) is
to be determined within the model along with the price level. Thus, we need
to explain the relationship between price and quantity demanded somewhat
differently.

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• The aggregate demand curve represents the combinations of
aggregate income and the price level at which two conditions are
satisfied. First, aggregate expenditure equals aggregate income.

• Second, the available real money supply is willingly held by

households and businesses.

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• Recall that GDP is defined as
• GDP = C + I + G + (X − M)

• We assume that government spending (G) is exogenous, set by government policy. To

explain why the aggregate demand curve slopes downward, we analyze how the price
level in the economy affects the consumption (C), investment (I), and net export (X − M)
components of GDP.

• The downward slope of the aggregate demand curve results from three effects: the
wealth effect, the interest rate effect, and the real exchange rate effect. We assume that
the nominal money supply is held constant.

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• The wealth effect is based on the concept of purchasing power of nominal wealth,
including nominal value of the money held by consumers, physically or in a bank
account.

• Nominal wealth does not change: One British pound is always worth one British
pound. Similarly, one euro is worth one euro, and one yen is worth one yen.

• The real value, however—the value of money in terms of goods and services—is not
fixed. It fluctuates with the prices of goods and services.

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• The effect of the change in the price level and the resulting change in the real
value of money holdings give the wealth effect its name, because as the real
value of our money holdings changes, so does our real wealth.

• The wealth effect is one reason that the aggregate demand curve is
downward sloping. An increase in the price level decreases the quantity of
goods and services that can be purchased with the fixed quantity of nominal
wealth—consumers are less wealthy (in real terms) and therefore demand
fewer goods and services.

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• An increase in the price level from
P1 to P2 reduces income from Y1 to
Y2. Conversely, a decrease in the
price level increases the quantity of
goods and services that can be
purchased with the fixed quantity of
money available—consumers are
wealthier (in real terms) and
therefore demand more goods and
services.

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• When the price level changes, the demand for money also changes.

• We need to get more money—our demand for money increases. With a fixed supply
of money, the price of money increases. Because the price of money is the interest
rate, then as the price level increases, the interest rate increases.

• Our demand for money may decreases also. With a fixed supply of money, the price
of money decreases. Therefore, as the price level decreases, the interest rate
decreases.

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• Why not just keep extra “lunches” (money) in our pocket?

• Because holding extra money in such liquid form means that we are giving
up the interest that we could be earning by lending the money out to others
(e.g. through purchasing a government or corporate bond or just leaving the
money in a bank account and letting the bank do the lending for us).
• The interest we would earn is the opportunity cost of keeping money in our
pocket. So, when the price level decreases, we will want to keep more of our
money in interest-bearing assets and our demand for money decreases.

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• Changes in the interest rate affect the quantity of goods and services
demanded. If interest rates increase, businesses invest less because their
borrowing costs increase.
• This shift leads to fewer profitable projects to invest in and also negatively
affects the demand for commercial real estate. In addition, higher interest
rates lead to lower consumption—especially for large purchases such as
automobiles or residential real estate, which are usually purchased with
loans.
• If interest rates decrease, then businesses have more profitable projects to
invest in, and consumers would be expecte to spend more.

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• This leads us to the interest rate effect. A higher price level creates greater
demand for money, which raises the interest rate.
• The higher interest rate decreases demand for investment and
consumption expenditures, which leads to less demand for goods and
services.
• Conversely, a lower price level leads to a lower demand for money, which
leads to a lower interest rate. The lower interest rate increases demand for
investment and consumption expenditures, which leads to more demand
for goods and services.

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• An increase in the domestic price level causes appreciation of the real exchange rate.
• A higher price level affects the real exchange rate and makes domestic goods more
expensive in other countries, reducing exports.
• It also makes non-domestic goods less expensive domestically, increasing imports. The
result is lower demand for domestic goods and services.
• Conversely, a decrease in the domestic price level (assuming the price level abroad
remains unchanged) leads to a depreciation of the real exchange rate. This decrease in
the real exchange rate makes domestic goods less expensive in other countries,
increasing exports, and non-domestic goods more expensive domestically, decreasing
imports. The result is higher demand for domestic goods and services.
• This dynamic gives us the real exchange rate effect.

