Aggregate Output, Prices, and Economic Growth

This reading introduces important macroeconomic concepts and principles for macroeconomic forecasting and related investment decision making. Macroeconomics examines the economy as a whole by focusing on a country’s aggregate output of final goods and services, total income, aggregate expenditures, and the general price level. The first step in macroeconomic analysis is to measure the size of an economy. Gross domestic product enables us to assign a monetary value to an economy’s level of output or aggregate expenditures. The interaction of aggregate demand and aggregate supply determines the level of GDP as well as the general price level. The business cycle reflects shifts in aggregate demand and short-run aggregate supply. The long-term sustainable growth rate of the economy depends on growth in the supply and quality of inputs (labor, capital, and natural resources) and advances in technology. From an investment perspective, macroeconomic analysis and forecasting are important because business profits, asset valuations, interest rates, and inflation rates depend on the business cycle in the short to intermediate term and on the drivers of sustainable economic growth in the long term. In addition, it is important to understand fiscal and monetary policies’ economic impact on and implications for inflation, household consumption and saving, capital investment, and exports.

• GDP is the market value of all final goods and services produced within a country in a given time period.

• GDP can be valued by looking at either the total amount spent on goods and services produced in the economy or the income generated in producing those goods and services.

• GDP counts only final purchases of newly produced goods and services during the current time period. Transfer payments and capital gains are excluded from GDP.

• With the exception of owner-occupied housing and government services, which are estimated at imputed values, GDP includes only goods and services that are valued by being sold in the market.

• Intermediate goods are excluded from GDP in order to avoid double counting.

• GDP can be measured either from the value of final output or by summing the value added at each stage of the production and distribution process. The sum of the value added by each stage is equal to the final selling price of the good.

• Nominal GDP is the value of production using the prices of the current year. Real GDP measures production using the constant prices of a base year. The GDP deflator equals the ratio of nominal GDP to real GDP.

• Households earn income in exchange for providing—directly or indirectly through ownership of businesses—the factors of production (labor, capital, natural resources including land). From this income, they consume, save, and pay net taxes.

• Businesses produce most of the economy’s output/income and invest to maintain and expand productive capacity. Companies retain some earnings but pay out most of their revenue as income to the household sector and as taxes to the government.

• The government sector collects taxes from households and businesses and purchases goods and services, for both consumption and investment, from the private business sector.

• Foreign trade consists of exports and imports. The difference between the two is net exports. If net exports are positive (negative), then the country spends less (more) than it earns. Net exports are balanced by accumulation of either claims on the rest of the world (net exports > 0) or obligations to the rest of the world (net exports < 0). 

• Capital markets provide a link between saving and investment in the economy.

• From the expenditure side, GDP includes personal consumption (C), gross private domestic investment (I), government spending (G), and net exports (X – M).

• The major categories of expenditure are often broken down into subcategories. Gross private domestic investment includes both investment in fixed assets (plant and equipment) and the change in inventories. In some countries, government spending on investment is separated from other government spending.

• National income is the income received by all factors of production used in the generation of final output. It equals GDP minus the capital consumption allowance (depreciation) and a statistical discrepancy.

• Personal income reflects pre-tax income received by households. It equals national income plus transfers minus undistributed corporate profits, corporate income taxes, and indirect business taxes.

• Personal disposable income equals personal income minus personal taxes.

• Private saving must equal investment plus the fiscal and trade deficits. That is, S = I + (G – T) + (X – M).

• Consumption spending is a function of disposable income. The marginal propensity to consume represents the fraction of an additional unit of disposable income that is spent.

• Investment spending depends on the average interest rate and the level of aggregate income. Government purchases and tax policy are often considered to be exogenous variables determined outside the macroeconomic model. Actual taxes collected depend on income and are, therefore, endogenous—that is, determined within the model.

• The IS curve reflects combinations of GDP and the real interest rate such that aggregate income/output equals planned expenditures. The LM curve reflects combinations of GDP and the interest rate such that demand and supply of real money balances are equal.

• Combining the IS and LM relationships yields the aggregate demand curve.

• Aggregate demand and aggregate supply determine the level of real GDP and the price level.

