EC108 Notes
L1: How to define aggregate output: Aggregate means total. Output means production.
The measure of aggregate output is called Gross Domestic Product. GDP
Intermediate goods are goods used in the production of another good and they are
excluded from the counting of GDP.
1. GDP is the value of final goods and services produced in the economy during a given
period.
2. GDP is the sum of value added in the economy during a given period. The value
added by a firm is the value of its production minus the value of the intermediate
goods used in production
3. GDP is the sum of incomes in the economy during a given period
Aggregate production and aggregate income are always equal.
Understand the distinction between real and nominal variables: Nominal GDP is the sum of
the quantities of final goods produced multiplied by their current price. Also called dollar
GDP or GDP in current dollars.
Real GDP is the sum of quantities of final goods multiplied by constant prices (taken out the
effects of inflation). Also called GDP in terms of goods, GDP in constant dollars, GDP
adjusted for inflation or GDP in 2009 (e.g.) dollars
The year used to construct prices when calculating real prices is called the base year.
Yt denotes real GDP in year t
Real GDP growth in year t is (Y t −Y t −1)/ Y t−1
Nominal GDP will be denoted by a dollar sign in front of them as that suggests everything is
measured in current prices e.g. $Yt
Measuring GDP is difficult: The quality of products is changing over time e.g. computers.
But, the approach used to adjust for improvements is called hedonic pricing – it looks at
specific characteristics of products, and then compares the change in the output by fixing
the characteristics of the computers.
New products are a problem e.g. Skype – free service which implies a reduction in GDP
Measuring illegal production is difficult e.g. prostitution (and it may be legal in some
countries so hard to compare)
Home production is normally excluded from GDP – only household services are included.
Unemployment: Employment is the number of people who have a job
Unemployment is the number of people who do not have a job but are looking for one
The labour force is the sum of employment and unemployment
The unemployment rate is the ratio of the number of people who are unemployed to the
number of people in the labour force.
The US Current Population Survey (CPS) relies on interviews of 60,000 households every
month to calculate unemployment rate. A person is unemployed if he or she does not have
a job and has been looking for a job in the last four weeks. Those who do not have a job and
are not looking for one are counted as not in the labour force.
Discouraged workers are those who give up looking for a job and so are no longer counted
as unemployed
,The participation rate is the ratio of the labour force to the total
population of working age (between 18 and 65)
Results of the German Socio-Economic Panel survey suggest
that becoming unemployed leads to a large decrease in
happiness, happiness declines before the actual unemployment
spell and happiness does not fully recover even four years later.
Inflation: is a sustained rise in the price level
The inflation rate is the rate at which the price level increases
Deflation is a sustained decline in the price level (negative inflation rates)
The GDP deflator in year t (Pt) is the ratio of nominal GDP to real GDP in year t
Nominal GD P t $ Y t
Pt = =
Real GD Pt Yt
( Pt −Pt−1 )
The rate of change = the rate of inflation: π t =
Pt−1
Therefore, Nominal GDP is equal to the GDP deflator times real GDP: $ Y t =P t Y t
The rate of growth of nominal GDP is equal to the rate of inflation plus the rate of growth of
real GDP
However, the set of goods produced in the economy is not the same as the set of goods
purchased by consumers – this means that GDP deflator includes some goods which are not
relevant to consumers. For example, consumers may import, and governments may
exclusively buy some goods – such as war planes
The Consumer Price Index (CPI) is a measure of the cost of living (and of the cost of the
consumption basket of a typical consumer).
Inflation affects income distribution when not all prices and wages rise proportionally and
inflation leads to distortions due to uncertainty, and because of its interaction with taxation
(bracket creep in taxes).
,L2: Composition of GDP (open/closed economy):
In a closed economy, GDP = total production = total income
GDP is made up of: Consumption (C): goods and services purchased by consumers
Investment (I): the sum of non-residential (e.g. machinery) and residential (housing) invest.
