<p>With this CFA Level 1 reading we begin with the fundamental macroeconomic concepts. This reading covers the building blocks of aggregate output and income measurement of an economy, aggregate demand and supply analysis and factors influencing economic growth.</p>

Aggregate Output, Prices and Economic Growth

<p>The Gross Domestic Product (GDP) is the market value of all final goods and services produced within a country during a certain time period. It is the total output of all economic activity in a country over a given period.&nbsp;</p>



<ul><li>A country’s GDP will include domestic output by foreign owned firms.</li><li>It does not include the sale or resale of goods produced in previous periods.</li><li>It does not include transfer payments by government such as unemployment, retirement, etc., since they are not considered economic outputs.</li><li>It considers the market value of final goods and services. So, the intermediate goods and services will not be separately added in GDP calculation. Their value will be included only in the price of the final product.</li><li>GDP includes the value of goods and services provided by the government also; for example, police, administration, judicial system, etc. are all services whose value is included in GDP.</li><li>&nbsp;It includes the value of self-occupied housing as well as the value of rental housing.</li><li>GDP is the total output of all economic activity in a country over a given period and a country’s GDP will include domestic output by foreign owned firms.</li><li>Nominal GDP = GDP in current prices</li><li>A price deflator must be applied to the current GDP in order to compare current GDP to the GDP of a prior year.</li></ul>



<p>There are two approaches to calculate GDP: Income Approach and Expenditure Approach.</p>



<p><strong>Income Approach</strong></p>



<p>Under this approach, the GDP is calculated as the total income earned by households and businesses in the country during a given time period.<strong></strong></p>



<p><strong>Expenditure Approach</strong></p>



<p>Under this approach, GDP is calculated as the total amount spent on goods and services produced in a country during a time period.</p>



<p>Both these approaches should produce the same result as in the whole economy the total expenditure and total income should be equal.</p>

Gross Domestic Product

<p>Within the expenditure approach, there are two approaches:</p>



<p><strong>Sum-of-value-added Approach</strong></p>



<p>Under this approach, GDP is calculated as the sum of value added at each stage of production and distribution. For example, suppose the raw material was worth $100, it was processed and converted into semi-finished goods worth $120. Then these semi-finished goods are converted into finished goods worth $150. The same product is sold in retail at $180. The sum-of-value-added approach calculates the total value as follows:</p>



<figure class="wp-block-table"><table><tbody><tr><td><strong>Stage</strong></td><td><strong>Sale Value</strong></td><td><strong>Value Added</strong></td></tr><tr><td><strong>Raw Material</strong></td><td>$100</td><td>$100</td></tr><tr><td><strong>Semi-finished Goods</strong></td><td>$120</td><td>$20</td></tr><tr><td><strong>Finished Goods</strong></td><td>$150</td><td>$30</td></tr><tr><td><strong>Retail</strong></td><td>$180</td><td>$30</td></tr><tr><td><strong>Sum of Value Added</strong></td><td><strong>$180</strong></td></tr></tbody></table></figure>



<p><strong>Value-of-final-output Approach</strong></p>



<p>Under this approach, GDP is calculated by summing the values of final goods and services produced during the period. In the above example, we will directly take the value $180 of the product.</p>

Methods of Calculating GDP

<p>At times, we would like to compare the GDP data in different time periods. Since the average level of prices of goods and services change over time, the GDP data may not be directly comparable. We will need to make some adjustments to differentiate a nominal change in GDP from a real change in GDP.</p>



<p>A nominal change in GDP is a change in GDP that occurs only due to the change in price levels. Nominal GDP is based on current prices. This is the GDP that we described in the nominal approach.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/gdp-1-1024x87.png" alt="" class="wp-image-28473" width="533" height="45"/></figure></div>



<p>A real change in GDP reflects the actual increase in the physical quantity of output. This is done by adjusting the GDP for inflation. It measures the current year output using the prices from a base year.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/gdp-2-1024x80.png" alt="" class="wp-image-28474" width="517" height="40"/></figure></div>



<h3><strong>Price Indexes</strong><strong></strong></h3>



<p>The nominal GDP can be converted into real GDP using a price index. A price index is a weighted average of the prices of a set of the goods and services produced in the economy over a period of time. Two commonly used price indexes are GDP deflator and Consumer Price Index (CPI)</p>



<h4><strong>Implicit GDP Price Deflator</strong></h4>



<p>The implicit GDP price deflator is calculated as follows:</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/gdp-3-1.png" alt="" class="wp-image-28480" width="604" height="80"/></figure></div>