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• An additional channel affecting exchange rates involves the interest rate effect.
When interest rates increase (because of a higher price level), non-domestic
investors increase their demand for the domestic currency in the foreign exchange
market because they want to earn the higher return on their savings. This increased
demand causes the domestic currency to appreciate, which in turn increases the
real exchange rate.

• When interest rates decrease (because of a lower price level), a similar but opposite
effect occurs. Domestic savers seek higher returns in non-domestic markets. This
increased supply of the domestic currency in the foreign exchange market causes
the domestic currency to depreciate, which in turn decreases the real exchange
rate.

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• The two effects are complementary, operate in the same direction
and magnify the impact of the change in price level on aggregate
demand.

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 Example

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• Aggregate supply curve shows the relationship between
domestic output and price level. In simple words, it shows
the amount of goods and services firms will produce in an
economy (real GDP) at each price level.

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Interpretation of the graph:
• Plots real GDP on the x-axis
(remember we had quantity in the
microeconomics supply curve).
• Plots price level on the y-axis.
• Very short run: AS curve is almost
flat. This is because companies
increase or decrease output without
changing prices.

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Short run:
• In the short run, firms consider the
price level to decide how much to
produce. AS curve is upward sloping – a
decrease in the price level reduces the
quantity of goods and services supplied.
Some costs such as labor and capital are
sticky (fixed) in the short run. So, when
prices increase, businesses can increase
output as it is more attractive (given the
high selling prices).

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Long run:
• In the long run, the AS curve is
vertical at a given level of output.
Aggregate price has no effect on
aggregate output because wages,
prices and expectation adjust; firms
do not decide how much to produce
based on the price level. In the long
run if prices are up, then costs such
as wages also go up and in real
terms, nothing ha changed.

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• There is a distinction in the terms short run and long run as
used in micro- and macroeconomics.
In microeconomics:
• In the short run, labor is variable, but capital is fixed.
In macroeconomics:
• In the short run, wages or some costs are sticky i.e. they do
not change. In the long run, all costs change.

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Interpretation of the graph:
• The output level at the intersection of the
three curves is called the long run
equilibrium level of output or natural level
of output.
• The output level is closely related to the
level of employment. At the natural level of
output, the economy is at the natural rate of
unemployment.

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• Full employment does not mean 100%
employment. It means that there is a natural
level of unemployment, which includes
people who are in between jobs. The
percentage of people who are in between
jobs is equal to the percentage of vacancies.

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The objective of this section is to understand the interaction of the
curves discussed above, what causes a shift in these curves, and to
answer these important macroeconomic questions:
• What causes an economy to expand and contract?
• What causes changes in price level and unemployment?
• What determines an economy’s rate of unsustainable growth?

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• The position of the LRAS curve is determined
by the potential output of the economy.
• Potential GDP measures the productive
capacity of the economy and is the level of real
GDP that can be produced at full employment.

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Short-run macroeconomic equilibrium may occur at a level above or below full employment;
there are four possible types of macroeconomic equilibrium:
• 1. Long-run full employment.
• 2. Short-run full employment.
• 3. Short-run inflation gap.
• 4. Short-run stagflation.

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• The price level and output at the point
where AD and SRAS curves intersect
is called the short-run macroeconomic
equilibrium.
• At this point, the aggregate quantity
demanded = aggregate quantity
supplied.

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• In the long run, the intersection of AD
and SRAS curve occurs at a point on
the LRAS curve; this point is the
equilibrium point.
• At equilibrium, labor, and capital are
fully employed. Unemployment is at
its natural rate.
• In the long run, equilibrium GDP =
potential GDP.

