Measuring Aggregate Output and GDP

Definition and Basic Example

• Understanding output measurement at the aggregate level
• Simple economy example: Two companies (Steel and Cars)
• GDP Calculation
  • Simplest but incorrect answer: Sum of companies' output ($300)
  • Correct through three methods:
    • Method 1: Value of Final Goods
      • GDP is the value of final goods only.
      • The steel company’s output isn’t final goods, so only the car company’s $200 counts.
    • Method 2: Value Added Method
      • GDP = total value added in each company (Revenue - Intermediate inputs)
      • Steel: $100 (no intermediate input costs), Cars: $200 - $100 (input cost) = $100.
      • Total: $100 + $100 = $200.
    • Method 3: Income Method
      • GDP = Sum of all incomes (wages and profits)
      • Workers' income: $80 + $70 = $150, Owners’ income: $20 + $30 = $50
      • Total Income: $150 + $50 = $200.
    • Conclusion: All methods lead to the same GDP ($200).
    • Methods remain consistent regardless of corporate mergers and organizational structure.

Nominal vs Real GDP

• Nominal GDP:
  • Measured using current prices.
• Real GDP:
  • Measured using prices from a fixed base year to account for inflation
  • Example: Economy producing only cars
    • 10 cars at $24,000 (base year) = $240,000
    • 13 cars at $24,000 (in later year) = $312,000 (Real GDP)
    • Faster rise in nominal GDP due to increasing prices.

Key Economic Indicators

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

IS-LM Model

Goods Market

• Components of Aggregate Demand in a closed economy
• Behavioral assumptions: Exogenous government expenditure & taxes
• Consumption function: Consumption increases with disposable income (Y - T)
• Key Assumption: Prices are fixed, output is aggregate demand determined
• Equilibrium Condition: Y = aggregate demand (Z)
• Multiplier Effect: Higher marginal propensity to consume (C1) leads to a larger multiplier

Financial Markets

• Simple model: Money and Bonds
• Money Demand:
  • Increases with nominal GDP
  • Decreases with the interest rate (opportunity cost of holding money)
• Money Supply: Controlled by the Central Bank
• Expansionary Monetary Policy: Increasing money supply to lower interest rates via open market operations

IS-LM Equilibrium

• IS Curve: Consistent equilibrium in the goods market (Output = Aggregate Demand)
• Constructing IS Curve: Adjusting interest rates and finding corresponding equilibrium outputs
• LM Curve: Equilibrium interest rate set by the Central Bank
• Fiscal and Monetary Policies:
  • Contractionary Fiscal Policy: Reducing G or increasing T shifts IS left
  • Expansionary Monetary Policy: Lowering interest rates shifts LM right
  • Balanced Budget Fiscal Policy: Changing G and T by the same amount

Extensions to the IS-LM Model

• Introducing inflation and credit spreads into the IS-LM model
• Firms’ Investment: Depends on the real interest rate (R = I - E(π))
• Policy Responses: Central Bank reacts to changes in credit spreads or expected inflation to stabilize output
• Zero Lower Bound: Limits on how much the Central Bank can reduce interest rates

Transition to Medium-Run Issues

Labor Market

• Wage Setting Equation: Real wages increase with expected prices, decrease with higher unemployment

• Price Setting Equation: Firms set prices based on marginal cost (wages) plus a markup

• Natural Rate of Unemployment: Rate where prices equal expected prices

  • Impacted by bargaining power, unemployment benefits

• Impact of Markup Increases: Leads to a higher natural rate of unemployment

  • Lower real wages offered by firms

Conclusion

• Understanding IS-LM and labor market models crucial for economic analysis
• Effects of fiscal and monetary policies on output and prices
• Important for understanding medium to long-run economic dynamics