Economics - Aggregate Output, Prices, and Economic Growth, CFA Level I

Level I – Economics Aggregate Output, Prices, and Economic Growth 1 Contents and Introduction 1. Introduction Macroeconomics: study of aggregate behavior of households, firms and markets 2. Aggregate Output and Income This reading analyzes a nation’s aggregate output and income, its competitive and comparative advantages and productivity of labor force 4. Economic Growth and Sustainability Investors are generally concerned about the future economic outlook of a country for investment decisions Bo 8 ok C /9 e 82 nt 06 er 3. Aggregate Demand, Aggregate Supply, and Equilibrium umption, Level of inflation, unemployment, consumption, nt affect affect the government spending and investment overall level of activity in a countryy 2 2. Aggregate Output and Income • Aggregate output of an economy: value of all goods and services produced in a period • Aggregate income of an economy: value of all payments earned by the suppliers of factors used in the production of goods and services ƒ ƒ ƒ ƒ Compensation of employees Rent Interest Profits The sum of rent, interest, and profit as the operating surplus of a company. It represents the return on all capital used by the business. 3 2. Aggregate Output and Income Aggregate expenditure is the total amount spent on goods and services produced in an economy during a given period Aggregate Expenditure = Aggregate Output = Aggregate Income (Different ways of decomposing the same quantity) Income $500 (Profits + Wages) Labor and Capital Households Business Firms Goods and Services Consumption Expenditure $500 4 2.1 Gross Domestic Product What is GDP? Market value of all final goods and services produced with an economy over a given period OR Aggregate income earned by all households, companies and government over a given period To ensure consistency across countries and across time, the following criteria are used: 1) Only count goods and services produced during the measurement period 2) Count goods and services whose value can be determined by being sold in the market (goods and services included at imputed prices) 3) Use market value of final goods and services 5 Calculating Gross Domestic Product • The income approach computes GDP as the total income earned by households, businesses and the government in a given period • The expenditure approach is based on calculating the total amount spent on goods and services ƒ Computed through the sum-of-value-added approach where GDP is calculated by summing the additions to value created at each stage of production and distribution en t ƒ Computed through the value-of-final-output approach where GDP is calculated by summing ng the values of all final goods and services produced during the period 6 Exhibit 2 Value of Final Products Equals Income Created Receipts at Each Stage Valued Added Receipts of farmer from miller Receipts of miller from baker 20 e 66 r Receipts of baker from retailer e Receipts of retailer from final buyer a Total M Example mple 1 7 Nominal and Real GDP Nominal GDP values goods and services at their current prices Real GDP measures current-year output using prices from a base year; eliminates inflation effect k C 82 Example: Consider a country which only produces cotton. In 2010, 1 million tons were produced at Rs. 100 per ton. In 2012, 1 million tons were produced at Rs. 120 per ton. What is the nominal and real GDP in 2012. Assume that 2010 is the base year emo ing The GDP Deflator is a price index that can be used to convert nominal GDP into real GDP by removing the effects of changes in prices. GDP Deflator = (Nominal GDP / Real GDP) x 100 8 Example Calculate the implicit GDP price deflator from 2009 to 2012 and the inflation rate for 2012 given the following data: 2009 2010 2011 2012 GDP at market 100 prices 110 118 125 Real GDP 92 94 95 90 Implicit GDP price deflator 9 M Example mple e2 9 2.2 The Components of GDP GDP components based on the expenditure approach Consumer spending on final goods and services Gross private domestic investment Government spending on final goods and services Current consumption (GC) plus Investment in capital goods (GI) Net exports Household and business sectors Government sector External sector 10 Exhibit 6: Output, Income and Expenditure Flows Factor Market Households Firms Goods Market Rest of the World Government Financial Markets 11 2.3 GDP, National Income, Personal Income, and Personal Disposable Income Refer to Exhibit 9a and 9b: GDP Release for the Canadian Economy (based on market prices) Consumer spending on goods and services + Business gross fixed investment + Change in inventories + Government spending on goods and services + Government gross fixed investment + Exports − Imports + Statistical discrepancy GDP based on income approach GDP = Gross domestic income (GDI) Net domestic income + Consumption of fixed capital (CFC) + Statistical discrepancy Gross domestic income = Compensation of employees + Gross operating surplus + Gross mixed income + Taxes less subsidies on factors of p production oduct + Taxes less subsidies on products ducts and imports im ha ka 11 li 15 8 GDP based on expenditure approach 12 Personal Income and Personal Disposable Income Personal income: broad measure of household income Æ ability to make purchases