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• Assume for some reason, there is a leftward
shift in the AD curve. It moves from AD1 to
AD2.
• This results in lower GDP and lower price
levels.
• The corresponding short-run equilibrium real
GDP has moved from Y1 to Y2. The price level
has come down from P1 to P2. As demand has
gone down, companies reduce workforce,
which leads to unemployment going up. We are
now below the natural level of unemployment.
This difference (Y2-Y1) is called the
recessionary gap.

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• Equilibrium GDP is below the potential GDP.
• The effects of a decline in AD are decline in
corporate profits, commodity prices, interest
rates, and demand for credit.

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• This happens if the aggregate demand curve
shifts to the right.
• If the AD curve moves from AD1 to AD2, then
output increases from Y1 to Y2. The price
level moves from P1 to P2.The short-run
equilibrium moves to the left. This gap
between Y1 and Y2 is called the inflationary
gap because it drives inflation. The economy
is over-utilizing its resources – workers are
putting in more hours.

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• At the new short-run equilibrium, GDP is above
the potential GDP. As there is an upward
pressure on prices, the company must pay
higher wages and input prices to increase
production.
• The economy cannot remain at Y2 for long
because people are working extra shifts and
will demand higher wages. Eventual increase in
prices will shift the SRAS to the left and the
economy will return to potential GDP.
• The effects of an increase in AD includes
increase in corporate profits, commodity
prices, interest rates, and inflationary
pressures.

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• SRAS curve shifts to the left.
• Output is down from Y1 to Y2.
Unemployment level is below the natural
level of unemployment. Price levels go up. In
short, there is high unemployment and
increased inflation.
• Over time, reduced output will cause wages
and input prices to decrease and shift SRAS
to the right.

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• The table below shows the effect of changes in AS and AD on real GDP. Fill the last two
columns in the table below for different combinations of AD and AS in the first two columns.

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• Economic growth is measured as the annual percentage change in real GDP or the annual
change in real per capita GDP. Growth in real GDP measures how the quantity of goods and
services produced has increased from one year to the next.
• Per capita GDP is Overall GDP/ Size of Total Population.
• It is a good measure as it tells us whether the standard of living is improving or not.
• For instance, if the GDP grew by 3% in a year and the population also grew by 3%, then there is
no improvement in the standard of living. But if GDP grows at a higher rate than the population,
then the per capita GDP would increase, and so would the potential standard of living.

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• Sustainable rate of economic growth is the rate of increase in the economy’s productive
capacity or potential GDP. Any growth should be sustainable over the long term. A sudden,
rapid increase in GDP is difficult to sustain as it leads to inflation, environmental damage, etc.

What is the difference between saying that there is a 4% change in real GDP and saying that
there is a 4% change in potential GDP? As an investor, what will excite you more?
• If the real GDP increases by 4%, then it means the AD has increased, and the AD curve shifts up
to the right. The corresponding GDP now is GDPreal. The equilibrium point has gone up in the
short term and it is likely it will come back to a point on the LRAS. As an investor, we will be
happy if the LRAS moves to the right as it means an increase in productive capacity.

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• The Solow growth model is the starting point for analyzing the drivers of long-term growth in
any economy. With this model, one can analyze why the growth in one country differs from
another. This model is relevant in determining the factors that cause the LRAS curve to shift
permanently to the right (increase in productive capacity of an economy).

According to the neo-classical model (also called the Solow growth model), productive
capacity (potential GDP) increases for the following reasons:
1. Accumulation of factors of production such as capital, labor, and raw materials.
2. Discovery of new technologies that give production efficiency.

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• The Solow model is based on a production function such as: Y = A * F (L, K) which means the
output is a function of labor and capital, and total factor productivity.

• The Solow model uses four variables:

• Y is the level of aggregate output in the economy.
• A represents total factor productivity and is a measure of efficiency.
• L is the quantity of labor or the number of workers in the economy.
• K is the capital stock.

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• The Solow model is based on a production function such as: Y = A * F (L, K) which means the output is
a function of labor and capital, and total factor productivity.