Government spending (G): spending by government excluding govt. transfers e.g.
unemployment benefits
Exports (X): purchases of national goods and services by foreigners
Imports (IM): purchases of foreign goods and services by nationals
Net exports or trade balance: X – IM: Exports > Imports = trade surplus
Inventory investment: difference between production and sales
Note: consumption is biggest part of GDP – 70% of US GDP
The Demand for Goods: Z ≡C + I + G+ X−ℑ
In a closed economy: X =ℑ=0 Therefore, Z ≡C + I + G
The symbol “≡” means that an equation is an identity, or definition
Consumption is a function of disposable income YD which is the income left over after
government transfers and taxes. C(YD) is called the consumption function
Keynesian consumption function (and the marginal propensity to consume): C = c0 + c1YD
C1 is the MPC, (1st derivative of consumption with respect to disposable income), or the
effect of an additional dollar of disposable income on consumption with 0 < c 1 < 1
C0 is what people would consume if their disposable income equals zero with c0 > 0
YD (disposable income) ≡Y −T where Y = income and T = taxes minus govt. transfers
Replacing YD in the original equation gives: C = c0 + c1(Y −T )
Endogenous versus exogeneous variables: Endogenous variables: variables depend on
other variables in the model
Exogenous variables: variables not explained within the model but are instead taken as
given e.g. exogenous investment is written as I
G and T are exogenous as they are typically treated as variables chosen by the government
and will not try to explain them within the model. They will always be exogenous so do not
need a bar over them when writing out the equations.
Equilibrium output (demand equals supply): Assume closed economy – X = IM = 0, so:
Z ≡C + I + G→ Z=c 0+ c 1 ( Y −T ) + I +G
Equilibrium in the goods market requires Y = Z which is an equilibrium condition. This is
because demand for goods is equal to the production of goods in equilibrium. Therefore,
Y =c 0+ c 1 ( Y −T ) + I +G
In equilibrium therefore, production (Y) is equal to demand, which in turn depends on
income (Y), which is itself equal to production. The above equation then reorganises to:
1
Y= [c + I +G−c 1 T ] which characterises equilibrium output in algebra
1−c1 0
Autonomous spending [c 0+ I +G−c 1 T ]is the part of the demand for goods that does not
depend on output. Autonomous spending is positive because if T = G (balanced budget) and
c1 is between 0 and 1, then (G – c1T) is positive, and so is autonomous spending
, 1
The multiplier of aggregate demand: The term is the multiplier, which is larger than 1
1−c 1
as 0 < c1 < 1. The multiplier is larger when c1 is closer to 1.
The Determination of Equilibrium Output: To characterise the equilibrium graphically:
Plot production as a function of income. Because production equals income, their
relation is the 45 degree line.
Plot demand as a function of income: Z = [ c 0 + I +G−c 1 T ] +c 1 Y .Sometimes the
demand line is labelled as ZZ, as demand depends on income
In equilibrium, production equals demand
An increase in autonomous spending will shift the ZZ line parallel upwards
with a higher y intercept. It has a more than one for one effect on
equilibrium output due to the multiplier effect.
As you can see in the diagram, the total increase in production after n + 1
rounds is: 1 + c 1 +c 21+ …+c n1 which is a geometric series with a limit of
1/(1-c1) i.e. the multiplier (which depends on MPC)
The adjustment of output over time is called the dynamics of adjustment.
How long the adjustment takes depends on how and when firms revise their production
schedule.
Investment equals savings: John Maynard Keynes said that investment equals savings.
Private saving (S) is: S ≡Y D−C∨S ≡Y −T −C
By definition, public saving = T – G
Public saving > 0 ⇔ Budget surplus
Pubic saving ¿ 0 ⇔ Budget deficit
In equilibrium: Y=C+I+G
Subtracting T from both sides and move C to the left: Y – T – C = I + G – T
Using the identity above: S=I+G–T
Or equivalently: I = S + (T – G)
Therefore, investment equals savings (in the whole economy). Known as the IS relation.
(1 – c1) is called the marginal propensity to save.
We can also derive the previous equation from the above equation:
S=Y −T −C → S=Y −T −c 0−c1 ( Y −T ) → S=−c 0 +(1−c 1)(Y −T )
In equilibrium, I = S + (T – G), so: I =−c 0 + ( 1−c 1 ) ( Y −T )+ (T −G )
1
Solving for output: Y = [c + I +G−c 1 T ]
1−c1 0
So, there are two equivalent ways of stating the condition for equilibrium in the goods
market: Production = Demand and Investment = Saving
L1: How to define aggregate output: Aggregate means total. Output means production.