All income received by households whether earned or unearned Personal income = Compensation of employees + Net mixed income from unincorporated businesses + Net property income Household disposable income (HDI) = Personal income – Net current transfers paid k Household net saving = ts HDI - Household final consumption expenditures + Net change in pension entitlements Example 3 13 Example GDP using expenditure approach Amount Final consumption expenditure 300 Gross fixed capital formation 100 Investment in inventories 30 Exports 70 Imports 80 Statistical discrepancy -10 GDP using income approach (GDI) Amount Compensation of employees 197 Gross operating surplus 150 Gross mixed income 25 Taxes less subsidies on factors of production 15 Taxes less subsidies on products and imports 13 Statistical discrepancy 10 Calculate the GDP using the expenditure approach and then using the income approach. 14 3. Aggregate Demand, Aggregate Supply and Equilibrium 1. Aggregate Demand 2. Aggregate Supply 3. Shifts in Aggregate Demand Supply 4. Equilibrium GDP and Prices 15 3.1 Aggregate Demand The aggregate demand (AD) shows the quantity of real output demanded at different price levels but two conditions much be satisfied ƒ Aggregate income and planned expenditure must be balanced (IS curve) ƒ Equilibrium in the money market (LM curve) Price Level Income, Output, Y 16 Relationship between saving, investment, fiscal balance and trade balance • Aggregate Income = Aggregate Expenditure • C + S + T = C + I + G + (X – M) • S = I + (G – T) + (X – M) • G – T = (S – I) – (X – M) • (S – I) = (G – T) + (X – M) • Consumption spending is a function of disposable income (Y – T) ƒ Marginal propensity to consume and marginal propensity to save 17 Practice Questions Given that aggregate expenditure must equal aggregate output, how can we express a government’s fiscal deficit in private saving, investment and net exports? Because of a decline in housing costs, savings are up. Assume output, investment spending and the fiscal deficit are unchanged. What is the impact on net exports and capital outflows? 18 Balancing Aggregate Income and Expenditure: The IS Curve IS curve shows the combinations of income and real interest rate at which planned expenditure equals income (S – I) = (G – T) + (X – M) Real Interest Rate Investment spending is based on interest rates and aggregate income Government spending determined outside the model but taxes depend on income Net exports depend on income differential and price differential between domestic economy and rest of the world S – I (r = r0) Bo ok er S – I (r = r1 < r0) Income, Y / (G – T) + ((X – M) M Income, Y 19 Equilibrium in the Money Market: The LM Curve The IS curve does not tell us about the appropriate level of interest rates; it also does not consider the price level Quantity theory of money: MV = PY Æ M/P = (1/V) Y Holding real money constant we have a positive relationship between interest rates and income If price level decreases Æ real money increases Æ LM curve shifts to the right Real Interest Rate Demand for money is inversely related to interest rates Demand for real money is an increasing function of real income and decreasing function of the interest rate Income, Y 20 The IS and LM curves can be used to generate the AD curve If price level decreases Æ real money increases Æ LM curve shifts to the right Real Interest Rate Price Level Income, Y ah IS Incom me, Output, Ou Income, Y 21 The Aggregate Demand Curve Movement along the AD curve: Price Level Aggregate income = planned expenditure (S – I) = (G – T) + (X – M) Real money supply is willingly held Equilibrium in the money market Assuming no changes in fiscal balance or trade balance: Changes in savings = changes in investment oo Income, Output, Y / 9 Ce As price level increases Æ real money supply decreases creases For real money demand to decrease interest rates rest rat es must mu rise Æ reduces I Æ reduces S 22 Practice Questions Which curve represents combinations of income and real interest rates at which planned expenditure = income? What is the relationship between investments and real interest rates What is the relationship between investments and aggregate output Which curve represents combinations of income and real interest rates such that supply of real money = demand for real money? 23 Practice Questions If there is an increase in government spending, what is the impact on the IS, LM and AD curves? If there is an increase in nominal money supply, what is the impact on the IS, LM and AD curves? 24 Practice Questions An increase in price level would shift which of the following curves: IS, LM, AD? In what direction? If there is a movement along the AD curve with output increasing, what is the likely direction of interest rates? 