Introduction Gross Domestic Product

					    CHAPTER 10 /An Open Economy Framework:
    Aggregate Production and the Flow of Income
• Gross Domestic Product (GDP)
• Economists track the overall or aggregate amount of
  economic activity using gross domestic product
  (GDP). Usually, the standard of well-being is
  measured by income per capita = GDP/Population
• GDP is the market value (constant dollars or in
  market prices) of all final goods and services
  produced within a nation’s borders during a given
  time period. Note: does not matter that some portion
  of it is produced by foreign plants in the USA!)

            Growth of Nominal GDP

 Nominal GDP has
increased each year
  in South Korea,
 Mexico, Germany
   and the United
   States for two
reasons: an increase
 in production (Y)
  and a rise in the
   price level (P).

                Nominal versus Real
1. Nominal GDP measures the current market value of all final goods and
   services produced within a nation’s borders during a given time period.
2. Real GDP, in contrast, is a price-adjusted measure of aggregate output.
3. Real GDP is calculated by dividing nominal GDP by the GDP price
Price Measures
1. The GDP price deflator is a measure of the overall price level of an
2. The consumer price index (CPI) is a weighted sum of prices of goods and
   services that the government determines a typical consumer purchases each
3. The producer price index (PPI) is a weighted average of the prices of
   goods and services that the government determines a typical business
   receives from selling its products during a given year.

       The GDP Price Deflator
• Nominal GDP (Y) is given by:
  Y≡ y • P,
  where y denotes real GDP and P is a measure of the
   overall price level.
• Economists refer to P as the GDP deflator,
  which by rearrangement yields real GDP:
  y ≡ Y/P = Gross Output/GDP Deflator or any
    suitable price index.

     The GDP Deflator and Real and
            Nominal GDP

The left-hand panel shows annual values of the GDP deflator for South Korea. The
                 right-hand panel displays nominal and real GDP.

U.S. GDP Deflator and Consumer
         Price Index.

 Although the GDP deflator and the CPI are computed differently,
       they tend to move very closely together over time.

    Real Income and Expenditures
1. Real income must equal the sum of real
    consumption (c), real saving (s), real taxes (s), and
    real imports (im). Hence, the income identity is:
             y ≡ c + s + t + im.
   2. Real domestic product is the sum of real
       household consumption (c), real realized
       investment (ir), real government spending (g),
       and real export spending (x). The product
       identity is:
       y ≡ c + ir + g + x.

      The Circular Flow of Income and
    The circular-flow
   diagram shows that
   earnings that firms
 derive from producing
   goods and services
    ultimately flow to
households, which own
the firms and factors of
  production. The real
   value of household
 income, therefore, is =
 to the real value of the
   output produced by

          Saving, Imports and Consumption

Panel (a) displays
     the saving
  function, panel
  (b) displays the
 import function,
   and panel (c)   MPS =Δs/Δyd             MPIM =Δim/Δyd
 displays the real slope of the              slope of the
 consumption of saving function, s        import function, im
 domestic goods
   and services.

                    MPC =Δc/Δyd
                     slope of the
                consumption function, c
      Factors Causing Changes in Desired
Panel (a) depicts a decline
   in the real interest rate
resulting from a fall in the
 nominal interest rate or a
        rise in anticipated
      inflation. Panel (b)
     depicts a shift in the
     investment schedule
  itself. Either causes an
       increase in desired     r =f (rr,πe) => shift factors
    investment spending.         Note: r is the ‘price’ of
                                       investment, i

Government Spending and Net Tax
   Schedules -> Fiscal Policy

  An increase in autonomous government spending or and an increase in
       autonomous net taxes shift upward the respective schedule.
                   The Export Schedule

 Changes in domestic
income have no direct
   effect on exports           ex = f (y*, S) ceteris paribus
 expenditures. Thus,                        Not
the export schedule is                   Ex=f (y)
 horizontal. If foreign
  incomes rise or the
  domestic currency
  depreciates, export
spending rises and the
    schedule shifts

   Deriving the Aggregate Expenditure
      Summing the
  combined amount of
    desired investment
 spending, government
  spending, and export
  expenditures with the
level of consumption at
   each point along the
 consumption function
   yields the aggregate
 expenditures schedule.

