READING NO.

16
AGGREGATE OUTPUT, PRICES, AND ECONOMIC GROWTH

Disclaimer: Certain materials contained within this text are the copyright property of CFA
Institute. The following is the source for these materials: “CFA® Program Curriculum
Level I Volume 2, Page No. 189 to 196”
READING NO. 16
AGGREGATE OUTPUT, PRICES, AND ECONOMIC GROWTH

LOS 16.a: Calculate and explain gross domestic product (GDP) using expenditure and income
approaches.
LOS 16.b: Compare the sum-of-value-added and value-of-final-output methods of calculating GDP.
 GDP: total value of all the goods and services produced in an economy over a period of time.
 Expenditure approach: total amount spent on the goods and services produced in the domestic economy
over a period of time.
 Income approach: total value of all payments earned by the suppliers of factors of production in an
economy over a period of time.

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Criteria for Inclusion in GDP
 Only goods and services produced during the measurement period are included.
 Transfer payments and income from capital gains are excluded.
 Only goods and services whose value can be determined by being sold in the market are included.
 The value of labor used in activities that are not sold in the market is excluded. Exception: owner-occupied
housing (equal to value of rental housing service) and services provided by the government such as services
provided by police, etc.
 Activities in the underground economy are not included.
 By-products of production, such as environmental damage, are not included in GDP.
 Only the value of final goods and services is included in the calculation of GDP. The value of
intermediate goods (that are resold to produce another good) is excluded because the entire value added
during the production process is reflected in the selling price of the final good produced (value-of-final-
output). GDP can also be measured by summing the value added at each stage of the production and
distribution processes (sum-of-value-added).

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LOS 16.c: Compare nominal and real GDP and
calculate and interpret the GDP deflator.
Nominal GDP = Quantity produced in Year t × Prices
in Year t
Real GDP = Quantity produced in Year t × Base-year
prices
GDP deflator =
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• [Example: Calculating and using the GDP deflator] GDP in 2019 is $1.50
billion at 2019 prices and $1.20 billion when calculated using 2018 prices.
Calculate the GDP deflator using 2018 as the base period.
• Nominal GDP was $117 billion in 2019 and $100 billion in 2014. The
2019 GDP deflator relative to the base year 2014 is 125. Calculate real
GDP for 2019 and the compound annual real growth rate of economic
output from 2014 to 2019.

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LOS 16.e: Explain the fundamental relationship among saving, investment,
the fiscal balance, and the trade balance.
C + I + G + (X-M) = C + S + T
or, (G-T) = (S-I) + (M-X)
or, fiscal deficit = excess of saving over investment + trade deficit

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LOS 16.d: Compare GDP, national income, personal income, and personal disposable
income.
GDP = National income + Capital consumption allowance + Statistical discrepancy
 National income equals the sum of incomes received by all factors of production used to
generate final output. It includes:
 Employee compensation
 Corporate and government enterprise profits before taxes
 Interest income
 Rent and unincorporated business net income (proprietor's income)
 Indirect business taxes less subsidies
 The capital consumption allowance (CCA) accounts for the wear and tear or depreciation that
occurs in capital stock during the production process.

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LOS 16.d: Compare GDP, national income, personal income, and personal disposable
income.
Personal income = National income − Indirect business taxes − Corporate income taxes −
Undistributed corporate profits + Transfer payments
Personal disposable income = Personal income – Personal taxes

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LOS 16.f: Explain the IS and LM curves and how they combine to generate the aggregate demand curve.
AD refers to the total value of final goods and services which all the sectors of an economy are planning to buy at a given level
of income during a period.
 AD is the aggregate expenditure that different sectors of the economy are willing to incur during a given period.
 The aggregate demand curve slopes downward because higher price levels reduce real wealth, increase real interest rates, and make
domestically produced goods more expensive compared to goods produced abroad, all of which reduce the quantity of domestic output
demanded.

