Aggregate Expenditure, GDP, Inflation, and AD-AS: Core Macroeconomics Study Notes

The Measurement of National Income

Nominal and Real GDP

Gross Domestic Product (GDP) measures the total value of goods and services produced in an economy. It can be calculated in nominal or real terms:

• Nominal GDP: Calculated using current prices and quantities for each year.

• Real GDP: Calculated using current quantities but base-year prices, removing the effect of inflation.

Example Calculation:

Year	Fur Coats (Q)	Fur Coat Price	Sunscreen (Q)	Sunscreen Price
2017 (base)	10	$15	80	$5
2018	20	$30	60	$10
2019	30	$50	40	$20

• Nominal GDP (2018): $$(GDP_{2018} = (20 \times 30) + (60 \times 10) = 600 + 600 = 1200)$$ Nominal GDP (2018) = $1200

• Real GDP (2019, base year 2017): $$(GDP_{2019}^{real} = (30 \times 15) + (40 \times 5) = 450 + 200 = 650)$$ Real GDP (2019 in 2017 dollars) = $650

Value-Added Method of GDP

• Value added = Value of output − Cost of intermediate goods

• This method prevents double counting in GDP calculation.

• Example: Farmer sells wheat ($2), baker makes bread ($5), store sells bread ($8):$$GDP = 2 + 3 + 3 = 8$$

GDP and Standard of Living

• Why GDP is a good measure:

  1. Higher GDP means more goods and services are available.

  2. GDP per capita reflects average income.

  3. GDP growth usually means more jobs and production.

• What GDP misses:

  • Environmental quality

  • Unpaid work

  • Income inequality

  • Leisure time

  • Health and happiness

The Measurement of Inflation

Consumer Price Index (CPI) and Inflation Rate

• CPI measures the average price level of a basket of goods and services consumed by households.

• Inflation rate formula: $$(\text{Inflation rate} = \frac{CPI_t - CPI_{t-1}}{CPI_{t-1}} \times 100)$$

• Finding missing CPI: $$(CPI_t = CPI_{t-1} \times (1 + \text{inflation}))$$

Year	CPI	Inflation %
2010	116.5	1.8
2011	119.9	2.9
2012	121.6	1.4
2013	123.1	1.2
2014	125.7	2.1
2015	126.6	0.7
2016	128.4	1.4
2017	130.4	1.6
2018	132.7	1.8
2019	136.0	2.5
2020	137.0	0.7

• Example calculation: 2012 inflation: $$(\frac{121.6 - 119.9}{119.9} \times 100 = 1.4\%)$$

• Adjusting values for inflation: $$(\text{Value in new-year dollars} = \text{Old value} \times \frac{CPI_{\text{new year}}}{CPI_{\text{old year}}})$$ e.g., $30,000 in 1993 ≈ $49,626 in 2021 dollars.

Aggregate Expenditure (AE) Model

Components of Aggregate Expenditure

• AE equation: $$(AE = C + I + G + NX)$$ Where:

  • C = Consumption

  • I = Investment

  • G = Government spending

  • NX = Net exports (exports − imports)

Classification Examples

Transaction	AE Category
Nestle buys equipment	Investment (I)
Books added to inventory	Investment (I)
Government buys materials for park	Government (G)
Family buys hamburgers	Consumption (C)
American pays for hotel in Banff	Net Exports (NX)

AE Function: Slope and Intercept

• Slope of AE: Marginal propensity to spend out of national income. $$(z = MPC(1 - t) - m)$$ Where:

  • MPC = marginal propensity to consume

  • t = tax rate

  • m = marginal propensity to import

• Intercept of AE: Autonomous spending (spending when income is zero): $$(AE = C_0 + I + G + X - MPC(T_0))$$

• Graph axes:

  • Vertical: Aggregate Expenditure (AE)

  • Horizontal: National Income (Y)

Equilibrium in the AE Model

• Equilibrium condition: $$(AE = Y)$$ Where planned spending equals output.

• Inventory adjustment:

  • If AE > Y: Inventories fall, production rises.

  • If AE < Y: Inventories rise, production falls.

  • If AE = Y: Equilibrium.

Marginal Propensity to Consume (MPC) and Save (MPS)

• MPC: Fraction of additional income spent on consumption. $$(MPC = \frac{\Delta C}{\Delta Y})$$

• MPS: Fraction of additional income saved. $$(MPS = 1 - MPC)$$

Investment (I) in AE

• Includes business equipment, buildings, and inventories (not stocks/bonds).

• Determined by expected rate of return, business expectations, technology, operating costs, capital stock, and interest rates.

• More volatile than consumption due to lumpiness and sensitivity to expectations.

Net Exports (NX) in AE

• Imports (IM): $$(IM = mY)$$ Endogenous (depends on national income).

• Exports (X): Exogenous (determined by foreign demand, exchange rates).

• Net exports: $$(NX = X - mY)$$

• Currency appreciation: Increases imports (IM).

