Gross Domestic Product and Gross National Product GDP is the market value of all newly produced final goods and services produced by resources located in the United States, regardless of who owns those resources

Final and Intermediate Goods and Services Final goods and services sold to ultimate, users Cotton shirts are a final good Intermediate goods and services are purchased for further reprocessing and resale Cotton is intermediate good Keeping final goods and intermediate goods separate in our thinking allows us to avoid double counting Value added is the difference between the value of goods as they leave a stage of production and the cost of the goods as they entered that stage. In calculating GDP, we can either sum up the value added at each stage of production, or we can take the value of final sales.

Calculating GDP GDP can be computed in two ways: The expenditure approach: A method of computing GDP that measures the total amount spent on all final goods during a given period. The income approach:

The Expenditure Approach The expenditure approach calculates GDP by adding together the four components of spending. In equation form:

The Circular Flow of Income and Expenditure aggregate income = GDP transfer payments taxes Disposable income Financial markets consumption (C) S Investment (I) Gov’t (G) X-M C+I+G+X-M

Categories of Expenditures Consumption (C) All household purchases (blue jeans, twinkies, etc.) Investment (I) Purchases not used for current consumption (newly built homes,plant, new inventories) Government Purchases (G) Examples include missile systems and paper clips Net Exports (X - M) Net exports = exports (X) - imports (M)

Personal Consumption Expenditures Personal consumption expenditures (C) are expenditures by consumers on the following: Durable goods: Goods that last a relatively long time, such as cars and appliances. Nondurable goods: Goods that are used up fairly quickly, such as food and clothing. Services: Things that do not involve the production of physical things, such as legal services, medical services, and education.

Gross Private Domestic Investment Investment refers to the purchase of new capital. Total investment by the private sector is called gross private domestic investment. It includes the purchase of new housing, plants, equipment, and inventory by the private sector.

Gross Private Domestic Investment Nonresidential investment includes expenditures by firms for machines, tools, plants, and so on. Residential investment includes expenditures by households and firms on new houses and apartment buildings. Change in inventories computes the amount by which firms’ inventories change during a given period. Inventories are the goods that firms produce now but intend to sell later. The relationship between total production and total sales is: GDP = final sales + change in business inventories

Government Consumption and Gross Investment Government consumption and gross investment (G) counts expenditures by federal, state, and local governments for final goods and services.

Net Exports Net exports (EX – IM) is the difference between exports and imports. The figure can be positive or negative. Exports (EX) are sales to foreigners of U.S.-produced goods and services. Imports (IM) are U.S. purchases of goods and services from abroad).

Classify each of these scenarios You buy an old house You buy some marijuana from a friend You buy stock in GM A Japanese firm buys City Brewery The government makes a welfare payment You buy a used car A business fails to sell some of its inventory A business buys a new truck You buy an old house You buy some marijuana from a friend You buy stock in GM A Japanese firm buys City Brewery The government makes a welfare payment You buy a used car A business fails to sell some of its inventory A business buys a new truck

Components of GDP, 2002: The Expenditure Approach BILLIONS OF DOLLARS PERCENTAGE OF GDP Personal consumption expenditures (C) 7303.7 69.9 Durable goods 871.9 8.3 Nondurable goods 2115.0 20.2 Services 4316.8 41.3 Gross private domestic investment (l) 1543.2 14.8 Nonresidential 1117.4 10.7 Residential 471.9 4.5 Change in business inventories 3.9 Government consumption and gross investment (G) 1972.9 18.9 Federal 693.7 6.6 State and local 1279.2 12.2 Net exports (EX – IM) - 423.6 - 4.1 Exports (EX) 1014.9 9.8 Imports (IM) 1438.5 13.8 Total gross domestic product (GDP) 10446.2 100.0 Note: Numbers may not add exactly because of rounding. Source: U.S. Department of Commerce, Bureau of Economic Analysis.

Current and Historical Data US data (BEA) http://www.bea.doc.gov/bea/newsrel/gdp499p.htm Historical US Data http://eh.net/hmit/gdp/ International http://www.stls.frb.org/publications/iet/ http://www.odci.gov/cia/publications/factbook/

The Keynesian Framework and the ISLM Model

Determination of Output Keynesian ISLM Model assumes price level is fixed Aggregate Expenditures AE= C + I + G + NX Equilibrium Y = AE Consumption Function C = a + (mpc  YD) Investment 1. Fixed investment 2. Inventory investment Only planned investment is included in AE NOTE: In many of the Slides Yd in place of AE they are the same thing.