The measure of aggregate output is called Gross Domestic Product. GDP
Intermediate goods are goods used in the production of another good and they are
excluded from the counting of GDP.
1. GDP is the value of final goods and services produced in the economy during a given
period.
2. GDP is the sum of value added in the economy during a given period. The value
added by a firm is the value of its production minus the value of the intermediate
goods used in production
3. GDP is the sum of incomes in the economy during a given period
Aggregate production and aggregate income are always equal.
Understand the distinction between real and nominal variables: Nominal GDP is the sum of
the quantities of final goods produced multiplied by their current price. Also called dollar
GDP or GDP in current dollars.
Real GDP is the sum of quantities of final goods multiplied by constant prices (taken out the
effects of inflation). Also called GDP in terms of goods, GDP in constant dollars, GDP
adjusted for inflation or GDP in 2009 (e.g.) dollars
The year used to construct prices when calculating real prices is called the base year.
Yt denotes real GDP in year t
Real GDP growth in year t is (Y t −Y t −1)/ Y t−1
Nominal GDP will be denoted by a dollar sign in front of them as that suggests everything is
measured in current prices e.g. $Yt
Measuring GDP is difficult: The quality of products is changing over time e.g. computers.
But, the approach used to adjust for improvements is called hedonic pricing – it looks at
specific characteristics of products, and then compares the change in the output by fixing
the characteristics of the computers.
New products are a problem e.g. Skype – free service which implies a reduction in GDP
Measuring illegal production is difficult e.g. prostitution (and it may be legal in some
countries so hard to compare)
Home production is normally excluded from GDP – only household services are included.
Unemployment: Employment is the number of people who have a job
Unemployment is the number of people who do not have a job but are looking for one
The labour force is the sum of employment and unemployment
The unemployment rate is the ratio of the number of people who are unemployed to the
number of people in the labour force.
The US Current Population Survey (CPS) relies on interviews of 60,000 households every
month to calculate unemployment rate. A person is unemployed if he or she does not have
a job and has been looking for a job in the last four weeks. Those who do not have a job and
are not looking for one are counted as not in the labour force.
Discouraged workers are those who give up looking for a job and so are no longer counted
as unemployed
,The participation rate is the ratio of the labour force to the total
population of working age (between 18 and 65)
Results of the German Socio-Economic Panel survey suggest
that becoming unemployed leads to a large decrease in
happiness, happiness declines before the actual unemployment
spell and happiness does not fully recover even four years later.
Inflation: is a sustained rise in the price level
The inflation rate is the rate at which the price level increases
Deflation is a sustained decline in the price level (negative inflation rates)
The GDP deflator in year t (Pt) is the ratio of nominal GDP to real GDP in year t
Nominal GD P t $ Y t
Pt = =
Real GD Pt Yt
( Pt −Pt−1 )
The rate of change = the rate of inflation: π t =
Pt−1
Therefore, Nominal GDP is equal to the GDP deflator times real GDP: $ Y t =P t Y t
The rate of growth of nominal GDP is equal to the rate of inflation plus the rate of growth of
real GDP
However, the set of goods produced in the economy is not the same as the set of goods
purchased by consumers – this means that GDP deflator includes some goods which are not
relevant to consumers. For example, consumers may import, and governments may
exclusively buy some goods – such as war planes
The Consumer Price Index (CPI) is a measure of the cost of living (and of the cost of the
consumption basket of a typical consumer).
Inflation affects income distribution when not all prices and wages rise proportionally and
inflation leads to distortions due to uncertainty, and because of its interaction with taxation
(bracket creep in taxes).
,L2: Composition of GDP (open/closed economy):
In a closed economy, GDP = total production = total income
GDP is made up of: Consumption (C): goods and services purchased by consumers
Investment (I): the sum of non-residential (e.g. machinery) and residential (housing) invest.
