Lecture Notes: Aggregate Output and the IS-LM Model

Measuring Aggregate Output

• Understanding GDP

  • GDP is the value of final goods only.
  • Example economy: Steel company sells to car company only.
  • Three methods to measure GDP:
    1. Final Goods Method: Only the car company's output is considered ($200).
    2. Value Added Method: Difference between revenue and intermediate inputs.
       • Steel: $100 value added.
       • Cars: $200 revenue - $100 intermediate = $100 value added.
       • Total value added: $200.
    3. Income Method: Sum of all incomes (wages + profits).
       • Wages: $80 + $70 = $150.
       • Profits: $20 + $30 = $50.
       • Total income: $200.
  • Methods robust to changes in organizational structure.

• Distinction between Nominal and Real Output

  • Nominal Output: Measured at current prices.
  • Real Output: Measured at constant prices (base year).
  • Example: Economy producing only cars.
  • Real GDP reflects true output growth.

Economic Definitions

• Unemployment Rate: Number of unemployed / labor force.
• Inflation Rate: Rate of change of prices (deflator, CPI).

IS-LM Model Introduction

• Goods Market

  • Aggregate demand (AD) components in a closed economy.
  • Government expenditure and taxes treated as exogenous.
  • Consumption function: Increasing with disposable income.
  • Equilibrium: Output is demand determined.
  • Multiplier Effect: Change in autonomous expenditure affects output significantly.
  • Paradox of Savings: Increased savings can lead to decreased output.

• Financial Markets

  • Simplified to money and bonds.
  • Money demand increases with nominal GDP, decreases with interest rate.
  • Money supply controlled by central bank (Fed).
  • Monetary policy affects interest rates via open market operations.

Advanced IS-LM Model

• Investment Function: Dependent on output and interest rate.

  • Higher interest rates decrease investment.

• IS Curve

  • Shows equilibrium combinations of output and interest rate.
  • Shifts with changes in fiscal policy (G, T).

• LM Curve

  • Represents equilibrium in financial markets.
  • Horizontal as central banks set interest rate.

Policy Implications

• Monetary Policy: Used to combat recession by lowering interest rates.

  • Open market operations are the primary tool.

• Policy Mix

  • Combination of fiscal and monetary policies used, especially in deep recessions.

Extended IS-LM Model

• Incorporates expected inflation and credit spreads.
  • Expected inflation decreases real interest rate, boosting investment.
  • Credit spreads indicate risk, affect borrowing costs.

Labor Market and Natural Rate of Unemployment

• Wage Setting Equation: Wages increase with expected prices, decrease with unemployment.

• Price Setting: Firms set prices based on marginal costs (wages + markup).

• Natural Rate of Unemployment: Equilibrium where actual prices equal expected prices.

  • Influenced by market parameters and worker conditions.

• Market Shocks

  • Unionization or benefits increase can raise unemployment.
  • Increased markups lower real wages, increase unemployment.

Summary

• Understanding IS-LM interactions is crucial.
• Mastering the concepts of multiplier, paradox of savings, and policy effects are essential.
• Awareness of inflation, credit spreads, and their economic impacts is vital.

Notes

• Focus on understanding economic mechanisms rather than rote memorization.
• Expect questions on policy impacts and equilibrium adjustments in the quiz.