              Equilibrium Real Income

Equilibrium real income
   arises at the point at
which aggregate desired
   real expenditures =
 aggregate real income.
This is true at the single
real income level, ye, at
   which the aggregate
 expenditures schedule
  crosses the 45-degree

    The Derivation of the IS Schedule
  An increase in the nominal
      interest rate induces a
       movement along the
    investment schedule and
   causes a decline in desired
investment spending in panel
    (a). This reduces desired
        aggregate desired
expenditures and a reduction
  in real income in panel (b).
 The IS schedule in panel (c)
   shows the combinations of
 real income and the nominal
  interest rate consistent with
 equilibrium real income and
                                     Note: without trade,
                               investment comes from savings,
                             Thus, the IS is an Investment-Saving   15
         The Demand for Money
1. Transactions Motive: The motive to hold money for
   use in planned exchanges (MD =f (Y))
2. Precautionary Motive: The motive to hold money
   for use in unplanned transactions (exchanges) (MD
   =f (Y))
3. Portfolio Motive: A speculative motive for holding
   money in which people hold both money and bonds
   and adjust their holdings of both based on their
   anticipations concerning interest rate movements
   (MD =f (r)). Putting (1) to (3) in one statement yields
4. L= MD =f (Y(+), r(-)) ceteris paribus. This is the
   Demand Side of the Money Market.
    The Money Demand Schedule
                                                   Increase in MD due to Y increase

As shown in panel (a), the demand for real money balances slopes downward as a
    result of the portfolio motive. The demand for real money balances shifts
     rightward when real income rises, as shown in panel (b), because of the
                       transactions and precautionary motives.                   17
               Money Market Equilibrium
          The equilibrium                         Assume that MS is not
        nominal interest rate                      sensitive to interest
          (r1) is the rate at                            changes
        which the quantity of
        real money balances
           demanded (MD)
         equals the quantity
            of real money
        balances supplied by
          the central bank

          Recall that from Chapter 9:
      M = m MB = m (DC + FER) so that
        M = m (DC + FER). Assume
that the CB controls M. This is the Supply Side
             of the Money Market.                                          18
The Derivation of the LM Schedule
                                                                          L= MD =f (Y, r) and
                                                                      M = m MB = m (DC + FER)

If real income rises, then the demand for real money balances increases, causing the equilibrium
   nominal interest rate (r2 ) to rise in panel (a). The LM schedule, in panel (b), illustrates the
   combinations of real income and the nominal interest rates that maintain equilibrium in the
            market for real money balances, given the supply of real money balances.                19
 Panels (a) and (b) show
the effects of a rise in the
    real money supply
   (=M/P) owing to an
 increase in the nominal
  quantity of money at a
  given price level (P is
   fixed). Because real
income does not change,
 the LM schedule shifts
  downward. Panels (c)
   and (d) illustrate the
  effects of a rise in the
price level (P increase) at
a given nominal quantity
   of money (fixed M).
This results in an upward
shift of the LM schedule.
                             The BP Schedule
      The BP schedule
    illustrates all of the
   combinations of real                       BP – is the Balance of Payments
 income [Goods Market]                                    schedule
and interest rate [Money       Point B: BOP equilibrium
Market] consistent with a         due to CI as R>R*
   balance-of-payments           BP = β (R-R*) ceteris
  equilibrium [External                 paribus
  Sector]. A rise in real
income would require an
 increase in the nominal
  interest rate to reach a                                  Point C: CA<0 because of
   balance-of-payments                                           a rise in imports:
        equilibrium.                                                im=f (y*, q)
Note: The Money Market
  has 4 markets – Spot,
     Forward, 2 money
   markets (domestic &                                                           21
      IS-LM Equilibrium and the BP Schedule

                                                                            Money Market
                                               Goods Market

        Point E displays an IS-LM
    equilibrium in which the nominal                                          External Sector
    interest rate and real income level
      yield import expenditures and
      capital flows consistent with a                           Domestic & External
    balance-of-payments equilibrium.                               Equilibrium

E represents an equilibrium in all markets (Money; FX, Goods, and External Sector)