L1 flash cards economics (ss5)

Gross Domestic Product (GDP)
Using the Expenditure Approach
 The Expenditures Approach measures the market value of all
the goods and services produced in an economy in a given
time period.
 GDP under the Expenditure Approach can be calculated as:
GDP=C+I+G+(X-M)
 where: C= Consumption usually the biggest factor
I= business investment it includes equipment
G= government spending
X= exports
M= imports
Study Session 5, Reading 17

Gross Domestic Product (GDP)
Using the Income Approach
 The Income Approach measures the aggregate income earned
by all households, companies and governments in an economy
during a period.
 GDP under the Income Approach can be calculated as:
GDP = R + I + P + SA + W
 Components of income include:
 Wages, salaries, and supplementary labor income
 Corporate profits
 Interest and miscellaneous investment income

Methods of Calculating GDP: Value-
of-Final-Output
 Under the Value of Final Output, only the value of the last
product is considered.
 As a result, the value of intermediate products is ignored.
 It measures the value of final goods and services.

Methods of Calculating GDP: Sum-
of-Value-Output
 The Sum of Value Added approach finds the sum of value
addition during the production process.
 Value addition also considers value added at the distribution
level.

Nominal GDP
 Nominal GDP measures the value of goods and services at
current price levels.
 It is calculated as:
GDPt = Pt * Qt
 where Pt is price in year t and Qt is quantity in year t

Real GDP
 Real GDP is adjusted for inflation/deflation.
 Real GDP can be calculated as:
GDPt = Pb * Qt
 where Pb is price in base year and Qt is the quantity in the
year t
 Real GDP per Capita, is Real GDP divided by population. It can
be used as a measure of the standard of living in a particular
country.

GDP Deflator
 The GDP Deflator is used to calculate Real GDP, given Nominal
GDP.
 GDP Deflator = (value of current year output at current year
prices/value of current year output at base year prices)* 100
 The GDP Deflator measures the aggregate change in prices in
the economy.
 Changes in the deflator are a good indicator of inflation in the
economy.

National Income
 National Income is the compensation paid to all factors of
production.
 National Income comprises of:
 Employee compensation
 Interest received net of interest paid
 Rental income
 Royalties paid for the use of intellectual property and
extractable natural resources.

Personal Income
 Personal Income is a broad measure of household income.
 It is a gauge for changes in the ability of consumers to spend.
 Personal Income measures all income received by the
household sector (earned or unearned).
 Personal Income= National Income- indirect business taxes -
corporate income taxes - undistributed corporate profits +
transfer payments

Personal Disposable Income
 Disposable Income is calculated as personal income less
personal taxes.
 Disposable Income measures income remaining to spend or
save after personal taxes.
 Disposable Income is the most relevant measure of household
spending and saving power.

Saving and Investment
 There is a positive relationship between saving and
investment.
 The higher the savings rate, the more money is available for
investment spending.
 Investment spending is undertaken to improve technology or
new equipment.

Fiscal Balance
 Fiscal Balance is a measure of Fiscal Policy. It measures
Government outflows and inflows.
 It measures the extent to which government receipts differ
from government outlays.
 If outlays exceed receipts, then the fiscal balance is negative.
 If receipts exceed outlays, then the balance is positive.
 For a negative fiscal balance, the government must borrow to
meet the shortfall.

Trade Balance
 Trade Balance is a measure of an economy’s transactions with
other economies.
 The Trade Balance measures the difference between a
country's imports and its exports.
 A country has a trade deficit if it imports more than it exports.
 A trade surplus occurs when a country’s exports exceed its
imports.

Aggregate Demand
 Four Sources
 Consumption
 Investment
 Government spending
 Net exports

Income/Saving and Liquidity
Preference/Money Supply Curves
 The Income/Savings and Liquidity Preference Money Supply
Curve demonstrates the relationship between interest rates
and real output in the goods and services market and the
money market.
 Each point on the curve represents a certain level of
equilibrium in the money market.

Aggregate Demand Curve
 The aggregate demand curve represents the total quantity of
all goods and services demanded by the economy at
different price levels.
 The vertical axis represents the price level of all final goods
and services. The aggregate price level is measured by either
the GDP deflator or CPI.
 The horizontal axis represents the real quantity of all goods
and services purchased as measured by the level of real GDP.