Consumption Function

Keynesian Cross Diagram AE Y=AE AE Assume G = 0, NX = 0, T = 0 AE= C + I = 200 + .5Y + 300 = 500 + .5Y Equilibrium: 1. When Y > Y*, Iu > 0  Y  to Y* 2. When Y < Y*, Iu < 0  Y  to Y*

Expenditure Multiplier

Analysis of Figure 3: Expenditure Multiplier I = + 100  Y/I = 200/100 = 2 1 Y = (a + I)  1 – mpc A = a + I = autonomous spending Conclusions: 1. Expenditure multiplier = Y/A = 1/(1 – mpc) whether change in A is due to change in a or I 2. Animal spirits change A

The Great Depression and the Collapse of Investment

Role of Government

Analysis of Figure 5: Role of Government G = + 400,  T = + 400 1. With no G and T, Yd = C + I = 500 + mpc Y = 500 + .5Y, Y1 = 1000 2. With G, Y= C + I + G = 900 + .5Y, Y2 = 1800 3. With G and T, Yd = 900 + mpc  Y – mpc T = 700 + .5Y, Y3 = 1400 Conclusions: 1. G  Y ; T  Y  2. G = T = + 400, Y  400

Role of International Trade NX = +100, Y/NX = 200/100 = 2 = 1/(1 – mpc) = 1/(1 – .5)

Summary: Factors that Affect Y

IS Curve IS curve 1. i  I  NX , Yad , Y  Points 1, 2, 3 in figure 2. Right of IS: Y > Yad  Y  to IS Left of IS: Y < Yad  Y  to IS IS Curve

LM Curve LM curve 1. Y , Md , i  Points 1, 2, 3 in figure 2. Right of LM: excess Md, i  to LM Left of LM : excess Ms, i  to LM

ISLM Model Point E, equilibrium where Y = Yad (IS) and Md = M s (LM ) At other points like A, B, C, D, one of two markets is not in equilibrium and arrows mark movement towards point E

Monetary and Fiscal Policy in the ISLM Model

1. C : at given iA, Yad , Y   IS shifts right 2. Same reasoning when I , G , NX , T  Shift in the IS Curve

Shift in the LM Curve from a Rise in Ms 1. Ms : at given YA, i  in panel (b) and (a)  LM shifts to the right

Shift in the LM Curve from a Rise in M d 1. M d : at given YA, i  in panel (b) and (a)  LM shifts to the left

Response to an Increase in Ms 1. M s : i , LM shifts right  Y  i 

Response to Expansionary Fiscal Policy 1. G  or T : Yad , IS shifts right  Y  i 

Summary: Factors that Shift IS and LM Curves

Effectiveness of Monetary and Fiscal Policy 1. M d is unrelated to i  i , M d = M s at same Y  LM vertical 2. Panel (a): G , IS shifts right  i , Y stays same (complete crowding out) 3. Panel (b): M s , Y so M d , LM shifts right  i  Y  Conclusion: Less interest sensitive is M d, more effective is monetary policy relative to fiscal policy

Ms vs. i Targets When IS Unstable 1. IS unstable: fluctuates from IS' to IS'' 2. i target at i*: Y fluctuates from YI' to YI'' 3. M target, LM = LM*: Y fluctuates from YM' to YM'' 4. Y fluctuation is less with M target Conclusion: If IS curve is more unstable than LM curve, M target is preferred

Ms vs. i Targets When LM Unstable 1. LM unstable: fluctuates from LM' to LM'' 2. i target at i*: Y = Y* 3. M target: Y fluctuates from YM' to YM'' 4. Y fluctuation is less with i target Conclusion: If LM curve is more unstable than IS curve, i target is preferred

The ISLM Model in the Long Run Panel (a) 1. Ms , LM right to LM2, go to point 2, i to i2, Y to Y2 2. Because Y2 > Yn, P , M/P , LM back to LM1, go back to point 1 Panel (b) 1. G , IS right to IS2, go to point 2 where i = i2 and Y = Y2 2. Because Y2 > Yn, P , M/P , LM left to LM2, go to point 2', i = i2` and Y = Yn.

Deriving AD Curve P , M/P , LM shifts in, Y  Points 1, 2, 3

Shift in AD from Shift in IS At given PA, IS shifts right: Y  in panel (b)  AD shifts right in panel (a)

Shift in AD from Shift in LM At given PA, LM shifts right: Y  in panel (b)  AD shifts right in panel (a)

The Aggregate Supply Curve Aggregate supply is the total supply of all goods and services in the economy.

The Aggregate Supply Curve The aggregate supply (AS) curve is a graph that shows the relationship between the aggregate quantity of output supplied by all firms in an economy and the overall price level.

The Aggregate Supply Curve: A Warning The aggregate supply curve is not a market supply curve or the sum of all the individual supply curves in the economy.

The Aggregate Supply Curve: A Warning Firms do not simply respond to market-determined prices, but they actually set prices. Price-setting firms do not have individual supply curves because these firms are choosing both output and price at the same time.

