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6. Measuring Total Output and Income & Aggregate Demand and Aggregate Supply

Measuring Total Output and Income 1

Limitations of GDP 2

  • GDP (Y) is the some of:
    • Consumption (C).
    • Investment (I).
    • Government spending (G).
    • Net exports (NX).
  • GDP = C + I + G + NX or Y = C + I + G + NX
  • GDP per capita: GDP divided by the population of a country.
  • GDP per capita is a useful measure of the standard of living or well-being of the average person in a country.
  • GDP: the aggregate measure of total production in an economy in a given period.
  • GDP is useful for Measuring:
    • Economic activity.
    • Size or influence of an economy.
  • GDP is not useful for:
    • It does not include non-market activities, that is, activities that are not exchanged for money; such as taking care of your children vs hiring a babysitter.
    • It does include under-the-table transactions, that is, transactions that are not reported to the government for tax purposes or because they are illegal.
    • It does not include information about pollution, that is, polluting the world toady will affect economic activity in the future.
    • Other things, like health, happiness, stress, feeling of community, etc; are not included in GDP.
    • It does not include the distribution of income and inequality.

Circular Flow of Income and Expenditures 3

  • gdp
  • The household sector is the group of people who live in the same house and share income and expenses.
  • Households supply firms with factors of production, such as labor, land, and capital. Firms pay households for these factors of production, and sell them goods and services.
  • Households has total expenditures, firms have total revenue, and households again have total income.
  • If the 3 numbers included in the GDP, then we are tripping the GDP.
  • Only one number should be included in the GDP, which is the total income of the households.

Aggregate Demand and Aggregate Supply 4

Aggregate Demand 5

  • Aggregate demand and supply are a macroeconomic model that works on the economy as a whole.
  • Axis:
    • X-axis: Real GDP, the total quantity of goods and services produced in the economy.
    • Y-axis: Price level, the average price of goods and services in the economy.
  • Aggregate demand curve:
    • It is downward sloping.
    • Ceteris paribus, as the price level increases, the quantity of goods and services demanded decreases.
    • Ceteris paribus, as the price level decreases, the quantity of goods and services demanded increases.
    • If prices are high, GDP will shrink.
    • If prices are low, GDP will grow.
  • Causes of the downward slope of the aggregate demand curve:
    • Wealth effect:
      • As prices decrease, the real value of money increases, and people feel wealthier, so they spend more.
      • If people have the same money, but prices decrease, they will feel wealthier as they can buy more with the same money.
      • If prices increase, people can buy less with the same money, so they feel poorer, and demand less.
    • Interest rate effect:
      • As prices decrease, interest rates decrease, so people borrow more and spend more.
      • Sometimes, the interest rate is fixed, so the price level will not affect the interest rate.
      • Sometimes, it is called the Saving effect.
      • If prices go down:
        • People will spend less money on essentials, and save more.
        • More saving means more money in the banks.
        • More money in the banks increases the supply of money, so the interest rate decreases (the price of borrowing money decreases).
        • The lower interest rate encourages people to borrow more money and spend more.
        • More money to spend means more demand and more investment.
        • More investment means more production, and more jobs, and more GDP.
      • If prices go up:
        • People will spend more money on essentials, and save less.
        • Less saving means less money in the banks, so the interest rate increases.
        • The higher interest rate discourages people to borrow money and spend less.
    • Exchange rate effect:
      • As prices decrease, the currency depreciates, so exports increase, and imports decrease.
      • If prices go down:
        • Interest rates go down, so people will find it more profitable to save money in other countries, where interest rates are higher.
        • People will sell their currency and buy other currencies, so the value of the currency will decrease.
        • Goods and services will become cheaper for customers in other countries (as other currencies convert to more of the local currency).
        • Foreign countries will demand more goods and services from the local country, and exports will increase.
        • To accommodate the increase in exports, local companies will increase production, and GDP will increase.
      • If prices go up:
        • Interest rates go up, more people converting to local currency as it gets stronger.
        • Stronger currency means that goods are more expensive for customers in other countries.
        • LEss demand from other countries, so exports will decrease, and GDP will decrease.
  • Aggregate Demand shifters:
    • Anything affecting C, I, G, and NX.
    • Example: C: Consumer spending:
      • Tax cuts: tax cuts make people feel wealthier, so they spend more, and consumption increases.
      • Tax increases: tax increases make people feel poorer, so they spend less, and consumption decreases.
Aspect Demand Aggregate Demand
Level Micro economic Macro economic
Axis X Quantity Real GDP
Axis Y Price Price level
Representation One product market All products, or the entire economy
Slope Downward Downward
Causes of downward slope Substitution effect, income effect Wealth effect, interest rate effect, exchange rate effect
Demand shifters consumer preferences, prices of related goods, income, demographics, and buyer expectations. Anything affecting C, I, G, and NX (see above).