Aggregate Demand Curve

Aggregate Supply Curve in the
Short and Long Run
 The Aggregate Supply Curve illustrates the level of domestic
output.
 In the short run, output can be changed but the prices remain
constant.
 Strong demand results in higher profits for producers. As a
result, producers increase supply.
 This leads to an upward sloping Aggregate Supply curve in the
long run.
 Aggregate Supply can be measured as:
Y=F(K,L)

Aggregate Supply Curve in the
Short and Long Run

Shifts in the Aggregate Demand
Curve

Shifts in the Aggregate Demand
Curve
 Changes in the level of spending by households, companies,
government and foreigners will cause the Aggregate Demand
curve to shift.
 An increase in aggregate demand at any price level will cause
the Aggregate Demand curve to shift to the right.
 A decrease in aggregate demand at any price level will cause
the Aggregate Demand curve to shift to the left.

Shifts in the Aggregate Supply
Curve

Shifts in the Aggregate Supply
Curve
 Changes in the factors affecting the cost of production will
shift the short run aggregate supply curve.
 The SRAS curve will shift by the same magnitude as the LRAS.
That is, changes in the same underlying resources and
technology have the same effect on LRAS and SRAS.

Economic Growth
 Sources
 Labour supply
 Human capital
 Physical capital
 Technology
 Natural resources (renewable and non-renewable)

Economic Growth
 Measures
 The Growth Accounting Equation measures the growth in
potential GDP. It is calculated as:
Growth in potential GDP = Growth in technology + WL(growth
in labour) + WC(growth in capital)
 There is no observed data on potential GDP or total
productivity.
 Labour Productivity = Real GDP/Aggregate Hours
 Labour productivity is an important measure of the health of
an economy.

Production Functions
 The Production Function specifies the output of an economy
for all combinations of inputs.
 A production function can be expressed as:
Q = f(X1,X2,X3,...,Xn)
 where:
 Q = quantity of output; X1,X2,X3,...,Xn = quantities of factor
inputs
 Output per worker is a measure of labour productivity. It is
calculated as:
Y/L=AF(1,K/L)Y/L

Input Growth and Total Factor
Productivity
 Increases in the quantity of inputs lead to increases in
economic activity.
 In addition to this, Total Factor Productivity also boosts
economic activity.
 Labour productivity depends on both TFP and combination of
inputs. Increase in TFP or capital to labour ratio increases
labour productivity.

The Business Cycle and Its Phases
 The Business Cycle is a series of fluctuations in the level of
growth in economic activity.
 There are typically 4 phases of the Business Cycle:
 trough
 expansion
 peak
 contraction

The Business Cycle and Its Phases

Business Cycle: Impact on
Inventories
 As the Business Cycle enters the contraction stage, Aggregate
Demand shifts to left resulting in the accumulation of
inventories.
 As the Business Cycle enters the expansion stage, Aggregate
Demand shifts to right resulting in a reduction of inventories.

Business Cycle: Impact on Labour
 The Business Cycle has a significant impact on employment
markets.
 As economic conditions slow, firms reduce output.
Therefore, they require less labour inputs which results in
higher unemployment of labour.
 As economic conditions strengthen, firms increase output.

Business Cycle: Impact on Labour

Impact on Physical Capital
Utilization
 Capacity utilisation fluctuates with different stages of the
business cycle.
 As economic conditions slow, firms reduce output which
lowers capacity utilization.
 At this stage of the economic cycle there is very little
investment in physical capital.
 Additionally, an economic slowdown often results in less
access to finance, which further restricts investment spending
by producers.

Impact on Physical Capital
Utilization

Theories of the Business Cycle
Neoclassical and Austrian Schools
 Markets will reach equilibrium because of the invisible hand or
free market.
 Market prices are found at the point where demand = supply.
 The free market ensures that resources are used efficiently.
 No involuntary unemployment or labour or capital.
 Equilibrium is reached as the point where MR = MC.
 Fluctuation in the aggregate economy is ignored.

