CFA lvl 1 - Reading 16 PDF

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Economics Reading 16: Aggregate Output, Prices, and Economic Growth  GDP: Gross Domestic Product Market value of all final goods and services produced in a country/economy within a certain time period - Only goods that are valued in the market - Final goods and services only (not intermediate) - Rental value for owner-occupied housing (estimated) - Government services (at cost) – not transfers  Calculation GDP 2 ways to calculate GDP - Income approach: sum of the amounts earned by households and companies during the period - => sum of value-added method o GDP = earnings of all households + businesses + government - Expenditure approach: sum of spent on goods and services produced during the period  Value of final output method o GDP = C + I + G + (X – M)  C = consumption spending  I = Business investment (capital equipment + change in inventories)  G = Government purchases  X = exports  M = imports  Nominal vs Real GDP Nominal GDP: sum of all current-year goods and services at current-year prices  ∑ Qt × Pt Real GDP: sum of all current year goods and services at base-year prices  ∑ Qt × Pt−5 => with base-year = t - 5 Per capita real GDP: real GDP divided by population  Used as a measure of the economic well-being of a country’s residents  GDP Deflator => measure of inflation Nominal GDP GDP Deflator= ×100 RealGDP

 National Income Income approach: GDP = National Income + Capital consumption allowance + Statistical discrepancy

Capital consumption allowance (CCA) measures the depreciation of physical capital from the production of goods and services over a period National Income = employees’ wages and benefits + corporate and government profits pre-tax + interest income + unincorporated business owners’ income + rent + indirect business taxes -Subsidies (taxes and subsidies that are included in final prices) Personal Income

= National Income + transfer payments to households -indirect business taxes -corporate income taxes -undistributed corporate profits Personal Income is a measure of the pretax income received by households and is one determinant of consumer purchasing power and consumption Personal Disposable Income = personal income – personal taxes = after-tax income PDI is a personal income after taxes  Deriving the Fundamental Relationship S = I + (G – T) + (X – M) o S = savings o T = taxes Savings = Investment (I) + Fiscal Balance (G-T) + Trade Balance (X-M) (G – T) = (S – I) – (X – M) => Government Budget = excess of savings over investment less trade deficit - (G-T) = fiscal balance - (X-M) = trade balance -

Increase in income develops savings more than investments Increase in come decreases fiscal deficit and increases imports Increase in real interest rate: o Investment decreases o Saving must also decrease o Decrease in savings must result from decrease in income

 The Aggregate Demand Curve Marginal propensity to consume (MPC): the proportion of additional income spent on consumption Marginal propensity to save (MPS): the proportion of additional income saved Consumption is a function of disposable income Investment is a function of expected profitability and the cost of financing

 Lower interest rates tend to decrease savings and tend to increase investment by firms  Liquidity-Money (LM) curve The LM curve illustrates the positive relationship between real interest rates and income consistent with equilibrium in the money market Real rates up => quantity demanded down Income up => quantity demanded up Higher real interest rates => higher income  Aggregate Supply The AS curve describes the relationship between the price level and the quantity of real GDP supplied In the very short run: aggregate supply is elastic In the SR: Input prices are fixed so businesses expand real output when (output) prices increase In the LR: Aggregate supply is fixed at full-employment or potential real GDP  Aggregate Demand The aggregate demand curve (AD) shows the relation between the price level and the real quantity of final goods and services (real GDP) demanded (the output)  AD = C + I + G + X net - Increases in wealth increase C - Increases in expectations for economic growth increase C and I - Capacity utilization > 85% increases I - Increases in tax rates decrease disposable income and C - Increases in the money supply reduce real rates and increase I and C - Depreciation of currency increases net X – import prices up, export prices down - Growth of foreign GDP increase net X  Aggregate Supply Factors that increase SR AS - Decreases in input prices - Improved expectations about future - Decreases in business taxes - Increases in business subsidies - Currency appreciation that reduces the cost of imported inputs Factors that increase LR AS - Increase in labor supply - Increased availability of natural resources - Increased stock of physical capital - Increased human capital (labor quality) - Advances in technology / labor productivity  Stagflation Recessionary gap: when real GDP is less than full employment GDP

Inflationary gap: difference between GDP and full employment GDP Stagflation = stagnation = inflation without economic growth Government can address inflation or recession, but not both  Combined changes in AS and AD

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Sources of Economic Growth Increase in labor supply Increased availability of natural resources Increased stock of physical capital Increased human capital (labor quality) Advances in technology / labor productivity

 Sustainable Growth Potential GDP = Aggregate hours worked x labor productivity Growth in Potential GDP = growth in labor force + growth in labor productivity  Production Function Approach A production function describes the relationship of output to the size of the labor force, the capital stock and productivity. Y = A x f(L,K) - Y = Aggregate economic output - L = size of labor force - K = amount of capital available - A = total factor productivity K Y =A×f ( ) L L Y/L = output per worker (labor productivity) K/L = physical capital per worker Diminishing marginal productivity: the amount of additional output produced by each additional unit of input declines Capital deepening investment: increasing physical capital per worker over time

 Per Capita Growth Growth in per-capital potential GDP = growth in technology + Wc (growth in the capital-tolabor ratio)...