PLEASE NOTE: These basic lecture notes on Hall and Taylor (HT) Chapter 2 are required for Econ 302. If possible, students should read these notes prior to attending class lectures on HT chapter 2. A more advanced detailed version of these notes is also available on this web site; the advanced notes are recommended but not required.
Roughly defined, the aggregate demand curve is a schedule relating the total planned demand for all final goods and services in an economy during some time period T to the general price level in the economy. Specifically, the aggregate demand curve aggregates the planned demands of government, consumers, and firms.
In graphical terms, the aggregate demand curve is a plot of aggregate demand against the general price level, where the price level is on the vertical axis and the quantity demanded is on the horizontal axis. As will be clarified in subsequent lectures, the aggregate demand curve is not a straightforward extension of the usual microeconomic demand curve. Nevertheless, it does obey the usual property that higher prices are associated with smaller aggregate demands, so that the aggregate demand curve is downward sloping. See HT Figures 1-9 and 1-10.
Note that the aggregate demand curve measures the demand plans of government, households, and firms at various different price levels, plans which could potentially fail to be realized. That is, it could happen that people are unable to purchase all they plan to at a given price level because supply is insufficient to meet this demand.
It is important in macroeconomics to distinguish between what people plan to do and what they actually end up doing. We will next take up a brief review of the national income accounting measures used by macroeconomists in the U.S. and elsewhere to measure actual levels for output, income, the general price level, inflation, and unemployment.
The gross national product (GNP) for some home (domestic) country HC during a specified time period T is the market value of all final goods and services produced during T using factors of production [capital, labor, and natural resource services] owned by the HC. Here are some points to note about this definition.
As an alternative to GNP, many countries (including the U.S.) now emphasize a modified measure of national production called "gross domestic product." The gross domestic product (GDP) for a country during a specified time period T is defined to be the market value of all final goods and services produced within the borders of the country during period T, regardless of who owns the factors of production.
Let HC denote a home (domestic) country and ROW denote the rest-of-the-world. By definition, the only difference between GNP and GDP for any given HC concerns the treatment of output produced by HC-owned factors of production outside the borders of the HC and the treatment of output produced by ROW-owned factors of production within the borders of the HC. Let NFP denote the net factor payments to the HC from ROW, that is, the payments received by HC-owned factors of production employed in production activities in ROW minus the payments received by ROW-owned factors of production employed in production activities within the borders of the HC. Then, for any given time period T,
GDP = GNP - NFP.
There are three equivalent ways to measure GDP:
Because inventories are counted as investment spending, total spending must necessarily be equal to the value of total net production (total value added). And, because profits are counted as owner-earned income, the value of total net production must necessarily be equal to the value of total earned income. That is,
GDP = TOTAL SPENDING = TOTAL VALUE ADDED = TOTAL EARNED INCOME,
where
TOTAL VALUE ADDED = FIRM REVENUES FROM - FIRM PAYMENTS TO OTHER
THE SALE OF PRODUCED FIRMS FOR GOODS AND SERVICES
GOODS AND SERVICES USED UP IN INTERMEDIATE STAGES
and
TOTAL EARNED INCOME = PRE-TAX WAGES + PRE-TAX PROFITS
+ PRE-TAX INTEREST + PRE-TAX RENT
= AFTER-TAX WAGES, PROFITS, INTEREST, AND RENT
+ GOVERNMENT TAX REVENUES.
We will concentrate in class on the spending definition of GDP. This spending definition, referred to as the National Income Accounting Identity, is expressed as follows:
GDP = C + I + G + [EX - IM] ,
Realized Realized gross Realized Realized net exports
consumption investment spend. spending by (exports - imports)
spending by by HC firms the HC gov't
HC households in period T in period T
in period T (including (including
(including spending on spending on
spending on imports) imports)
imports)
where exports (EX) denotes the total spending by ROW on final goods and services produced within the borders of the HC in period T and imports (IM) denotes the total spending by the HC on final goods and services produced within the borders of ROW in period T. Rearranging terms, the national income accounting identity can alternatively be expressed as
GDP = [ C + I + G - IM] + [ EX ]
Value of all final Spending by HC private Spending by ROW
goods and services and government sectors on on final goods and
produced within the final goods and services services produced
borders of the HC produced within the borders within the borders
in period T of the HC in period T of the HC in period T
Comparing this national income accounting identity with the previous definition for aggregate demand, one might wonder whether GDP necessarily coincides with the value of aggregate demand. The answer is no. The crucial difference between aggregate demand and GDP is that aggregate demand is planned expenditure on goods and services corresponding to some possibly hypothetical price level whereas GDP is realized expenditure on goods and services for the actual price level. As previously stressed, planned expenditures on goods and services may fail for various reasons to be actually realized -- for example, actual purchases could fall short of planned purchases because the available supply of goods is insufficient to meet all demand for goods.