Keynesian and Monetarist Schools
 Generalized price and wage reduction is hard to attain.
 The policies used to reduce inflation will cause Aggregate
Demand to shift to the left.
 Keynesian economics supports government intervention in
form of fiscal policy.
 It argues that lower interest rates may not reignite growth if
business confidence is too low.
 When this occurs, a larger fiscal deficit should be borne by
government in order to bring equilibrium back.

New Classical Schools
 The New Classic School suggests that actions of economic
agents should be shown with the utility function and budget
constraints.
 Agents are assumed to be roughly alike.
 It is a dynamic model for describing fluctuations over many
periods.

Models without Money - Real
Business Cycle Theory
 Cycles have real causes.
 Monetary variables such as inflation are assumed to have no
effect on GDP and unemployment.
 External real shocks cause contractions and expansions.
 It argues for no intervention from the government.
 Unemployment can only be short term.
 Aggregate supply is given a more prominent role.

Models with Money
 Inflation often a cause of business cycle.
 Central bank intervention to control inflation through
monetary policy.
 Neo-Keynesians put more focus on sound macroeconomic
foundations.

Types of Unemployment
 Structural unemployment arises due to an absence of
demand for the workers that are available.
 Frictional unemployment comes from people moving
between jobs, careers, and locations .
 Cyclical unemployment occurs when the unemployment
rate changes due to fluctuations in economic activity.
 Long Term Unemployment: People who have been out of
job for long time.

Measures of Unemployment
 The Unemployment Rate is the most commonly used measure
of labour market conditions.
 The Participation Rate is the ratio of the labour force to the
total working age population.
 Underemployment occurs when a person has a job, but their
skill set is underemployed in their current role.
 A discouraged worker is a person who has stopped looking for
a job due to the difficulty in gaining employment.

Inflation
 Inflation is a sustained rise in price levels.
 It causes a fall in purchasing power, because one unit of
currency is now tradeable to less goods and services.
 As a result, central banks try to control inflation.
 The inflation rate is measured as a percentage change in a
price index.

Disinflation
 Disinflation is a decline in the inflation rate.
 Disinflation is different from deflation.
 After the period of disinflation, inflation remains positive.

Deflation
 Deflation is a sustained decline in price levels.
 Deflation is often caused by a decrease in money supply or
credit.
 Deflation can also be caused by a decrease in spending.

Construction of Indices to Measure
Inflation
Laspeyres Index
 Under a Paspeyres Index, the composition of the consumption
basket for measuring a price index is unchanged.
 Inflation under a Paspeyres Index can be calculated as:
PL=∑Pnqo/∑Poqo
 As a result, these price indices can suffer from three biases: 1)
substitution bias, 2) quality bias, and 3) new product bias.

Inflation
Paasche’s Index
 Paasche’s Index is a ratio of the total purchase cost of a
specified bundle of commodities at current prices, with the
value of those same commodities at base period prices. This
ratio is multiplied by 100.
 It is calculated as: Pp=∑Pnqn/∑Poqn
 This index tends to understate the price increases

Inflation
Fisher’s Index
 Fisher’s Index is the geometric mean of a Laspeyre’s and
Paasche’s index. It is calculated as:
Pb=√PLPp

Comparison of Inflation Measures
 The Consumer Price Index (CPI) is a commonly used measure
of inflation.
 However, when comparing across countries, a user needs to
consider the different weights assigned to products within the
consumer basket of goods.
 Price data can be collected from both urban and rural areas, or
just from urban areas.
 Personal Consumption Expenditures (PCE) and the Producer
Price Index (PPI) can also be used to measure inflation.

Uses and Limitations
 Weight differences may cause an understatement of prices in a
Wholesale Price Index.
 Laspeyres Index has an upward bias because of the
substitution effect.
 The Private Consumption Expenditures Index (PCE) covers the
complete range of goods and services purchased by
consumers.
 Price indices can also be used to deflate GDP.

Factors That Affect Price Levels
Cost Push Inflation
 Cost Push Inflation occurs when prices rises due to an increase
in costs.
 Higher unemployment can decrease wages cost, and hence
reduce cost push inflation pressures.
 Productivity per hour an important factor in limiting cost push
inflation.
 Unit Labour Costs can be calculated as:
ULC = W/O
 where w is total labour compensation per hour and O is
output.