• When NX = 0: $$(X = mY \implies Y = \frac{X}{m})$$

The Multiplier

• Multiplier formula: $$(\text{Multiplier} = \frac{1}{1 - z})$$ Where z is the marginal propensity to spend.

• Change in equilibrium income: $$(\Delta Y = \text{Multiplier} \times \Delta I)$$

• If saving increases (MPC falls), multiplier and equilibrium income fall (paradox of thrift).

Fiscal Policy and Output Gaps

• Tax reductions vs spending increases: Tax cuts have a smaller effect than direct spending increases because part of tax cuts is saved.

• Budget definitions:

  • Balanced: $T = G$

  • Deficit: $G > T$

  • Surplus: $T > G$

• Recessionary gap: $AE < Y_{full}$; fix with expansionary policy (increase G, decrease T, increase I or X).

• Inflationary gap: $AE > Y_{full}$; fix with contractionary policy (decrease G, increase T, reduce I or X).

Summary of the AE Model

• AE equation: $AE = C + I + G + (X - IM)$

• Slope: $z = MPC(1 - t) - m$

• Multiplier: $\frac{1}{1 - z}$

• Equilibrium: $AE = Y$

Aggregate Demand and Aggregate Supply (AD-AS) Model

Aggregate Demand (AD)

• AD equation: $AD = C + I + G + (X - M)$

• Why AD slopes downward:

  1. Wealth effect: Lower prices increase real wealth, boosting consumption.

  2. Interest-rate effect: Lower prices reduce money demand, lowering interest rates and increasing investment.

  3. International-trade effect: Lower domestic prices make exports more competitive, increasing net exports.

• Shifts in AD: Caused by changes in C, I, G, or (X − M) for reasons other than the price level (e.g., confidence, fiscal policy, foreign demand).

Aggregate Supply (AS)

• Short-Run AS (SRAS): Upward sloping due to sticky wages and input prices.

• Sticky wages: Wages and some input costs adjust slowly, so higher prices increase profits and output in the short run.

• Shifts in SRAS:

  • Right (increase): Lower input costs, higher productivity, better technology, lower taxes, higher subsidies, fewer regulations, lower inflation expectations.

  • Left (decrease): Higher input costs, lower productivity, worse technology, higher taxes, lower subsidies, more regulations, higher inflation expectations.

• Supply shock: Sudden change in production costs or productivity (e.g., oil price spike, natural disaster).

• Adjustment mechanism: In a recessionary gap, wages fall and SRAS shifts right; in an inflationary gap, wages rise and SRAS shifts left, returning the economy to equilibrium.

Long-Run Aggregate Supply (LRAS) and Potential Output (Y*)

• LRAS: Vertical at potential output (Y*), determined by resources, technology, and productivity.

• Short run: Y* is fixed; shocks shift SRAS.

• Long run: Changes in labour force, human capital, or technology shift LRAS and Y*.

Automatic Stabilizers

• Parts of the budget that automatically change with GDP, stabilizing the business cycle (e.g., progressive taxes, EI, welfare).

• During recession: Taxes fall, transfers rise, deficit increases, supporting demand.

• During boom: Taxes rise, transfers fall, deficit shrinks.

• Difference from discretionary policy: Automatic stabilizers work without new laws; discretionary policy requires government action.

• Stabilizers reduce the size of the multiplier and dampen economic swings.

Loanable Funds Market

Supply and Demand for Loanable Funds

• Supply: Household saving

• Demand: Business investment

• Interest rate: Adjusts to balance saving and investment

Event	Effect
Business optimism rises	Investment demand increases; interest rate rises
Business taxes increase	Investment demand decreases; interest rate falls
Tax-free saving limits rise	Saving supply increases; interest rate falls

Summary Table: AD-AS Events

Event	What changes	AD/AS Shift
Higher household expectations	C ↑	AD right
Better business expectations	I ↑	AD right
Domestic income grows faster than foreign	NX ↓	AD left
Canadian dollar appreciates	NX ↓	AD left
Minimum wage increase	Costs ↑	SRAS left
Productivity increase	Costs ↓	SRAS right
Export demand increase	NX ↑	Movement along AS (AD right)
Higher inflation expectations	Costs ↑	SRAS left

Key Formulas and Definitions

• Nominal GDP: $\sum (P_t \times Q_t)$

• Real GDP: $\sum (P_{base} \times Q_t)$

• Inflation rate: $\frac{CPI_t - CPI_{t-1}}{CPI_{t-1}} \times 100$

• Multiplier: $\frac{1}{1 - z}$

• AE Slope: $z = MPC(1 - t) - m$

• Marginal Propensity to Consume: $MPC = \frac{\Delta C}{\Delta Y}$

• Marginal Propensity to Save: $MPS = 1 - MPC$

• Imports: $IM = mY$

• Net Exports: $NX = X - mY$

• Equilibrium: $AE = Y$

Additional info: Where slides were fragmented or brief, standard macroeconomic context and definitions were added for completeness and clarity.