Lecture on Measuring Aggregate Output and Introduction to IS-LM Model

Measuring Aggregate Output

• Understanding aggregate output measurement is more complex than measuring output at the factory level.
• Example economy: Two companies - Steel company (sells to car company) and Car company (sells to consumers).
• Question: What is the GDP?
  • Simplistic sum approach: Add outputs ($300) - Incorrect.
  • Method 1: Value of final goods only
    • Steel company sells as input, not counted.
    • Only the car company's production counts: GDP = $200.
  • Method 2: Value added method
    • Steel company's value added: $100.
    • Car company's value added: $200 (output) - $100 (input) = $100.
    • Total value added: $200.
  • Method 3: Income method
    • Sum of incomes to workers and owners.
    • Workers: $80 + $70 = $150.
    • Owners: $20 + $30 = $50.
    • Total income: $200.
• Key Point: Organizational changes do not affect GDP measured by these methods.

Nominal vs. Real Output

• Nominal Output: Measured at current prices.
• Real Output: Measured at fixed base year prices.
• Example:
  • 3 years of car production and prices.
  • Nominal GDP rises significantly due to price rise.
  • Real GDP accounts only for production volume, not price changes.
• Real GDP Calculation:
  • Base year: 10 cars x $24,000 = $240.
  • Subsequent years' real GDP: Cars produced x base year price.

Key Definitions

• Unemployment Rate: Number of unemployed / labor force (not population).
• Inflation Rate: Rate of change of prices.
• Different price indices: GDP deflator, CPI, etc.

Introduction to IS-LM Model

Goods Market

• Components of aggregate demand (closed economy): C + I + G.
• Assumptions:
  • Government expenditure (G) and taxes (T) are exogenous.
  • Consumption (C) depends on disposable income (Y – T).
• Consumption Function: C = c0 + c1(Y – T)
• Equilibrium Condition: Output (Y) = Aggregate demand (Z).
• Multiplier Effect:
  • Multiplier = 1 / (1 – c1).
  • Example: If marginal propensity to consume c1 is high, small autonomous consumption change has large output effect.

Alternative Representation

• Saving equals Investment (S = I): Alternate way to find equilibrium.
• Paradox of Saving:
  • Increases in saving at constant income reduce output/income because of reduced consumption.

Financial Markets

• Simplified to money and bonds.
• Money Demand: Depends on nominal GDP and inverse of interest rate.
• Money Supply: Set by central bank; equilibrium interest rate where supply meets demand.
• Central Bank Operations:
  • Expansionary: Buys bonds, lowers interest rate.
  • Contractionary: Sells bonds, raises interest rate.
• Bond Prices and Interest Rates: Inversely related; Central bank operations affect both.

IS-LM Model

• IS Curve: Represents equilibrium in Goods Market (Y = Z.
  • Downward sloping: Higher interest rates reduce investment and output.
• LM Curve: Represents equilibrium in Financial Market (money demand = money supply).
• Equilibrium: Determined at intersection of IS and LM curves.
• Policy Implications:
  • Fiscal Policy: Shifts IS curve (e.g., changes in G or T).
  • Monetary Policy: Shifts LM curve (e.g., changes in money supply affecting interest rate).

Extended IS-LM Model

• Real vs. Nominal Interest Rates:
  • Real interest rate = Nominal interest rate - expected inflation.
• Credit Spreads: Difference between borrowing cost for firms and risk-free rate.
• Impact on Investment: Investment depends on real borrowing cost.

Transition to Medium-Run Issues

• Natural Rate of Unemployment: Unemployment rate when actual price equals expected price.
• Wage Setting and Price Setting:
  • Nominal wage depends on expected price and unemployment rate.
  • Firms set prices based on marginal cost and markup.
• Equilibrium Unemployment: Where wage-setting and price-setting curves intersect.

Conclusion

• Understanding of aggregate output, nominal vs. real GDP, and the basics of IS-LM model crucial for quiz.
• Apply concepts like the multiplier effect, paradoxes in saving, and policy impacts in different scenarios. Ensure comprehension of financial operations and their role in real vs. nominal interests and investments.