Demand Pull Inflation
 Demand Pull Inflation refers to the increase in prices due to an
increase in demand.
 Higher rate of capacity utilization due to higher demand can be
a driver of demand pull inflation.
 A surplus of money in an economy may inflate prices.
 Money supply indicators can be used to track the impact that
monetary policy may have on demand pull inflation.

Inflation Expectations
 Inflationary expectations can become self fulfilling.
 Therefore, it is important for central banks to gain creditability
regarding their ability to manage inflation.
 Some surveys can be undertaken to measure inflation
expectations, however, typically it is not easy to measure.
 Past inflation trends tend to provide a gauge for expectations.

Types of Economic Indicators
There are 3 broad classes of economic indicators:
 Leading economic indicators have turning points which
precede changes in the overall economy.
 Coincident indicators change broadly simultaneously to the
overall economy.
 Lagging indicators highlight trends in economic activity later
than the overall economy.

Aggregate Indicators
 Economists often consider aggregate leading, lagging and
coincident indicators when getting a feel for underlying
economic conditions.
 The exact components of aggregate indicators vary for
different economies.
 One example if the Index of Leading Economic Indicators (LEI)
in the US which has 10 components.

Monetary Policy
 Monetary Policy is uses changes in the money supply and
credit in the economy to control economic growth.
 It is undertaken by the central bank and often the focus is to
control inflation.
 Interest rates in the economy are impacted by changes in the
money supply.
 Monetary Policy can be either expansionary (lower interest
rates designed to increase economic activity) or contractionery
(higher interest rates designed to decrease economic activity).

Fiscal Policy
 Fiscal Policy involves government decisions about taxation and
spending.
 It can be used to redistribute wealth and income, as well as to
control fluctuations in the business cycle.
 Aggregate demand and the level of economic activity can be
impacted by fiscal policy.
 Fiscal Policy can take neutral, expansionary and contractionery
stances.

Money
 Money is any object or record that is generally accepted
as payment for goods and services and repayment of debts.
 Money supply can be measured by either:
 M1 –Includes all physical denominations of coins and
currency, demand deposits, and traveller’s checks
 M2 – This category adds M1 to all time-related deposits,
savings deposits, and non-institutional money-market funds
 M3 – The broadest class of money, M3 combines all money
included in the definition of M2 and adds to it all large time
deposits, institutional money-market funds

Characteristics of Money
 Is easily divisible
 Is difficult to be counterfeit
 Has a known value
 Is readily acceptable
 Has a high value relative to its weight

Functions of Money
 Medium of exchange
 Store of value
 Unit of account

Money Creation
 Money creation is the process by which the money supply of
an economy is increased.
 There are two principal stages of money creation:
 The central bank introduces new money into the economy
by purchasing financial assets or lending money to financial
institutions.
 The new money introduced by the central bank is
multiplied by commercial banks so that it is a multiple of
the amount originally created by the central bank.

Demand and Supply for Money
 The Quantity Theory of Money suggests that total spending is
proportional to the money supply, as stated in the following
formula:
In the case of Money Neutrality, an increase in the money
supply will not affect real output.
 Demand for Money is the amount of wealth that citizens want
to hold.
 The amount of money that citizens was to hold can be driven
by transactions, a precautionary measure, or a speculative
measure.

Demand and Supply for Money

The Fisher Effect
 The Fisher Effect that the real rate of interest remains stable in
an economy over time.
 Nominal rates comprise of three components:
 The required real return
 Expected inflation (inflation premium)
 Risk premium for uncertainty

Roles of Central Banks
 Supplies currency in an economy.
 Banker to the government.
 Lender of last resort.
 Banker’s bank
 Provides regulation and supervision of the payments system.
 Conducts monetary policy.
 The gold standard was used in the past, whereby money was
exchanged for gold by the central bank.

Objectives of Central Banks
 Regulate the financial system.
 Stimulate economic growth.
 Implement monetary policy.
 Manage a country’s foreign reserves.
 Supply money and control credit.

Implementation of Monetary Policy
 Open Market Operations
 Policy Rate
 Reserves Requirement

Qualities of an Effective Central
Bank
 Central banks are given degree of freedom from government.
 Credibility of the ability to influence inflation is a key quality,
as is the transparency of its actions.
 Central banks should adopt and disclose a good decision
making framework comprising of a wide range of economic
and financial market indicators.
 Central banks should have a clear forward looking inflation
target.