Nominal GDP for any particular country is simply the value of its GDP measured in terms of its current money prices. For example (see the ERP, Table B-1), nominal GDP for the U.S. in 1995 was approximately seven trillion dollars.
Ideally, real GDP should then be a measure of GDP in physical terms rather than in money terms. However, apples cannot simply be added to oranges. Something is needed to transform the various heterogeneous types of goods and services into a common unit so that addition can take place.
Prior to 1996, to undertake the computation of annual real GDP, a commonly agreed upon "base year" (e.g., 1987) was first designated. Real GDP for year T was then simply defined to be the value of final goods and services produced in year T measured in these base year prices.
Year-T Real GDP = Value of final goods and services
(Traditional measure) produced in year T, measured in
base year prices
In 1996, the U.S. Commerce Department changed to a new measure for real GDP -- a "Fisher ideal index" usually simply referred to as a "chain-weighted measure." Using the chain-weighted measure, real GDP is essentially calculated by deflating nominal GDP by an inflation rate yardstick that is updated every year. The difference between the traditional fixed-weight measure for real GDP and the new chain-weighted measure for real GDP can be rather substantial. (See the ERP, page 48, for examples).
Although the chain-weighted measure for real GDP corrects for inflation effects in a more timely up-to-date fashion than the traditional measure, the chain-weighted measure is more complicated to present, motivate, and manipulate, and it has not yet been incorporated routinely into economic texts. We will therefore follow HT in using the more traditional fixed-weight measure of real GDP for the duration of this course.
As in HT, let Y(T) denote the traditionally measured real GDP for period T; and let GDP(T) denote nominal GDP for period T. Then the GDP implicit price deflator for period T, denoted by P(T), is defined to be the ratio of these two values:
Period-T Nominal GDP GDP(T)
P(T) = --------------------- = ---------- .
Period-T Real GDP Y(T)
P(T) x Y(T) = GDP(T)
"price" "quantity" "total money expenditure"
To avoid substantial confusion in the discussion of saving and investment, it is essential to distinguish between what is planned and what is actually realized, as follows:
Realized Saving = Planned Savings + Unintended Savings
(positive or negative)
Realized Investment = Planned Investment + Unintended Inventory
Build-Up or Take-Down
Planned saving can and typically does differ from planned investment. Indeed, as will be clarified in later lectures, the equality of planned saving and planned investment is equivalent to the equilibrium condition that aggregate demand equals aggregate supply.
On the other hand, realized saving S is defined to be realized GDP (income) minus realized consumption C. Given this definition for realized saving, it follows from the National Income Accounting Identity that realized saving S must coincide with realized investment I.
To see the latter point, consider first an economy without a foreign sector (i.e., a closed economy) and without a government sector. In this case one has:
GDP (realized total income) = C (realized consumption expenditure)
+ I (realized investment expenditure)
together with
S (realized saving) = GDP (realized total income)
- C (realized consumption expenditure),
which implies
S = I .
Now consider the generalization of this result to an economy HC that is open and that has a government sector. As in HT, the following terms and abbreviations will be used.
HC Private Sector = HC Household Sector plus HC Business Sector;
F = Government transfers to the HC private sector;
N = Interest paid by HC government to HC private sector holders
of HC government debt instruments (e.g., bonds);
T = HC tax revenues;
V = Net factor income and transfer payments to the HC from ROW;
S_p = HC private saving (savings of the HC household sector
plus savings of the HC business sector);
S_g = HC government saving (the negative of the HC government deficit);
S_r = ROW saving vis-a-vis the HC (net HC borrowing from ROW);
Y = real GDP for the HC;
C = HC consumption expenditure;
I = HC investment expenditure;
G = HC government expenditure;
NE = HC net exports.
Then, by accounting definition,
S_p = [Y + V + F + N - T] - C
Private Sector Private Sector
Disposable Income Consumption
S_g = [T - F - N] - G = -1 x Government Deficit
Govt Income (Tax Rev's Government
Net of Transfer and "Consumption"
Interest Payments)
S_r = IM - V - EX = - V + [HC trade deficit]
Income received ROW Consumption | |
by ROW from HC of HC goods and | |
and services ------------------------
HC current account deficit
( -1 x HC current account)
Summing the three sources of savings, and letting net exports EX-IM be denoted by NE, one obtains
S = S_p + S_g + S_r = ([Y+V+F+N - T] - C) + (T-F-N-G) + (IM - V - EX)
= Y - C - G - NE
= I .
It is useful to reexpress this accounting identity in the following informative way:
S_p + S_g + S_r = I
| |
| |
HC national saving ROW saving HC investment
| |
| |
--- Total Saving -----------
at the Disposal
of the HC
The difficulty with financing I through ROW savings rather than through HC national savings is that the HC government ends up selling ever more financial assets to ROW, including ownership claims to HC productive physical assets such as corporations and commercial real estate. In addition to losing control over its productive assets, the HC runs the risk that ROW may decide at some future time to reduce or even discontinue lending to the HC.
