Robert J. Stonebraker, Winthrop University
Equilibrium GDP and Economic Growth
There are few sorrows, however poignant, in which a good income is of no avail.
author Logan Pearsall Smith
The United States economy produces more goods and services than any other economy in the world. Output per person in the poorer countries of the world might average less than five percent of what we in America enjoy. Why? Why are some countries rich and growing and others not? What determines the overall level of output in an economy?
Gross domestic product
The concept of total or aggregate output can be tricky. If we produce one pound of hot dogs and one personal computer, does total output equal two? No. Hot dogs are not the same as computers. Adding hot dogs and computers makes little sense. Instead of measuring physical units of output, we measure values of output and then ask about the total or aggregate value of output.
Economists use the term Gross Domestic Product (GDP) to measure aggregate output. Specifically, GDP is the value of all final goods and services produced within the country during a year. GDP for the U.S. in 2013 will top $16 trillion. Megabucks.
Note that GDP measures only the value of final goods. Intermediate goods that are reprocessed in some way are excluded. For example, if $50 of flour, sugar, eggs and flavorings are turned into $80 of cookies, only the cookies will appear in the GDP calculations. Why? The value of the intermediate goods is already reflected in the value of the cookies. The prices charged for the cookies reflect the costs of the raw materials and intermediate goods needed to bake them. Counting the cookies and the flour, sugar, eggs and flavorings essentially double-counts the value of the intermediate goods.
Although the actual methods of measuring GDP are quite complex and constantly are being tweaked by government statisticians, the basic process is straightforward. We calculate the total revenue earned by firms producing final goods and services and add them up. If we produce and sell one pound of hot dogs at $3 and one computer at $1,200, then GDP = $1,203. Not only can we say that total output equals $1,203, we can also say that total spending and total income are $1,203. The concepts of output, spending and income are identical at this level. If we produce and sell $1,203 of output, then people must have spent $1,203 to buy it. And if one group is spending $1,203, then another must be receiving it as income.
Nominal versus real GDP
Measuring total output in terms of dollar values creates an additional problem. GDP can rise for at least two reasons. It can rise because of an increase in real production (which we like), or because of an increase in prices for the same amount of real production (which we do not like). To determine which is which, we differentiate the concepts of nominal GDP (that values products in terms of prices of that year) and real GDP (that adjusts for any price changes).
Consider an economy that produces only pizza and ice cream. Suppose that last year it produced 9 pizzas @ $8 [for a total of $72 of pizza] and 14 units of ice cream @ $2 [for a total of $28 of ice cream]. Last year’s nominal GDP was an even $100 [$72 of pizza + $28 of ice cream]. Next, suppose that this year’s production is 10 pizzas @ $12 and 20 units of ice cream @ $4. This year’s nominal GDP is $200 [$120 of pizza + $80 of ice cream]. Nominal GDP doubled from $100 to $200, but real production did not. Part of the nominal increase was not “real,” it was the result of higher prices.
To calculate “real” changes we must adjust for price changes. We ask what GDP would have been if prices had not changed. For example, suppose prices had remained at last year’s levels. If prices had not changed, this year’s output of 10 pizzas would be worth $80 [10 pizzas @ $8] and this year’s output of 20 units of ice cream would be worth $40 [20 units of ice cream @ $2]. In other words, if prices had not changed, this year’s GDP would have been only $120 [$80 of pizza + $40 of ice cream] rather than $200. Thus "real" GDP rose only from $100 to $120, an increase of 20 percent. The rest of the nominal increase was the result of higher prices or inflation.
The amount of inflation is measured by price indexes. These indexes measure the level of prices today relative to those in a base year. One common way of calculating a price index (PI) is dividing the cost of goods in terms of current prices by the cost of same goods in terms of prices in the base year (and then multiplying by 100 to eliminate the decimal). Or:
PI = (cost of goods in terms of current prices/cost of same goods in terms of base prices)(100)
In the example above, this year’s nominal GDP was $200. But, if pizza and ice cream prices had remained at their earlier level, current GDP would only have been $120. In other words, what cost $200 in current prices would have cost only $120 at the old prices. If we use the past year as the base year, then the price index is (200/120)(100) = (1.67)(100) = 167. The 167 means that prices on average have risen 67% since the base year, or that what would have cost $100 at base year prices would cost $167 at current prices.
In practice, the federal government calculates these prices indexes every month. The rate of inflation over any specific period is simply the percentage change in the price index over the same period.