Relationships between Monetary
Policy and Economic
Growth, Inflation, Interest
Rates, and Exchange Rates
 Inflation - controlled by monetary policy.
 Economic Growth - impact interest rates in an economy
 Interest Rates - The money supply in an economy can be
decreased through open market operations, leading to an
increase in interest rates.
 Exchange Rates - Some central banks attempt to manipulate
exchange rates as part of its monetary policy stance.

Expansionary Monetary Policy
 An increase in the money supply will result in a decrease in
interest rates which encourages economic growth and
investment.
 An increase in money supply is caused by the purchase of
securities in the open market.
 A central bank may lower the reserves requirement
 The lower interest rates make domestic bonds less attractive,
hence demand for domestic bonds falls, and demand for
foreign bonds rises.

Contractionary Monetary Policy
 A central bank will control monetary policy by selling securities
on the open market.
 Additionally, a central bank may raise the reserve requirement
which restricts the amount of capital that a bank can lend,
therefore decreasing the money supply.
 Contractionary monetary policy lowers inflation.
 Contractionary monetary policy causes a decrease in bond
prices and an increase in interest rates.
 Higher interest rates lead to lower levels of capital investment.

Limitations of Monetary Policy
 Interest rate adjustments may not be seen by the market as a
central bank intends.
 Rate rises to control inflation may actually cause long term
borrowing to be cheap.
 If the central bank is not credible enough, an increase in rates
can cause economic expansion.
 Money desposited by households and corporations in the
banks as deposits cannot be controlled
 Increasing the willingness of institutions to expand credit in an
attempt to increase money supply is not easy.

Roles and Objectives of Fiscal
Policy
 Changing Fiscal Policy involves managing the economy through
changes in aggregate demand.
 Changes in Fiscal Policy can be used to encourage investment,
or increase savings.
 Fiscal Policy can also impact the distribution of wealth,
through the methods of taxation determination.

Tools of Fiscal Policy
 The level of transfer payments can be adjusted through the
social security system. For example, the amount of transfer
payments could be increased if the government wanted to
adopt of a more expansionary fiscal policy.
 Tax policy should have four attributes:
 Simplicity
 Efficiency
 Fairness
 Revenue efficiency

Fiscal Deficit
 A budget deficit is an indicator of the fiscal stance. It occurs
when government expenditure exceeds government receipts.
 A budget deficit differs from a balanced budget and budget
surplus.
 Budget deficits occur when tax collection is lower, and
government spending is high.
 A fiscal deficit can be financed by borrowing by the
government.

Should We Be Concerned With a
Budget Deficit – Arguments For and
Against
 The quality of growth in an economy is important.
 In the case of good growth, a fiscal deficit is not necessarily
bad.
 However, large and consistent fiscal deficits may not be good
for an economy in the long run as they may result in significant
fiscal debt balances.

Difficulties in Implementation
 Aggregate demand cannot be controlled completely by fiscal
policy.
 The effectiveness of Fiscal Policy can also be impacted by
policymaker’s lack of complete information about the
economy.
 Additionally, lags implementation may be due to:
 Recognition Lag - lags in data may cause a delay in action
 Action Lag - delay in taking action
 Impact Lag - late actions cause a late impact

Expansionary Fiscal Policy
 Expansionary fiscal policy is used to stimulate economic
growth.
 Results in aggregate expenditure and hence, increased
aggregate demand.
 Government spending increased (G).
 Decrease in taxes may also lead to higher C or I.
 Leads to larger budget deficit or smaller budget surplus.

Contractionary Fiscal Policy
 Contractionary fiscal policy is used to restrain the economy
during or in anticipation of an inflation-inducing business-
cycle.
 Results in a decrease in aggregate demand and aggregate
expenditure.
 Results in a decrease in government spending.
 Increase in taxes may reduce C and I spending.

Interaction of Monetary and Fiscal
Policy
 Both monetary and fiscal policies can be used to influence the
economy.
 Easy monetary policy/tight fiscal policy
 Easy monetary policy/easy fiscal policy
 Tight monetary policy/tight fiscal policy
 Tight monetary policy/easy fiscal policy

L1 flash cards economics (ss5)

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