Many countries, including the U.S., keep track of international exchanges of newly produced goods and services and existing physical and financial assets in the form of "balance of payments accounts." These accounts record the flow of ROW currency reserves into or out of the HC over a given specified period of time. These currency flows can be divided into two main categories: (1) the "current account"; and (2) the "capital account." In simple diagrammatic form:
--> (1) Current Account (Trade between HC
| and ROW in newly produced goods and
| services, plus transfers)
|
Balance of Payments --|
Accounts |
|
|
|
--> (2) Capital Account (Trade between HC
and ROW in existing assets, real
or financial)
Current Account (CA):
CA = HC net trades of newly produced goods and services
+ HC net transfer receipts
= [HC Exports-HC Imports]
+ [ROW payments to HC factors - HC payments to ROW factors]
+ [ROW Transfers to HC - HC Transfers to ROW]
= NE + V .
Capital Account (KA):
The capital account (2) can in turn be broken down into two
subcategories: (2a) ROW net lending to HC resulting from asset
transactions by agents other than the HC central bank; and (2b) the
net change in HC "official reserve assets" resulting from HC central
bank transactions.
Official reserve assets are assets held by central banks, other
than domestic money or securities, that can be used in making
international payments. For simplicity, it will be assumed that the
only official reserve asset available to the HC central bank is ROW
currency, the only official reserve asset available to the ROW central
bank is HC currency, and all ROW currency reserves are held by the HC
central bank. [In actuality, the U.S. holds its international currency
reserves in two main forms: gold; and reserve positions at the
International Monetary Fund.]
The capital account KA can now be broken out as follows:
KA = (Change in ROW ownership of HC assets)
- (Change in HC ownership of ROW assets)
= (ROW net lending to the HC resulting from asset transactions
other than those conducted by the HC central bank)
less
Net change in HC official reserve assets
(ROW currency reserves held by HC central bank)
= The "non-official capital account" NKA
less
The "balance of payments" BP
(or the "Official Settlements Balance")
In terms of realized transactions, all HC purchases of newly produced goods and services from ROW and all HC transfers to ROW must be financed either by giving goods or services to ROW, or by borrowing from ROW, or by transfers of ROW currency reserves (cash) to ROW. In other words, recalling that V denotes HC net factor payments and transfer receipts from ROW (hence -V denotes ROW net factor payments and transfer receipts from the HC), it must hold as an accounting identity that
IM - V = EX + (ROW net lending to HC)
- (Net change in ROW currency reserves)
or equivalently, moving EX over to the left hand side, that
- CA = ( NKA ) - ( BP ) = KA,
or equivalently, isolating BP on the left hand side, that
BP = CA + NKA .
Note, in particular, that BP may differ from zero. A nonzero BP implies that the HC central bank is building up or running down its ROW currency reserves in order to make up for an imbalance between the demand and supply of ROW currency arising from the transactions between HC and ROW private citizens. [For a more detailed interpretation of a nonzero BP as a situation of excess demand or supply of ROW currency, see the advanced class lecture notes for HT chapter 2.]
BOTTOM LINE: The HC market for foreign exchange (the HC market for ROW currency) is said to be in equilibrium if the purchase, sale, and transfer plans of ROW and HC nationals are such that BP = 0, i.e., if the purchase, sale, and transfer plans of ROW and HC nationals can be met without reliance on changes in the ROW currency reserves held by the HC central bank. In this case, the HC is said to be in BP equilibrium or external balance.
Eventually, in the face of a persistently negative BP (i.e., a persistent BP deficit), the HC central bank would run out of ROW currency reserves and would no longer be able to intervene in the foreign exchange market. Consequently, a negative BP is not a tenable long-run situation. Another possibility, however, is that a nonzero BP -- interpreted as an imbalance between the demand and supply of ROW currency -- might result in offsetting movements in the exchange rate (i.e., the price of HC currency measured in ROW currency) so that the demand for ROW currency "automatically" comes back into balance with the supply of ROW currency (the BP returns to zero) without the need for central bank intervention.
The HC (nominal) exchange rate, denoted by E, measures the price of HC currency in terms of ROW currency. For example, if the HC is the U.S. and the ROW is China, then
E = number of yuan/ per dollar.
In principle, if the exchange rate E is flexible in the sense that it is free to increase (decrease) in response to excess supply (demand) for ROW currency relative to HC currency, then E should continuously adjust to equate the demand and supply for ROW currency. In this case the BP would remain at zero without the need for any HC central bank intervention in the form of official reserve transactions.
From 1944 to 1973, under the Bretton Woods Agreement, exchange rates were officially fixed. This agreement broke down in stages from 1971 to 1973. In our present post-1973 system, exchange rates are officially supposed to be flexible; but central banks do nevertheless frequently intervene in currency markets by engaging in the purchase and sale of currencies.