The Aggregate Supply Curve: A Warning When we draw a firm’s supply curve, we assume that input prices are constant. In macroeconomics, an increase in the overall price level means that at least some input prices will be rising as well. The outputs of some firms are the inputs of other firms.

The Aggregate Supply Curve: A Warning Rather than an aggregate supply curve, what does exist is a “price/output response” curve — a curve that traces out the price and output decisions of all the markets and firms in the economy under a given set of circumstances.

Aggregate Supply in the Short Run In the short run, the aggregate supply curve (the price/output response curve) has a positive slope. Firms may at time have excess capital and excess labor on hand. The reasons for this are associated with the costs of getting rid of capital and labor.

Aggregate Supply in the Short Run At low levels of aggregate output, the curve is fairly flat. As the economy approaches capacity, the curve becomes nearly vertical. At capacity, the curve is vertical. Firms may at time have excess capital and excess labor on hand. The reasons for this are associated with the costs of getting rid of capital and labor.

Aggregate Supply in the Short Run Macroeconomists focus on whether or not the economy as a whole is operating at full capacity. As the economy approaches maximum capacity, firms respond to further increases in demand only by raising prices.

Output Levels and Price/Output Responses When the economy is operating at low levels of output, an increase in aggregate demand is likely to result in an increase in output with little or no increase in the overall price level.

The Response of Input Prices to Changes in the Overall Price Level There must be a lag between changes in input prices and changes in output prices, otherwise the aggregate supply (price/output response) curve would be vertical. If input and output prices rise by the same percentage amount, no firm would find it advantageous to change its level of output.

The Response of Input Prices to Changes in the Overall Price Level Wage rates may increase at exactly the same rate as the overall price level if the price-level increase is fully anticipated. Most input prices, however, tend to lag increases in output prices. If input and output prices rise by the same percentage amount, no firm would find it advantageous to change its level of output.

Shifts of the Short-Run Aggregate Supply Curve A cost shock, or supply shock, is a change in costs that shifts the aggregate supply (AS) curve. Cost shocks refer to an increase in costs, which may be the result of an increase in wage rates, energy prices, natural disasters, economic stagnation, and the like.

Shifts of the Short-Run Aggregate Supply Curve Bad weather, natural disasters, destruction from wars Good weather Public policy waste and inefficiency over-regulation Public policy supply-side policies tax cuts deregulation Stagnation capital deterioration Economic growth more capital more labor technological change Higher costs higher input prices higher wage rates Lower costs lower input prices lower wage rates Shifts to the Left Decreases in Aggregate Supply Shifts to the Right Increases in Aggregate Supply Factors That Shift the Aggregate Supply Curve

The Equilibrium Price Level The equilibrium price level is the point at which the aggregate demand and aggregate supply curves intersect.

The Equilibrium Price Level P0 and Y0 correspond to equilibrium in the goods market and the money market and a set of price/output decisions on the part of all the firms in the economy.

The Long-Run Aggregate Supply Curve Costs lag behind price-level changes in the short run, resulting in an upward-sloping AS curve. Costs and the price level move in tandem in the long run, and the AS curve is vertical.

The Long-Run Aggregate Supply Curve Output can be pushed above potential GDP by higher aggregate demand. The aggregate price level also rises.

The Long-Run Aggregate Supply Curve When output is pushed above potential, there is upward pressure on costs, and this causes the short-run AS curve to the left. Costs ultimately increase by the same percentage as the price level, and the quantity supplied ends up back at Y0.

The Long-Run Aggregate Supply Curve Y0 represents the level of output that can be sustained in the long run without inflation. It is also called potential output or potential GDP.

Aggregate Demand, Aggregate Supply, and Monetary and Fiscal Policy AD can shift to the right for a number of reasons, including an increase in the money supply, a tax cut, or an increase in government spending. Expansionary policy works well when the economy is on the flat portion of the AS curve, causing little change in P relative to the output increase.

Aggregate Demand, Aggregate Supply, and Monetary and Fiscal Policy On the steep portion of the AS curve, expansionary policy does not work well. The multiplier is close to zero. When the economy is operating near full capacity, an increase in AD will result in an increase in the price level with little increase in output.

Long-Run Aggregate Supply and Policy Effects If the AS curve is vertical in the long run, neither monetary policy nor fiscal policy has any effect on aggregate output. In the long run, the multiplier effect of a change in government spending or taxes on aggregate output is zero.

The Simple “Keynesian” Aggregate Supply Curve The output of the economy cannot exceed the maximum output of YF. The difference between planned aggregate expenditure and aggregate output at full capacity is sometimes referred to as an inflationary gap.

Causes of Inflation Inflation is an increase in the overall price level. Sustained inflation occurs when the overall price level continues to rise over some fairly long period of time.

Causes of Inflation Demand-pull inflation is inflation initiated by an increase in aggregate demand. Cost-push, or supply-side, inflation is inflation caused by an increase in costs.