PRODUCTION, GROWTH, AND THE AD-AS MODEL

real gdp per person

• living standard

• vary widely from country to country

growth rate

how rapidly real gdp per person grew in the typical year

because of the differences in growth rates

ranking of countries by income changes substantially over time

productivity

• quantity of goods and services produced form each unit of labor input

why productivity is so important

• key determinant of living standards

• growth in productivity is the key determinant of growth in living standards

• an economy’s income is the economy’s output

physical capital

• stock of equipment and structures

• used to produce goods and services

human capital

• knowledge and skills that workers acquire through education, training, and experience

natural resources

• inputs into the production of goods and services

• provided by nature, such as land, rivers, and mineral deposits

technical knowledge

society’s understanding of the best ways to produce goods and services

raise future productivity

• invest more current resources in the production capital

• trade off - devote fewer resources to goods and services for current consumption

higher savings rate

• fewer resources used to make consumption goods

• more resources to make capital goods

• capital stock increases

• rising productivity

• more rapid growth in GDP

catch-up effect

• countries that start off poor tend to grow more rapidly than countries that start off rich

poor countries

• low productivity

• even small amounts of capital investment increase workers’ productivity substantially

investment from abroad

• another way for a country to invest in new capital

• foreign direct investment - capital investment that is owned and operated by a foreign entity

• foreign portfolio investment - investment financed with foreign money but operated by domestic residents

benefits from investment

• some flow back to the foreign capital owners

• increase the economy’s stock of capital

• higher productivity

• higher wages

• state-of-the-art technologies

education

• investment in human capital

• opportunity cost: wages forgone

• conveys positive externalities

• public education - large subsidies to human capital investment

• problem for poor countries : brain drain

human capital

• education

• expenditures that lead to a healthier population

healthier workers

more productive

wages

reflect a worker’s productivity

right investments in the health of the population

• increase productivity

• raise living standards

historical trends: long-run economic growth

• improved health from better nutrition

• taller workers-higher wages-better productivity

to foster economic growth

• protect property rights - ability of people to exercise control over the resources they own

• courts enforce property rights

• promote political stability

property rights

prerequisite for the price system to work

political instability

• a threat to property rights

• revolutions and coups

• revolutionary government might confiscate the capital of some business

• domestic residents - less incentive to save, invest, and start new businesses

• foreigners - less incentive to invest

inward-oriented policies

• avoid interaction with the rest of the world

• infant-industry argument

• tariffs

• other trade restrictions

• adverse effect on economic growth

outward-oriented policies

• integrate into the world economy

• international trade in goods and services

• economic growth

amount of trade is determined by

• government policy

• geography - easier to trade for countries with natural seaports

knowledge is public good

• government encourages research and development

• farming methods

• aerospace research (air force, NASA)

• research grants (National Science Foundation, National Institutes of Health)

• tax breaks

• patent system

large population

• more workers to produce goods and services

• larger total output of goods and services

• more consumers

stretching natural resources

• malthus : an ever increasing population strain society’s ability to provide for itself

• mankind is doomed to forever live in poverty

diluting the capital stock

• high population growth

• spread the capital stock more thinly

• lower productivity per worker

• lower gdp per worker

reducing the population growth rate

• government regulation

• increased awareness of birth control

• equal opportunities for women

promoting technological progress

• world population growth

• engine for technological progress and economic prosperity

• more people = more scientists, more inventors, more engineers

economic activity

fluctuates from year to year

recession

• economic contraction

• period of declining real incomes and rising unemployment

depression

severe recession

three key facts about economic fluctuations

• irregular and unpredictable (the business cycle)

• most macroeconomic fluctuate together (recessions: economy-wide phenomena

• as output falls, unemployment rises

AD-AS model

• model of aggregate demand (AD) and aggregate supply (AS)

• most economists use it to explain short-run fluctuations in economic activity (around its long-run trend)

aggregate demand curve

• shows the quantity of goods and services that households, firms, the government and customers abroad want to buy t each price level

• downward sloping

aggregate supply curve

• shows the quantity of goods and services that firms choose to produce and sell at each price level

• upward sloping

long-run aggregate spply curve is vertical LRAS

• price level does not affect the long-run determinants of GDP

• supplies of labor, capital, and natural resources

• available technology

short run

aggregate supply curve is upward sloping

natural level of output

• production of goods and services that an economy achieves in the long-run when unemploymen is at its normal rate

• potential output

• full-employment output

assumption

• economy begins in long-run equlibrium

long-run equilibrium

• intersection of AD and LRAS curves (natural level of output and actual price level)

• intersection of AD and short-run AS curve (expected price level = actual price level

shifts in aggregate demand

• wave of pessimism: AD shifts left

• short run (output falls, price level falls)

• long run (short-run aggregate supply curve shifts right, ouput is on natural level, price level falls)