# 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!)

1
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).

2
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
deflator.
Price Measures
1. The GDP price deflator is a measure of the overall price level of an
economy.
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
year.
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.

3
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.

4
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.

5
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.

6
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.

7
The Circular Flow of Income and
Expenditures
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
firms.

8
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
9
Factors Causing Changes in Desired
Investment
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

10
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.
11
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
upward.

12
Deriving the Aggregate Expenditure
Schedule
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.

13
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
line.

14
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
expenditures.
investment comes from savings,
Thus, the IS is an Investment-Saving   15
schedule
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.
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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
(MS/P).

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
foreign)
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)

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