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The aggregate demand (AD) curve shows the combinations of aggregate income and price level at which the following
conditions are satisfied:
 Planned expenditures equal actual (or realized) income/output: derive from IS curve
 There is equilibrium in the money market: derive from LM curve

Income savings (IS) curve is an graphical representation of real interest rates and real income, where aggregate expenditure and
aggregate income are equal.
 C +I + G + (X - M) = C + S + T
 or, (S – I) = (G - T) + (X - M)

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Liquidity money (LM) curve is an graphical representation of real interest rates and real income, where
money market is in equilibrium i.e. real money demand = real money supply.
 Given the real money supply, an increase in real income (which would lead to an increase in real money demand)
must be accompanied by an increase in interest rates (which would lead to a decrease in real money demand) so that
demand for real money remains the same and equilibrium in the money market is maintained.
 Therefore, if real money supply is held constant, we can infer a positive relationship between real income (Y) and the real
interest rate (r).

The Aggregate Demand Curve

If money supply is held constant, the only variable that affects real money supply is price. A decrease
(increase) in the price level leads to an increase (decrease) in real money supply. The increase (decrease) in
real money supply leads to a rightward (leftward) shift in the LM curve so the point of intersection of the IS
and LM curves now occurs at a higher (lower) level of income.
The inverse relationship between the price level (P) and real income (Y) is captured by the aggregate demand
curve. IS-LM analysis also suggests a positive relationship between the price level and real interest rates.

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Consumption is a function of personal disposable income, varies positively with income,
but negatively with taxes.
Investment expenditure varies positively with income, and negatively with real interest
rates.
Government expenditure does not vary with income. Taxes vary positively with income.
Therefore, the government's fiscal balance varies negatively with income.
Net exports vary negatively with income, and negatively with domestic price levels.

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LOS 16.g: Explain the aggregate supply curve in the short run and long run.
Aggregate supply (AS) represents the quantities of goods and services that domestic producers are willing and
able to supply at various price levels.
 The very short-run aggregate supply curve is horizontal: firms will adjust output without changing price by adjusting labor
hours and intensity of use of plant and equipment in response to changes in demand.
 The short-run aggregate supply curve is upward-sloping:
 The long-run aggregate supply curve is vertical

In the long run, wages, prices and expectations can adjust but capital and technology remain fixed.
The LRAS curve basically defines the potential output of the economy. The potential output of any economy does
not vary with the price level. When an economy operates at its potential output level, all its resources are fully
employed and it is said to be working at full employment. At this output level, unemployment is at its natural rate.
 Structural unemployment results from structural changes in the economy, which make some skills obsolete and leave
previously employed people jobless.
 Cyclical unemployment is the unemployment generated as an economy goes through the phases of a business cycle.

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LOS 16.h: Explain causes of movements along and shifts in aggregate demand and supply
curves.
Rightward shifts in the aggregate demand curve (C + I + G + (X – M)) are caused by:
 Increase in household wealth, for example: stock prices, real estate
 Better business expectations
 Higher consumer expectations
 High capacity utilization
 Expansionary fiscal policy
 Expansionary monetary policy
 Deprecation of local vis-s-a-vis foreign currency
 Improvement in global economic growth rates

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LOS 16.h: Explain causes of movements along and shifts in aggregate demand and supply curves.
Rightward shifts in the short run aggregate supply are caused by:
 Increase in factors of production such as supply of labor, natural resources, human capital, physical
capital
 Improvement in productivity and technology
 Reduction in input prices such as wages, energy prices
 Increase in expectation of future prices
 Decrease in business taxes
 Increase in subsidy
 Appreciation of local currency

LRAS will shift to the right only if there is increase in factors of production or improvement in
technology

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• Which curve represents combinations of income and the real interest rate at which
planned expenditure equals income?
A. The IS curve.
B. The LM curve.
C. The aggregate demand curve.

A is correct. The IS curve represents combinations of

income and the real interest rate at which planned
expenditure equals income.

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• An increase in government spending would shift the:
A. IS curve and the LM curve.
B. IS curve and the aggregate demand curve.
C.B isLM curveThe
correct. andISthe aggregate
curve demand
represents curve. of income and the real interest rate at which
combinations
planned expenditure equals income. Equivalently, it represents combinations such that
S(Y) = I(r) + (G – T) + (X – M)
where S(Y) indicates that planned saving is a (increasing) function of income and I(r) indicates that
planned investment is a (decreasing) function of the real interest rate. To maintain this relationship,
an increase in government spending (G) requires an increase in saving at any given level of the
interest rate (r). This implies an increase in income (Y) at each interest rate level—a rightward shift
of the IS curve. Unless the LM curve is vertical, the IS and LM curves will intersect at a higher
level of aggregate expenditure/income. Since the LM curve embodies a constant price level, this
implies an increase in aggregate expenditure at each price level—a rightward shift of the Aggregate
Demand curve.