Long-run Aggregate Supply 6

  • Time for a lot of fixed costs and fixed prices to adjust, change, or expire.
  • Aggregate supply in long term is vertical, that is, it does not depend on the price level.
  • Shifters of the long-run aggregate supply curve:
    • Population increase: more people, more labor, more production => more GDP.
    • Technology advancements: more technology, more production => more GDP.
    • Resource availability: more resources discovered, more production => more GDP.
    • Low unemployment: more people working, more production => more GDP.
    • War: population decrease or factories destroyed, less production => less GDP.
  • aggregate supply

Short-run Aggregate Supply 7

  • In the short run, the aggregate supply curve is upward sloping.
  • Causes of the upward slope of the short-run aggregate supply curve:
    • Misperception theory:
      • Firms may think that the price increase is due to an increase in demand for their product, so they produce more.
      • Misunderstanding the price increase as an increase in demand, as in microeconomics.
      • According to the microeconomic’s law of supply, if the price increases, the quantity supplied increases.
    • Sticky wages, costs, prices theory:
      • Wages are sticky, that is, they do not change quickly.
      • Not all prices move at the same time, some move faster than others.
      • Sickness may be due to contracts, unions, menu costs, or other reasons.
      • If prices increase, while wages are still sticky, firms will interpret the increase in profits as an increase in demand, so they will produce more.
      • In the long run, wages will adjust, and prices will adjust, and the temporal profit will disappear.

Short-run and Long-run Equilibrium and the Business Cycle 8

  • Short run equilibrium:
    • The intersection of the aggregate demand curve and the short-run aggregate supply curve.
    • The price level and the real GDP are determined by the intersection of the two curves.
    • short run equilibrium point
  • Long run equilibrium:
    • The intersection of the aggregate demand curve and the long-run aggregate supply curve.
    • long run equilibrium point

References

  1. Rittenberg, L. & Tregarthen, T. (2009). Principles of Economics. Flat World Knowledge. Chapter 21: Measuring Total Output and Income.https://my.uopeople.edu/pluginfile.php/1894561/mod_book/chapter/527815/Principles%20Of%20Economics%20Chapter%2021.pdf ↩

  2. Khan Academy. (2018, February 5). Limitations of GDP | Economic indicators and the business cycle | AP Macroeconomics | Khan Academy [Video]. Youtube. https://youtu.be/SXMhCO2vYcE ↩

  3. Khan Academy. (2012, February 1). Circular flow of income and expenditures | Macroeconomics | Khan Academy [Video]. Youtube. https://youtu.be/Hfz1bwK5C4o ↩

  4. Rittenberg, L. & Tregarthen, T. (2009). Principles of Economics. Flat World Knowledge. Chapter 22: Aggregate Demand and Aggregate Supply. https://my.uopeople.edu/pluginfile.php/1894566/mod_book/chapter/527823/Principles%20Of%20Economics%20Chapter%2022.pdf ↩

  5. Khan Academy. (2012, March 1). Aggregate demand | Aggregate demand and aggregate supply | Macroeconomics | Khan Academy [Video]. YouTube. https://yougttu.be/oLhohwfwf_U ↩

  6. Khan Academy. (2jtg,jjű012, March 2). Long-run aggregate supply | Aggregate demand and aggregate supply | Macroeconomics | Khan Academy [Video]. YouTube.https://youtu.be/8W0iZk8Yxhs ↩

  7. Khan Academy. (2012, March 5). Short run aggregate supply | Aggregate demand and aggregate supply | Macroeconomics | Khan Academy [Video]. YouTube. https://youtu.be/3nbalsyibKU ↩

  8. Khan Academy. (2018, February 23). Short run and long run equilibrium and the business cycle | AP Macroeconomics | Khan Academy [Video]. YouTube. https://youtu.be/dD_9KBz3pN0 ↩