LM03 Aggregate Output, Prices and Economic Growth

Part 1

1.  Introduction

The previous few readings focused on microeconomics, which is the study of individual economic units such as individual households, firms, or markets. In this reading, we will start with the basics of macroeconomics, which is a study of aggregate behavior of households, firms and markets.

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 shifts and movements along these curves.
• Factors that affect the equilibrium price and output.
• Sources and measures of economic growth.

2.  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.

Operating surplus of Company = Rent + interest + profit

Operating surplus represents the return on all capital used by the business.

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

Let us take a simple economy, comprising households and business firms. Households provide labor and capital to the firms. Businesses, in turn, make payments to households to compensate them for labor. Households earn an income of $500 towards labor and profits earned on the capital invested. This income can also be seen as the households’ expenditure on firms. This shows the total output produced by the firms must equal aggregate income.

2.1. Gross Domestic Product

What is GDP?

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.

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:
  • The value of labor for activities that are not used in production. Ex: commuting to work.
  • By-products that have no explicit value. Ex: air/water pollution
• 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 wipers 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.

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.

Let’s take a simple example discussed in the curriculum.

• A farmer sells wheat to a miller for €0.15.
• The miller sells flour (after grinding wheat) to a baker for €0.46.
• The baker makes bread out of flour and sells to a retailer for €0.78.
• The retailer sells bread to the customers for €1.00.

The data associated with the example is presented in the table below:

There are two ways to calculate the value of output:

• Value of the final product, bread, which is €1.00.
• Sum of value added at each stage, which is also equal to, €1.00.

Nominal and Real GDP

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.

Solution:

Nominal GDP = 120 * 1 million = 120 million

Real GDP = 1 million * 100 = 100 million

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.

GDP Deflator: 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.

It can also be written as:

Going back to the cotton example, using this formula, the GDP deflator for 2010 = . For 2012, GDP deflator for 2012 =. The GDP deflator indicates that the price has increased by 20% over the two years.

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 prices	100	110	118	125
Real GDP	90	92	94	95
Implicit GDP price deflator

Solution:

	2009	2010	2011	2012
Implicit GDP price deflator

Inflation rate for 2012 =

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