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• An increase in the nominal money supply would shift the:
A. IS curve and the LM curve.
B. IS curve and the aggregate demand curve.
C. LM curve and the aggregate demand curve.

C is correct. The LM curve represents combinations of income and the interest rate at which the
demand for real money balances equals the supply. For a given price level, an increase in the
nominal money supply is also an increase in the real money supply. To increase the demand for real
money balances, either the interest must decline or income must increase. Therefore, at each level
of the interest rate, income (= expenditure) must increase—a rightward shift of the LM curve. Since
the IS curve is downward sloping (higher income requires a lower interest rate), a rightward shift in
the LM curve means that the IS and LM curves will intersect at a higher level of aggregate
expenditure/income. This implies a higher level of aggregate expenditure at each price level—a
rightward shift of the Aggregate Demand curve.

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• An increase in the price level would shift the:
A. IS curve.
B. LM curve.
C. aggregate demand curve.

B is correct. The LM curve represents combinations of income

and the interest rate at which the demand for real money
balances equals the supply. For a given nominal money supply,
an increase in the price level implies a decrease in the real
money supply. To decrease the demand for real money balances,
either the interest must increase or income must decrease.
Therefore, at each level of the interest rate, income (=
expenditure) must decrease—a leftward shift of the LM curve.

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• As the price level declines along the aggregate demand curve, the interest rate is most
likely to:
A. decline.
B. increase.
C. remain unchanged.

A is correct. A decrease in the price level increases the real

money supply and shifts the LM curve to the right. Since the IS
curve is downward sloping, the IS and LM curves will intersect
at a higher level of income and a lower interest rate.

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LOS 16.i: Describe how fluctuations in aggregate demand and aggregate supply cause
short-run changes in the economy and the business cycle.
LOS 16.j: Distinguish between the following types of macroeconomic equilibria: long-run
full employment, short-run recessionary gap, short-run inflationary gap, and short-run
stagflation.
LOS 16.k: Explain how a short-run macroeconomic equilibrium may occur at a level above
or below full employment.
LOS 16.l: Analyze the effect of combined changes in aggregate supply and demand on the
economy.

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Type of change Real GDP Unemployment Price level Gap Action point
Increase in AD Increase Decrease Increase Inflationary gap Fiscal/Monetary
Decrease in AD Decrease Increase Decrease Recessionary gap Fiscal/Monetary
Increase in AS Increase Decrease Decrease NA NA
Decrease in AS Decrease Increase Increase Stagflation No action point

Short-run effects of shifts in both aggregate demand and aggregate supply on the price
level and real GDP:
AD AS Real GDP Price level
Increase Increase Increase May increase or decrease
Decrease Decrease Decrease May increase or decrease
Increase Decrease May increase or decrease Increase
Decrease Increase May increase or decrease Decrease

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LOS 16.m: Describe sources, measurement, and sustainability of economic growth.
Sources of economic growth:
 Labor supply
 Human capital
 Physical capital stock
 Technology
 Natural resources

Growth in potential GDP = growth in labor force + growth in labor productivity

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LOS 16.n: Describe the production function approach to analyzing the sources of economic
growth.
Y = A × f (L, K)
 where: Y = aggregate economic output
 L = size of labor force
 K = amount of capital available
 A = total factor productivity

The multiplier, A, is referred to as total factor productivity and quantifies the amount of
output growth that is not explained by increases in the size of the labor force and capital.
Total factor productivity is closely related to technological advances.

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LOS 16.o: Distinguish between input growth and growth of total factor productivity as
components of economic growth.
growth in potential GDP = growth in technology + WL(growth in labor) + WC(growth in
capital)
 where WL and WC are labor’s percentage share of national income and capital’s percentage
share of national income.

In developed economies, where capital per worker is already relatively high, growth of
technology will be the primary source of growth in GDP per worker.

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