Economics: GDP and Economic Growth

Aggregates

• Aggregates are used to simplify the complex economy.
• They consider the total quantity and average price of goods and services.
• Helps understand the overall economic system.

Output (Y)

• Aggregate output (Y) is the total quantity of goods and services demanded.
• It is equivalent to the quantity in supply-demand diagrams.
• Measured primarily by Gross Domestic Product (GDP).

Gross Domestic Product (GDP)

• GDP measures a country's output, sales, income, and spending.
• GDP is calculated as the total value of all goods produced and sold, total income earned, and total spending on goods and services.
• Ideally, these measures would always yield the same result in calculation; however, this is not always the case.

Economic Growth

• Growth is the change in output over time.
• A recession is a decline in output lasting for two consecutive quarters.
• Growth is essential for maintaining a consistent standard of living and requires substantial exponential increase.

Price Level

• The average price of all goods and services is called the price level.
• Equivalent to the price in supply-and-demand diagrams, it is typically measured with a basket of commonly purchased goods.

Inflation

• Inflation is the rise in the general price level—meaning things are becoming more expensive.
• Deflation is a fall in prices.
• Disinflation is a fall in the rate of inflation.
• Inflation measures the increasing cost of goods and services.

Real vs. Nominal

• Real values account for changes in prices (inflation).
• Nominal values are the raw data, as reported.
• Nominal wages are what one earns, and real wage is the purchasing power of those earnings.
• When inflation is low, nominal and real values are similar; with high inflation, the real value is significantly lower, even as a nominal wage remains constant.

Why Inflation is Bad

• Erodes savings because the buying power of savings decreases.
• Transfers wealth from savers to borrowers, potentially causing excessive risk-taking.
• Transfers wealth from employees to employers, especially impacting those with low bargaining power.
• Disrupts market mechanisms and makes the economy less efficient.
• Affects wages, predominantly impacting low-wage workers.

Inflation Spiral

• Inflation can be self-perpetuating.
• Rising prices may lead to expectations of continued price increases, causing workers and businesses to demand higher compensation & subsequent price increases to cover those rising costs.
• These mechanisms create a cycle of escalating prices.
• Once an inflationary or deflationary trend starts, reversing it is often difficult and costly.

Fighting Inflation

• Central banks commonly combat inflation by raising interest rates.
• Rising interest rates increase borrowing costs, reducing demand and eventually curbing inflation.
• Higher interest rates can, however, lead to economic slowdown or recession.

Aggregate Demand and Supply

• Aggregate supply is the total value of all output produced.
• Aggregate demand is the total value spent by consumers, businesses, and the government on goods and services.
• Equilibrium exists where aggregate supply and aggregate demand intersect.
• Equilibrium output is equivalent to the GDP, and the equilibrium price level is measured using the market basket of goods.

Factors Affecting Inflation and Growth

• Changes in aggregate supply and demand cause shifts in prices and output.
• Decreased aggregate supply reduces output and raises prices, i.e., recessionary pressures.
• Increased aggregate demand increases prices and output (boom conditions)

Supply-Side Policies

• Designed to increase aggregate supply (output).
• Includes measures such as tax cuts, deregulation, labor market reforms, funding for education/training, infrastructure, and research/development, and trade liberalization.

Problems with Supply-Side Policies

• Frequently have distributional consequences, potentially affecting different groups differently.
• Implementation is often difficult and takes time.

Aggregate Demand Policies

• Used to manage the overall demand in an economy.
• Contractionary policies are used to lower inflation. Expansionary policies are used to reduce problems of economic recessions.

Fiscal Policy

• Government spending and taxation policies.
• Contractionary fiscal policies reduce demand; expansionary policies stimulate demand.

Monetary Policy

• Central bank actions to adjust interest rates to influence the money supply.
• Open Market Operations (OMOs) involve buying or selling government bonds to affect interest rates.
• Higher interest rates reduce aggregate demand.
• Lower interest rates increase aggregate demand.

Taylor Rule

• A guideline for central banks to set interest rates based on inflation and output goals.

Central Bank Credibility

• A central bank's reputation for fighting inflation is crucial in managing expectations.
• A strong reputation can make inflation more manageable.