1. ✔ Gross Domestic Output
  2. ✔ Aggregate Demand, Aggregate
  3. Supply, and Equilibrium Output
  4. ✔ Changes in Aggregate Output
  5. ✔ Business Cycles
  6. ✔ Unemployment and the Labor Force
  7. ✔ Inflation



Gross Domestic Output


Gross domestic product (GDP) measures total output in the
domestic economy. Nominal GDP, real GDP, and potential
GDP are three different measures of aggregate output.
Nominal GDP is the market value of all final goods and services
produced in the domestic economy in a one-year pe-
25



By this definition, (1) only output exchanged in a
market is included (do-it-yourself services such as cleaning your own
house are not included); (2) output is valued in its final form (output is in
its final form when no further alteration is made to the good which would
change its market value); and (3) output is measured using current-year
prices.

Because nominal GDPvalues are inflated by prices that increase over
time, aggregate output is also measured holding the prices of all goods
and services constant over time. This valuation of GDPat constant prices
is called real GDP.

The third measure of aggregate output is potential GDP, the maximum
production that can take place in the domestic economy without
putting upward pressure on the general level of prices. Conceptually, potential
GDP represents a point on a given production-possibility frontier.

The U.S. economy’s potential output increases at a fairly steady rate
each year while actual real GDP fluctuates around potential GDP. These
fluctuations of real GDP are identified as business cycles. The GDP gap
is the difference between potential GDPand real GDP; it is positive when
potential GDP exceeds real GDP and negative when real GDP exceeds
potential GDP. A positive gap indicates that there are unemployed resources
and the economy is operating inefficiently within its productionpossibility
frontier. It therefore follows that an economy’s rate of unemployment
rises as its GDP gap increases, and falls when the gap declines.
An economy is operating above its normal productive capacity when
there is a negative gap.

Aggregate Demand, Aggregate Supply,
and Equilibrium Output

The economy’s equilibrium level of output occurs at the point of intersection
of aggregate supply and aggregate demand. In microeconomics,
equilibrium price exists where quantity demanded equals quantity supplied.
The supply and demand schedules in macroeconomics differ in that
they relate the aggregate quantity supplied and the aggregate quantity demanded
to the price level.

An aggregate demand curve represents the collective spending of
consumers, businesses, and government, as well as net foreign purchases
of goods and services, at different price levels. An aggregate demand
curve, like the demand curve in microeconomics, is negatively related to
price, holding constant other factors that influence aggregate spending
decisions.
Price, presented as price level in macroeconomics, affects aggregate
spending because of an interest rate effect, a wealth effect, and an international
purchasing power effect. The interest rate
effect traces the effect that interest rate levels have
upon aggregate spending. The nominal rate of interest
is directly related to the price level, ceteris
paribus. Increases in the price level push up interest
rates, which usually will depress interest-sensitive
spending. The wealth effect relates changes in
wealth to changes in aggregate spending. The market
value of many financial assets falls as price level
and interest rates increase. Ahigher price level will decrease the household
sector’s net wealth, lower consumer spending, and cause lower
aggregate spending. Acountry’s imports and exports are also affected by
a changing price level, i.e., by an international purchasing power effect.
When the price level increases in the home country and is unchanged in
foreign countries, foreign-made commodities become relatively less expensive,
the home country’s exports fall, its imports increase, and there
is less aggregate spending on the home country’s output.
An aggregate demand curve shifts when there is a change in a variable
(other than price level) that affects aggregate spending decisions.
Outward shifts (to the right) occur when consumers become more willing
to spend or there are increases in investment spending, government
expenditures, and net exports. Determinants of these factors will be taken
up in the next chapter.
CHAPTER 3: Unemployment, Inflation, and Income 27
An aggregate supply schedule depicts the relationship of aggregate
output and price level, holding constant other variables that could affect
supply. There is some disagreement among economists on the shape of
the aggregate supply curve. Three distinct curves can characterize this
disagreement. The Keynesian aggregate supply curve is horizontal until
it reaches the economy’s full-employment level of output, at which point
it becomes positively sloped. Others view the aggregate supply curve as
always being positively sloped. The classical aggregate supply curve is
vertical at the full-employment level, indicating there is no relationship
between aggregate output and the price level.
Changes in economy-wide resource availability, resource cost, and
technology shift the aggregate supply curve. The aggregate supply curve
shifts rightward when (1) improved technology increases the potential
output of a given quantity of resources; (2) the quantity of economic resources
increases; or (3) the cost of resources declines.


Changes in Aggregate Output

The effect of changes in aggregate demand and/or aggregate supply upon
equilibrium output and the price level depends upon the shape of the aggregate
supply curve. With a Keynesian aggregate supply curve, an increase
in aggregate demand affects only output as long as the economy
is below full-employment output, whereas an increase in aggregate supply
has no effect upon either the price level or output. Increases in aggregate
demand and/or aggregate supply affect both the price level and
real output when aggregate supply is positively sloped, as can be seen in
Figure 3-1. For a classical aggregate supply curve, increases in aggregate
demand result in only a higher price level, whereas increases in aggregate
supply result in a higher level of output and a lower price level.

