1. The Product Market Equation x = p + q. The Product Market Equation

2. Comments on the Equations All of the variables in these two equations are written using lower case letters Lower case letters are used to indicate that all the variables are rates of change. That is, we are describing “by what percent this value has changed since a year ago.” The definitions of these terms will therefore include phrases such as: “the percent change of …”, “the rate of change of …”, “the growth rate of …”, “the ___ growth rate.”

3. The Product Market Equation: x = p + q x = the growth rate of total spending (GDP) x = 6% means, “we spent 6% more this year than we did last year.” p = the growth rate of prices (or the “cost of living”) p = 3% means, “on average, the prices of goods are 3% more than last year.” p has an easier name. p is ________ q = real growth (or “the real growth rate”) q = 3% means that the economy produced 3% more goods and services (“stuff”) than last year. inflation

4. The Product Market Equation: x = p + q x = the growth rate of nominal GDP The easiest terms to use for these three concepts are: p = the inflation rate q = the growth rate of real GDP

5. The Product Market Equation: x = p + q The equation says that if we spend 6% more this year than we did last year (x = 6), then we are either: (a) paying higher prices for what we are buying, and/or (b) we are buying more “stuff.” (real output) That is, we can think of increases of spending (x) as being split between changes of prices (p) and changes of output (q) It is a good mathematical approximation that the percent changes add up as the equation says they do.

6. The Product Market Equation: x = p + q To understand “q” (real growth) look at the equation as q = x - p Suppose we spend 6% more this year than last year (x = 6). Suppose that prices are, on average, 2% higher than they were last year (p = 2%). The equation says that we must have bought 4% more “stuff” than last year. Of the 6% spending increase, 2% went to higher prices. The other 4% must have gone to real growth (more stuff).

7. The Product Market Equation: x = p + q This equation draws our attention to something important: the difference between nominal growth (x) and real growth (q) Nominal GDP (X) measures how much we spend, in dollar terms. This is the easiest statistic to collect Real GDP (Q) is often the more significant of the two measures. It is measuring actual production – the economy’s output. Importantly, employment is more closely related to real spending than to nominal spending.

8. PrM Eq. x = p + q. Some examples xpq #163 #228 #31013 #4-10-4 What is p (inflation)? 3 What is x (nominal growth)? What is q (real growth)? 10 -3 -6 What is q (real growth)? Both year #2 and #3 had x = 10. Which was the better year? Why? Of the three variables – x, p, q – which would you pick to indicate how good the year was? q is the best indicator