Government spending (G): spending by government excluding govt. transfers e.g.
unemployment benefits
Exports (X): purchases of national goods and services by foreigners
Imports (IM): purchases of foreign goods and services by nationals
Net exports or trade balance: X – IM: Exports > Imports = trade surplus
Inventory investment: difference between production and sales
Note: consumption is biggest part of GDP – 70% of US GDP
The Demand for Goods: Z ≡C + I + G+ X−ℑ
In a closed economy: X =ℑ=0 Therefore, Z ≡C + I + G
The symbol “≡” means that an equation is an identity, or definition
Consumption is a function of disposable income YD which is the income left over after
government transfers and taxes. C(YD) is called the consumption function
Keynesian consumption function (and the marginal propensity to consume): C = c0 + c1YD
C1 is the MPC, (1st derivative of consumption with respect to disposable income), or the
effect of an additional dollar of disposable income on consumption with 0 < c 1 < 1
C0 is what people would consume if their disposable income equals zero with c0 > 0
YD (disposable income) ≡Y −T where Y = income and T = taxes minus govt. transfers
Replacing YD in the original equation gives: C = c0 + c1(Y −T )
Endogenous versus exogeneous variables: Endogenous variables: variables depend on
other variables in the model
Exogenous variables: variables not explained within the model but are instead taken as
given e.g. exogenous investment is written as I
G and T are exogenous as they are typically treated as variables chosen by the government
and will not try to explain them within the model. They will always be exogenous so do not
need a bar over them when writing out the equations.
Equilibrium output (demand equals supply): Assume closed economy – X = IM = 0, so:
Z ≡C + I + G→ Z=c 0+ c 1 ( Y −T ) + I +G
Equilibrium in the goods market requires Y = Z which is an equilibrium condition. This is
because demand for goods is equal to the production of goods in equilibrium. Therefore,
Y =c 0+ c 1 ( Y −T ) + I +G
In equilibrium therefore, production (Y) is equal to demand, which in turn depends on
income (Y), which is itself equal to production. The above equation then reorganises to:
1
Y= [c + I +G−c 1 T ] which characterises equilibrium output in algebra
1−c1 0
Autonomous spending [c 0+ I +G−c 1 T ]is the part of the demand for goods that does not
depend on output. Autonomous spending is positive because if T = G (balanced budget) and
c1 is between 0 and 1, then (G – c1T) is positive, and so is autonomous spending
, 1
The multiplier of aggregate demand: The term is the multiplier, which is larger than 1
1−c 1
as 0 < c1 < 1. The multiplier is larger when c1 is closer to 1.
The Determination of Equilibrium Output: To characterise the equilibrium graphically:
Plot production as a function of income. Because production equals income, their
relation is the 45 degree line.
Plot demand as a function of income: Z = [ c 0 + I +G−c 1 T ] +c 1 Y .Sometimes the
demand line is labelled as ZZ, as demand depends on income
In equilibrium, production equals demand
An increase in autonomous spending will shift the ZZ line parallel upwards
with a higher y intercept. It has a more than one for one effect on
equilibrium output due to the multiplier effect.
As you can see in the diagram, the total increase in production after n + 1
rounds is: 1 + c 1 +c 21+ …+c n1 which is a geometric series with a limit of
1/(1-c1) i.e. the multiplier (which depends on MPC)
The adjustment of output over time is called the dynamics of adjustment.
How long the adjustment takes depends on how and when firms revise their production
schedule.
Investment equals savings: John Maynard Keynes said that investment equals savings.
Private saving (S) is: S ≡Y D−C∨S ≡Y −T −C
By definition, public saving = T – G
Public saving > 0 ⇔ Budget surplus
Pubic saving ¿ 0 ⇔ Budget deficit
In equilibrium: Y=C+I+G
Subtracting T from both sides and move C to the left: Y – T – C = I + G – T
Using the identity above: S=I+G–T
Or equivalently: I = S + (T – G)
Therefore, investment equals savings (in the whole economy). Known as the IS relation.
(1 – c1) is called the marginal propensity to save.
We can also derive the previous equation from the above equation:
S=Y −T −C → S=Y −T −c 0−c1 ( Y −T ) → S=−c 0 +(1−c 1)(Y −T )
In equilibrium, I = S + (T – G), so: I =−c 0 + ( 1−c 1 ) ( Y −T )+ (T −G )
1
Solving for output: Y = [c + I +G−c 1 T ]
1−c1 0
So, there are two equivalent ways of stating the condition for equilibrium in the goods
market: Production = Demand and Investment = Saving
