Economic Growth, Aggregate Demand, and Money

Economic growth

An increase in the goods and services an economy produces over time.

Best measure of improving living standards

Real GDP per capita.

Real GDP

The value of goods and services produced, adjusted for inflation.

Labor productivity

Goods and services produced per worker or per hour of work.

Physical capital

Equipment and structures used to produce goods.

Human capital

Knowledge and skills gained through education and training.

Technology

Knowledge of how to produce goods and services.

Property rights

Legal protection of ownership that encourages investment.

Solow growth model

Explains long-run growth in real GDP per capita.

Production function

Y = A × F(K, H, L), relating output to technology, capital, and labor.

Diminishing marginal product

Additional output from another unit of an input decreases as that input increases.

Marginal product of capital

Change in output divided by change in capital.

Production-function movement

More capital moves the economy along the existing production curve.

Production-function shift

Better technology shifts the production curve upward.

Steady state

A condition where investment equals depreciation and net investment is zero.

Convergence

Lower-income countries can grow faster as wealthier countries approach their steady states.

Limits to convergence

Differences in institutions, education, health, saving, investment, and stability can prevent catch-up.

Rule of law

Government enforcement of laws, particularly those protecting property and contracts.

Saving and investment in a closed economy

Saving equals investment.

Foreign direct investment

A firm builds or buys a facility in another country.

Foreign portfolio investment

Purchasing stocks or bonds issued in another country.

Globalization

Countries become more open to foreign trade and investment.

New growth theory

Technological change responds to economic incentives and the workings of markets.

Knowledge capital

Knowledge firms create through research and development.

Nonrival knowledge

One person's use does not prevent another person's use.

Free rider

Someone who benefits from knowledge without paying its creation costs.

Patent

A limited-period exclusive legal right to an invention.

AD-AS model

Explains short-run fluctuations in real GDP and the price level.

Aggregate demand equation

AD = C + I + G + NX.

Net exports

Exports minus imports.

Wealth effect

A higher price level reduces money's purchasing power and household consumption.

Interest-rate effect

A higher price level raises interest rates, reducing borrowing and investment.

International-trade effect

A higher domestic price level reduces net exports.

Movement along aggregate demand

A change in the price level moves the economy along the AD curve.

Aggregate demand shift

A spending change unrelated to the price level shifts the AD curve.

Government purchases and aggregate demand

Higher government purchases shift aggregate demand right.

Taxes and aggregate demand

Higher taxes reduce disposable income and shift aggregate demand left.

Dollar appreciation and aggregate demand

Exports fall and imports rise, shifting aggregate demand left.

Long-run aggregate supply

Sustainable productive capacity when firms operate at capacity.

Potential GDP

Real GDP attained when firms produce at capacity and unemployment is at its natural rate.

LRAS curve

Vertical because long-run output depends on resources and productivity, not the price level.

LRAS shifts

More resources or better technology shift LRAS right.

Short-run aggregate supply

The amount firms are willing and able to produce in the short run.

Upward-sloping SRAS

Wages and some production costs do not immediately adjust to price-level changes.

Menu costs

Costs businesses incur when changing prices.

Money illusion

Focusing on nominal dollar amounts rather than real purchasing power.

Production costs and SRAS

Higher production costs shift SRAS left; lower costs shift it right.

Supply shock

An unexpected event that shifts aggregate supply.

Short-run equilibrium

The intersection of aggregate demand and short-run aggregate supply.

Long-run macroeconomic equilibrium

The intersection of AD, SRAS, and LRAS at potential GDP.

AD increase: short-run effects

Real GDP and the price level rise; unemployment falls.

AD increase: long-run adjustment

Higher wages shift SRAS left, returning output to potential at a higher price level.

AD decrease: short-run effects

Real GDP and the price level fall; unemployment rises.

AD decrease: long-run adjustment

Lower wages shift SRAS right, returning output to potential at a lower price level.

Negative supply shock

SRAS shifts left, reducing real GDP and raising the price level.

Stagflation

Inflation and recession occurring together.

Simultaneous leftward AD and SRAS shifts

Real GDP falls; the price-level effect is muted by opposing pressures.

Inflation approximation

Inflation ≈ spending growth − real GDP growth.

Money

An asset generally accepted for goods, services, or payment of debts.

Double coincidence of wants

Each trader wants what the other offers; money removes this requirement.

Functions of money

Medium of exchange, unit of account, store of value, and standard of deferred payment.

Liquidity

The ease with which an asset can be converted into the medium of exchange.

Commodity money

A good used as money that also has value independently of that use.

Fiat money

Government-authorized money that need not be exchanged for a commodity.

M1

Currency plus checking deposits and savings deposits.

M2

M1 plus small time deposits and retail money market fund shares.

Bank balance-sheet equation

Assets = liabilities + stockholders' equity.

Monetary base

Currency in circulation plus bank reserves; B = currency + reserves.