Aggregate demand and supply
What determines the overall level of output in an economy? With only slight fudging we can adapt familiar demand and supply concepts to the macro or aggregate economy. The graph will look quite similar; however the definitions of the variables measured change somewhat. Instead of measuring the output of a single product on the horizontal axis, we now measure the real, inflation-adjusted value of all final goods
and services (real GDP). And instead of measuring the price of a single product on the vertical axis, we measure the average price level of all goods and services (a price index ). Finally, instead of looking at the demand and supply of a single product, we use the notions of aggregate demand or AD (the demand for all final goods and services summed together) and aggregate supply or AS (the supply of all final goods and services summed together).
Aggregate demand often is divided into four components. The demand for U.S. goods and services comes from four different groups: (1) from domestic consumers for consumption goods (C), (2) from domestic businesses for investment in new capital goods such as machines, equipment and factories (I), (3) from federal, state and local governments for spending on new goods and services such as military equipment, highways, police protection, education, etc. (G), and (4) from people and organizations in foreign countries (F). Symbolically, AD = C + I + G + F. Statistically, C is the largest component by far. An AD curve should have the conventional negative slope. As prices fall, all else equal, the value of real goods and services demanded will increase
Similarly, an AS curve should be positively sloped. Higher prices, all else equal, should generate a greater real supply of goods and services. However AS ultimately is constrained by the economy’s production possibilities curve (PPC) that depends upon the number of resources available in the economy and the technology with which to use them. [If you want to brush up on PPC’s, you might review the What to Produce reading.] Once an economy reaches its potential output, no more real supply can be created. At that potential level of output all resources are fully and efficiently employed and the AS becomes vertical. No matter how high prices might go, no additional output can be produced.
Equilibrium in the aggregate economy looks just like it does for a single product. The intersection of AD and AS creates an equilibrium overall level of prices and an equilibrium real GDP. Price levels above the equilibrium will create aggregate surpluses and drive prices down; price levels below equilibrium will create aggregate shortages and drive prices up.
Check out the graph above. Does it look familiar? It should. The AS and AD intersect to form an equilibrium at price level P and potential GDP.
Of course AD and AS curves shift over time and, therefore, move the equilibrium. If we start with an initial equilibrium that is below the potential level (like GDP0 in the below graph), an increase in AD will increase the equilibrium level of real GDP. For example, if AD rises from AD0 to AD1. the level of real GDP will rise from GDP0 to GDP1. But ultimately growth is constrained by production possibilities and AS. No matter how many goods and services might be demanded, we cannot produce more in the long run than our resources and technology allow. If AD rises from AD1 to AD2. there is no change in real GDP; it remains at GDP1. The only effect is to raise prices to P2.
We cannot go past the potential level of real GDP. In the long run, an economy can grow only if increased production possibilities shift AS to the right. That means we either must increase the available resources or else improve the technology with which those resources are used.
Do you remember the four types of economic resources? They are land, labor, capital, and entrepreneurship. Which of these can we increase? Not land. In the long run we can make more effective use of our natural resources, but we cannot create more. Labor and entrepreneurs certainly increase with population over time, but the value of these might be limited. Growth in output per person is the type of growth that matters. Plunking more bodies into an economy can create more output, but normally will not increase output per person. What remains? Capital or manufactured resources. Along with improved technology, increases in capital hold the key to long-run economic growth.
If increased capital and technology drive economic growth, from where do they come? Primarily from investment. Firms invest in new capital goods; they invest in new technologies. From an AD standpoint, increasing I rather than increasing C, G or F is more likely to create growth. However, private I is not the only source of capital and technology. G also is a potential source. Government spending to develop the transportation and communication infrastructure of the economy can be considered public investment. Similarly, government spending to improve educational opportunities might be considered an investment in human capital. Such public investment might be every bit as critical as private investment for economic growth. In addition, government spending on education and basic research could help drive the development of new technologies.
Regrettably, both private and public investment carry a price tag. If we expect to push more resources into the production of new capital and technology, we must be willing to devote fewer resources to consumption. Resources tied up in the production of compact discs, golf clubs and tanning lotions are not available to generate productivity-enhancing capital and technology. If we want to grow enough to boost future consumption, we must be willing to reduce current consumption. We must be willing to save. A political slogan that exhorts citizens to consume less so that resources can be diverted into investments may not win any elections, but probably would spur long-run economic growth.
To test your understanding of the major concepts in this reading, try answering the following:
1. Define Gross Domestic Product.
2. Explain why only "final" goods and services are included in GDP.
3. Explain why the sum of expenditures for final and goods and services must always equal the sum of incomes.
4. Differentiate between real and nominal GDP and be able to calculate either from data.
7. Identify when increases in AD will increase real GDP and when they will not. Illustrate graphically and explain.
8. Identify and explain the critical variables for increasing per capita output in the long run.
9. Explain the disadvantage of policies that might spur long-run economic growth.