Equilibrium real output is y1 and the price level is p1 for aggregate supply
and aggregate demand curves AS and AD in Figure 3-1. Increased
government spending shifts the aggregate demand curve outward to AD,
and the point of equilibrium changes from E1 to E2. Equilibrium output
increases from y1 to y2 as the price level rises from p1 to p2.

Business Cycles


Abusiness cycle is a cumulative fluctuation in aggregate output that lasts
for some time. Although recurrent, the duration and intensity of each fluctuation
varies. Points at which aggregate output changes direction are
marked by peaks and troughs. A peak is a point which marks the end of
economic expansion (rising aggregate output) and the beginning of a recession
(decline in economic activity). A trough marks the end of a re-
Figure 3-1
cession and the beginning of economic recovery.
The time span between troughs and peaks is classified
as an expansionary period (trough to peak) or
a contractionary period (peak to trough).
There are a number of explanations for the cyclical behavior of aggregate
output. The central focus of many of these theories is investment
spending and consumer purchases of durable goods. These expenditures
consist of large-ticketed items whose purchase, in most cases, can be
postponed. For example, an individual can repair an existing car rather
than purchase a new one. Thus, purchases of such items occur when credit
(borrowing) is more readily available or less costly, individuals are
more optimistic about the future, and/or cash flows are more certain.
However no one theory is able to explain why some business cycles are
more severe than others. This suggests that there are numerous causes and
that the importance of each cause varies.

Unemployment and the Labor Force



The U.S. labor force does not include the entire population but only those
who are at least 16 years old, employed, or unemployed and looking for
work. A working-age person who is not looking for work is considered
voluntarily unemployed and is not included in the labor force. Thus, the
size of the labor force and the number of people unemployed can be understated
when a significant number of workers, after some searching, become
discouraged and stop looking for work.
The unemployment rate is the percent of the total labor force that is
unemployed. Unemployment arises for frictional, structural, and cyclical
reasons. Frictional unemployment is temporary and occurs when a person
(1) quits a current job before securing a new one, (2) is not immediately
hired when entering the labor force, or (3) is let go by a dissatisfied
employer. Workers who lose their jobs due to a change in the demand for
a particular commodity or because of technological advance are structurally
unemployed; their unemployment normally lasts for a longer
period since they usually possess specialized skills which are not demanded
by other employers. Cyclical unemployment is the result of insufficient
aggregate demand. Workers have the necessary skills and are
available to work, but there are insufficient jobs because of inadequate
aggregate spending. Cyclical unemployment occurs when real GDP falls
below potential GDP.

Inflation


A price index relates prices in a specific year, month, or quarter to prices
during a reference period. For example, the consumer price index (CPI),
the most frequently quoted price index, relates the prices that urban consumers
paid for a fixed basket of approximately 400 goods and services

in a given month to the prices that existed during a
reference period. The producer price index (PPI) and
GDP deflator are the other two major price indexes.
The PPI measures the prices for finished goods, intermediate
materials, and crude materials at the
wholesale level. Because wholesale prices are eventually
translated into retail prices, changes in the PPI are usually a good
predictor of changes in the CPI. The GDP deflator is the most comprehensive
measure of the price level since it measures prices for net exports,
investment, and government expenditures, as well as for consumer
spending.
Inflation is the annual rate of increase in the price level. Disinflation
is a term used to denote a slowdown in the rate of inflation; deflation exists
when there is an annual rate of decrease in the price level. While there
have been some monthly decreases in the price level, the U.S. economy
has not experienced deflation since the 1930s


Economists identify two distinct causes of inflation. Demand-pull inflation
is inflation that occurs when aggregate spending exceeds the economy’s
normal full-employment level of output, i.e., when aggregate demand
is pushed too far to the right along a given aggregate supply curve.
Demand-pull inflation is normally characterized by both a rising price
and output level. It often results in an unemployment rate lower than the
natural rate. Cost-push inflation originates from increases in the cost of
producing goods and services, such as wages or the prices of raw materials.
Aggregate supply is pushed to the left, which is referred to as
stagflation. It is associated with increases in the price level, decreases in
aggregate output, and an increase in the unemployment rate above the
natural rate.
Inflation can slow economic growth, redistribute income and wealth,
and cause economic activity to contract. Inflation impairs decision making
since it creates uncertainty about future prices and/or costs and
distorts economic values. For example, a business may postpone the purchase
of equipment because of increasing uncertainty about the purchasing
power of future money streams. Such postponed capital outlays slow
capital formation and economic growth.