Measuring Macroeconomic Performance and the AD/AS Model

Measuring Macroeconomic Performance

Gross Domestic Product (GDP)

Gross Domestic Product (GDP) is the market value of all final goods and services produced within a country in a given time period. It is a key indicator of a nation's economic activity and performance.

• Market value: The prices at which items are traded in markets.

• Final goods and services: Goods bought by the final user during a specified period. Intermediate goods are used as inputs in the production of final goods and are not counted separately in GDP.

• Produced within a country: Only goods and services produced domestically are included.

• In a given time period: GDP measures production within a specific period, such as a quarter or a year.

GDP can be measured by the total income earned producing GDP or the total expenditure on GDP. The equality between these values is crucial for understanding the relationship between productivity and living standards.

Methods of Measuring GDP

• The Expenditure Approach: Sums all expenditures on final goods and services. The formula is:

$Y = C + I + G + (X - M)$

• C: Personal consumption expenditures

• I: Gross private domestic investment

• G: Government expenditure on goods and services

• X - M: Net exports (exports minus imports)

• The Income Approach: Sums all incomes earned by factors of production (wages, interest, rent, profit). Adjustments are made for indirect taxes, subsidies, and depreciation to arrive at GDP.

Nominal and Real GDP

• Nominal GDP: The value of final goods and services produced in a given year, valued at current year prices.

• Real GDP: The value of final goods and services produced in a given year, valued at the prices of a reference base year.

• GDP Deflator: Measures the price level relative to the base year:

$\text{GDP Deflator} = \frac{\text{Nominal GDP}}{\text{Real GDP}} \times 100$

The Uses and Limitations of Real GDP

• Comparing living standards over time: Real GDP per person is used to compare the value of goods and services available to the average person over different years.

• Comparing living standards across countries: Requires converting GDP to a common currency and adjusting for purchasing power parity (PPP).

• Potential GDP: The maximum level of real GDP that can be produced while avoiding shortages of labor, capital, land, and entrepreneurship.

• Limitations: Real GDP does not account for household production, underground economic activity, leisure time, or environmental quality.

Real GDP per person:

$\text{Real GDP per person} = \frac{\text{Real GDP}}{\text{Population}}$

Alternative Measures of Economic Activity

• Net Economic Welfare (NEW): Adjusts GDP for factors affecting well-being, such as leisure and environmental damage.

• Happy Planet Index (HPI): Measures human well-being and environmental impact.

• Human Development Index (HDI): Combines life expectancy, education, and income per capita.

• Genuine Progress Indicator (GPI): Adjusts GDP for positive and negative social and environmental factors.

The Aggregate Demand and Aggregate Supply (AD/AS) Model

The Aggregate Demand (AD)

The aggregate demand curve shows the relationship between the price level and the quantity of real GDP demanded by households, businesses, government, and foreigners.

• Formula:

$Y = C + I + G + (X - M)$

• Determinants: The price level, expectations, fiscal and monetary policy, and the world economy.

• Wealth effect: Higher price levels reduce real wealth and decrease consumption.

• Substitution effect: Higher price levels lead to higher interest rates, reducing investment and consumption.

The Aggregate Supply (AS)

The aggregate supply curve shows the relationship between the price level and the quantity of real GDP supplied.

• Short-run Aggregate Supply (SRAS): The relationship when the money wage rate and other input prices are fixed. The SRAS curve slopes upward.

• Long-run Aggregate Supply (LRAS): The relationship when the money wage rate adjusts to maintain full employment. The LRAS curve is vertical at potential GDP.

• Determinants: Quantity of labor, capital, human capital, technology, and the money wage rate.

Shifts in Aggregate Supply

• Changes in potential GDP: Increases in labor, capital, or technology shift both SRAS and LRAS rightward.

• Changes in the money wage rate: Affect SRAS but not LRAS.

AD/AS Model and Macroeconomic Equilibrium

Purpose of the AD/AS Model

The AD/AS model explains changes in real GDP and the price level, and is used to analyze business cycle fluctuations, economic growth, and inflation trends.

• Equilibrium: Occurs where the AD and AS curves intersect.

• Short-run equilibrium: The money wage rate is fixed; real GDP can be above or below potential GDP.

• Long-run equilibrium: The money wage rate adjusts; real GDP equals potential GDP.

Fluctuations in Aggregate Demand and Supply

• Increase in AD: Raises real GDP and the price level in the short run; in the long run, the money wage rate rises and real GDP returns to potential GDP.

• Decrease in AS: Causes stagflation (recession and inflation) as real GDP falls and the price level rises.

Macroeconomic Schools of Thought

Classical View

• Economy is self-regulating and tends toward full employment.

• Technological change is the main driver of growth.

• Money wage rate is flexible; real GDP quickly returns to potential GDP.

• Taxes should be minimized to avoid inefficiency.

Keynesian View

• Economy may not always operate at full employment.

• Active fiscal and monetary policy are needed to achieve full employment.

• Expectations are crucial for aggregate demand.

• Money wage rate is sticky in the short run.

Monetarist View

• Economy is self-regulating if the money supply grows steadily.

• Monetary policy is the main influence on aggregate demand.

• Money wage rate is sticky in the short run.

• Taxes should be kept low to avoid reducing potential GDP.