25 Slope of the AD Curve Note: The learning objectives do not explicitly mention the slope of the AD curve. However, the curriculum covers this material at the end of section 3.1. To be safe, the main points are being reproduced here: The slope of the AD curve is determined by the relative sensitivities of investment, saving and money demand to income and the interest rate. The AD curve is flatter if: • Investment expenditure is highly sensitive to the interest rate • Saving is insensitive to income • Money demand is insensitive to interest rates • Money demand is insensitive to income 26 3.2 Aggregate Supply Aggregate supply curve shows the relationship between domestic output and price level Price Level LRAS SRAS In the very short run companies increase or decrease output without changing prices VSRAS 98 2 In the short run some costs are sticky so businesses increase output when prices increase Output, Y Outpu l 15 What is the relationship between wages and tthe slope of the SRAS curve? ka In the long run wages, prices and expectations adjust 27 3.3 Shifts in Aggregated Demand and Aggregate Supply LRAS SRAS Critical macro-economic questions: 1. What causes an economy to expand and contract 2. What causes changes in price level and unemployment 3. What determines an economy’s rate of sustainable growth AD Output, Y Long-run equilibrium level of output Natural level of output GDP growth impacts corporate profits which impacts stock prices Expected inflation impacts bond yields lds k Price Level Full employment Natural rate of unemployment 28 Shifts in Aggregate Demand An Increase in the Following Factors Shifts the AD Reason Curve Stock prices Right Higher consumption LRAS Price Level Housing prices SRAS Consumer confidence Business confidence VSRAS Capacity utilization Government spending Taxes C 82 0 er AD Bank reserves Exchange rate Output, O utput, Y Global growth Exhibit 18 Example 7 Example le 8 29 Shifts in Aggregate Supply An Increase in the Following Factors Shifts SRAS Shifts LRAS Reason Supply of labor Right Right Resource base up Supply of natural resources Supply of human capital Supply of physical capital Productivity and technology Nominal wages Input prices Expectation of future prices Business taxes Subsidy Exchange rate Example 9 Example ple 10 M Exhibit 20 Example 11 30 3.4 Equilibrium GDP and Prices Short-run macroeconomic equilibrium may occur at a level above or below full employment; four possible types of macroeconomic equilibrium 1. 2. 3. 4. Long-run full employment Short-run full employment Short-run inflation gap Short-run stagflation 31 Long-Run Macroeconomic Equilibrium LRAS Recessionary Gap LRAS SRAS Price Level SRAS Price Level AD AD Y Y Inflationary flationary Gap Stagflation LRAS LRAS SRAS Price Level 5 Price Level SRAS AD A D AD Y Y 32 Effect of Combined Changes in AS and AD (Exhibit 26) Effect on Real GDP Effect on Aggregate Price Level Increase Decrease Decrease Increase Decrease Decrease Increase Change in AS Change in AD Effect on Real GDP Effect on Aggregate Price Level Increase Increase Increase Intermediate Decrease Decrease Decrease Intermediate Increase Decrease Intermediate Decrease Decrease Increase Intermediate Increase Examples 12, 13 3 and 14 2 Increase a Change in AD M Change in AS 33 4. Economic Growth and Sustainability • Economic growth is measured as the % change in real GDP • We can also look at economic growth as the change in per capita GDP • Sustainable rate of economic growth is the rate of increase in the economy’s productive capacity or potential GDP LRAS SRAS Price Level AD D o What is the difference between saying that there is a 4% change in real GDP versus saying that there is a 4% change in potential GDP. As an investor what will excite you more? Y 34 4.1 Production Function and Potential GDP According to the neoclassical model (also called the Solow growth model), productive capacity (potential GDP) increases for the following reasons: 1. Accumulation of factors of production 2. Discovery of new technologies that give production efficiency This model is based on a production function such as: Y = A F(L,K) A represents total factor productivity (TFP) Production function exhibits diminishing marginal productivity Two implications of diminishing marginal productivity: 1) Long-term sustainable growth cannot rely solely on capital deepening investment 2) Higher productivity of capital in developing countries should lead to convergence 35 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 Growth in per capita potential GDP = Growth in technology + Wc (Growth in K/L ratio) Example: In a given economy the growth in potential GDP is given by: 2 + 0.7(Growth in labor) + 0.3 (Growth in capital) How should we interpret 2, 0.7 and 0.3? 36 4.2 Sources of Economic Growth • Labor supply • Human capital • Physical capital • Technology • Natural resources Example 15 37 4.3 Measures of Sustainable Growth Not easy to measure potential GDP; labor productivity is easier to measure Labor productivity = Real GDP/Aggregate hours; Y/L = AF(1, K/L) Higher labor productivity Æ more goods and services per-person 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 li B 58 Potential GDP = Aggregate hours worked x Labor productivity a Potential growth rate = Long-term growth rate of labor force + Long-term labor productivityy ggrowth rowth rate 4 ah Examples 16, 17, 18 38 Summary • Calculation and interpretation of GDP • Nominal and real GDP • Net domestic income, personal income, household disposable income • Saving, investment, fiscal balance and trade balance • IS, LM and AD curves • AS in the short-run and long-run • Shifts in AD/AS curves and impact on the economy • Economic growth 39 Conclusion • Read summary • Review learning objectives • Examples (handle with care) • Practice problems • Practice questions from other sources 40