• The aggregate demand curve is the relationship between real output (GDP) demanded and the price level, holding underlying factors constant. Movements along the aggregate demand curve reflect the impact of price on demand.

• The aggregate demand curve is downward sloping because a rise in the price level reduces wealth, raises real interest rates, and raises the price of domestically produced goods versus foreign goods. The aggregate demand curve is drawn assuming a constant money supply.

• The aggregate demand curve will shift if there is a change in a factor, other than price, that affects aggregate demand. These factors include household wealth, consumer and business expectations, capacity utilization, monetary policy, fiscal policy, exchange rates, and foreign GDP.

• The aggregate supply curve is the relationship between the quantity of real GDP supplied and the price level, keeping all other factors constant. Movements along the supply curve reflect the impact of price on supply.

• The short-run aggregate supply curve is upward sloping because higher prices result in higher profits and induce businesses to produce more and laborers to work more. In the short run, some prices are sticky, implying that some prices do not adjust to changes in demand.

• In the long run, all prices are assumed to be flexible. The long-run aggregate supply curve is vertical because input costs adjust to changes in output prices, leaving the optimal level of output unchanged. The position of the curve is determined by the economy’s level of potential GDP.

• The level of potential output, also called the full employment or natural level of output, is unobservable and difficult to measure precisely. This concept represents an efficient and unconstrained level of production at which companies have enough spare capacity to avoid bottlenecks and there is a balance between the pool of unemployed workers and the pool of job openings.

• The long-run aggregate supply curve will shift because of changes in labor supply, supply of physical and human capital, and productivity/technology.

• The short-run supply curve will shift because of changes in potential GDP, nominal wages, input prices, expectations about future prices, business taxes and subsidies, and the exchange rate.

• The business cycle and short-term fluctuations in GDP are caused by shifts in aggregate demand and aggregate supply. 

• When the level of GDP in the economy is below potential GDP, such a recessionary situation exerts downward pressure on the aggregate price level.

• When the level of GDP is above potential GDP, such an overheated situation puts upward pressure on the aggregate price level.

• Stagflation, a combination of high inflation and weak economic growth, is caused by a decline in short-run aggregate supply.

• The sustainable rate of economic growth is measured by the rate of increase in the economy’s productive capacity or potential GDP.

• Growth in real GDP measures how rapidly the total economy is expanding. Per capita GDP, defined as real GDP divided by population, reflects the standard of living in a country. Real GDP growth rates and levels of per capita GDP vary widely among countries.

• The sources of economic growth include the supply of labor, the supply of physical and human capital, raw materials, and technological knowledge.

• Output can be described in terms of a production function. For example, Y = AF(L,K) where L is the quantity of labor, K is the capital stock, and A represents technological knowledge or total factor productivity. The function F(·) is assumed to exhibit constant returns to scale but diminishing marginal productivity for each input individually.

• Total factor productivity is a scale factor that reflects the portion of output growth that is not accounted for by changes in the capital and labor inputs. TFP is mainly a reflection of technological change.

• Based on a two-factor production function, Potential GDP growth = Growth in TFP + W_L (Growth in labor) + W_C (Growth in capital), where W_L and W_C (= 1 – W_L) are the shares of labor and capital in GDP.

• Diminishing marginal productivity implies that

  • increasing the supply of some input(s) relative to other inputs will lead to diminishing returns and cannot be the basis for sustainable growth. In particular, long-term sustainable growth cannot rely solely on capital deepening, that is, increasing the stock of capital relative to labor.

  • given the relative scarcity and hence high productivity of capital in developing countries, the growth rate of developing countries should exceed that of developed countries.

• The labor supply is determined by population growth, the labor force participation rate, and net immigration. The capital stock in a country increases with investment. Correlation between long-run economic growth and the rate of investment is high.

• In addition to labor, capital, and technology, human capital—essentially, the quality of the labor force—and natural resources are important determinants of output and growth.

• Technological advances are discoveries that make it possible to produce more and/or higher-quality goods and services with the same resources or inputs. Technology is the main factor affecting economic growth in developed countries.

• The sustainable rate of growth in an economy is determined by the growth rate of the labor supply plus the growth rate of labor productivity.