• The Solow model uses four variables:

• Y is the level of aggregate output in the economy.
• A represents total factor productivity and is a measure of efficiency.
• L is the quantity of labor or the number of workers in the economy.
• K is the capital stock.
Recall that the production function is based on two assumptions:
• Constant returns to scale for two variables (capital and labor)
• Diminishing marginal productivity

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Diminishing marginal productivity has two major implications on potential
GDP:
• Long-term sustainable growth cannot rely solely on capital deepening
investment. Capital deepening is increasing the amount of capital per
worker (labor).
• But, adding more capital in developing countries leads to a
substantially higher productivity (a higher rate of output) relative to
developed countries. It implies that the growth rate of developing
countries must exceed that of developed countries.

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Growth Accounting Equation
• Growth in potential GDP = growth in technology + WL(growth in labor) + WC(growth in capital)
• WL and WC are the relative share of labor and capital in the national income

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• In a given economy, the growth in potential GDP is given by:
• 2.0 + 0.7 (growth in labor) + 0.3 (growth in capital)
• How should we interpret 2, 0.7, and 0.3?

Interpretation:
• 2.0: growth in technology.
• 0.7: relative share of labor in national income.
• 0.3: relative share of capital in national income.
• In other words, if all else stays constant, a 1% growth in labor will result in 0.7% growth in
potential GDP. Or, if all else stays constant, a 1% growth in capital will result in 0.3% growth in
potential GDP.

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Increase in Labor Supply
• Increase in labor supply leads to an increase in economic growth. Labor force is the number of
people available for work from the working age population. This includes unemployed people
who are looking for work.

• Total hours worked = Labor force * average hours worked per worker

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Increase in Human Capital
• This is the quality of the workforce i.e. the skill and knowledge of the workers. Investment in
education and on-the-job training improves human capital, which in turn causes the production
function to shift upward, and improves productivity/standard of living/economic growth. The
spillover effect is the effect of this investment in human capital on the people around.

Increase in Physical Capital

• This refers to buildings, machinery, and equipment. If net investment is positive, then physical
capital is growing. Countries with a higher rate of net investment have a higher GDP growth. Ex:
China, India, and South Korea.

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Investments in Technology
• Spending on R&D leads to discoveries or technological improvements that make it possible to
increase a firm’s output with the same inputs. Ex: growth in IT; semiconductor industries.

• This is one factor that allows an economy to grow because other inputs (capital, labor) face
diminishing marginal returns. The faster the growth in technological change, the greater the
growth in productivity and GDP. TFP represents the amount by which an output increases due
to improvements in the production process.

• TFP Growth = Growth in potential GDP – [WL(Growth in labor) + WC(Growth in capital)]

Prepared & Presented by Jugal Shah

Natural Resources
• Comprises renewable (can be replenished, such as trees and water) and non-renewable
resources (coal and oil). Higher natural resources lead to higher growth.

Prepared & Presented by Jugal Shah

• It is not easy to measure sustainable GDP as it depends on growth of technological change,
capital, labor, and natural resources. This is because there is no observed data on TFP or
potential GDP and hence it must be estimated.

• Labor productivity is easier to measure. It is the amount of output produced by an average

worker in one hour.

• Labor productivity = Real GDP / Aggregate Hours

• An increase in any of the factors – capital; technology – improves productivity of the labor force.

Prepared & Presented by Jugal Shah

• Level of labor productivity: Higher labor productivity means more goods and services per
person. This, in turn, depends on the level of human and physical stock. The higher the
accumulated capital, the higher the productivity.

• Growth rate of labor productivity: % increase in productivity over a year.

• Labor productivity can be used to estimate the rate of sustainable growth of the economy and
differences in living standards.

Prepared & Presented by Jugal Shah

• Potential GDP = Aggregate hours worked * Labor productivity.

• Potential growth rate =

Long-term growth rate of labor force + long-term labor productivity growth
rate.

Prepared & Presented by Jugal Shah

Prepared & Presented by Jugal Shah