<h4><strong>Consumer Price Index</strong></h4>



<p>It is a fixed-weight price index, which takes the quantities in some base year as being the typical goods bought by the average consumer during that base year, and then uses those quantities (same basket) as weights to calculate the index in each year.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/gdp-4-1024x123.png" alt="" class="wp-image-28476" width="591" height="70"/></figure></div>



<h3>Example</h3>



<p>Assume that the GDP of a country in 2013 based on 2013 prices is $1 billion and the GDP calculated using 2012 prices is 0.8 billion. Considering 2012 as the base year, calculate the GDP deflator.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/gdp-5-1024x74.png" alt="" class="wp-image-28477" width="596" height="42"/></figure></div>

Nominal Vs. Real GDP

<p>Under the&nbsp;<strong>expenditure approach</strong>, GDP is calculated as follows:</p>



<p class="has-background" style="background-color:#fff9b1"><strong>GDP = Personal Consumption + Investment + Government Consumption + (Exports – Imports)</strong></p>



<p class="has-background" style="background-color:#fff9b1"><strong>GDP = C + I + G + (X-M)</strong></p>



<p>Under the&nbsp;<strong>income approach</strong>, GDP is calculated as follows:</p>



<p class="has-background" style="background-color:#fff9b1"><strong>GDP = National Income + Capital Consumption Allowance + Statistical Discrepancy</strong></p>



<p>Domestic Income is the total income earned by the people and businesses within a country’s borders. National Income is the total income earned by citizens and businesses of a country, no matter where they are located. National Income includes income received by all factors of production:</p>



<ul><li><strong>Compensation to employees:</strong>&nbsp;Wages, salaries, Social Security benefits, and employee benefit plans plus the monetary value of fringe benefits, tips, and paid vacations.</li><li><strong>Corporate and govt. profits before taxes:</strong>&nbsp;All income earned by the stockholders of corporations.</li><li><strong>Non corporate business net income:</strong>&nbsp;All forms of income earned by self-employed individuals and the owners of unincorporated business, including unincorporated farmers.</li><li><strong>Interest income:</strong>&nbsp;The interest income received by households and government minus the interest they paid out.</li><li><strong>Rent:</strong>&nbsp;Income of persons is the income received by individuals for the use of their non-monetary assets.</li><li>Indirect business taxes – subsidies</li></ul>



<p class="has-background" style="background-color:#fff9b1"><strong>National Income = Compensation of employees + Non-corporate Business Net Income + Corporate Profits + Rental Income + Net Interest + Indirect Business Taxes</strong></p>



<p>Capital consumption allowance refers to the depreciation on the physical capital. It is the cost to replace capital goods that break or wear down.&nbsp;</p>



<p>Apart from this, statistical discrepancies or pure computational errors often occur, i.e., the difference between GDP under expenditure approach and income approach.&nbsp;</p>



<h3>Other National Income Accounting Measurements&nbsp;</h3>



<p class="has-background" style="background-color:#fff9b1"><strong>Net Domestic Product = GDP – Capital consumption allowance</strong></p>



<p>Personal income is the pre-tax income received by households.</p>



<p class="has-background" style="background-color:#fff9b1"><strong>Personal Income = National income – Undistributed Corporate Profits – Social Security Taxes – Corporate Profits Taxes + Transfer Payments</strong></p>



<p>Personal disposable income is the personal income after taxes.</p>



<p class="has-background" style="background-color:#fff9b1"><strong>Disposable Income = Personal Income – Personal Taxes&nbsp;</strong></p>

GDP, National Income, and Personal Income

<p>To understand the relation between savings, investments, fiscal balance, and trade balance, we will combine the income and expenditure approach to calculating GDP.</p>



<p>We know that,</p>



<p class="has-background" style="background-color:#fff9b1">GDP = C + I + G + (X – M)</p>



<p>We also know that,</p>



<div class="wp-block-group has-background" style="background-color:#fff9b1"><div class="wp-block-group__inner-container">
<p>GDP = C + S + T</p>



<p>Where,</p>



<p>C = Consumption spending</p>



<p>S = Government and household saving</p>



<p>T = Net taxes</p>
</div></div>



<p>We can equate the above two equations:</p>



<p class="has-background" style="background-color:#fff9b1">C + I + G + (X – M) = C + S + T</p>



<p>The government deficit (G – T) deficit can be expressed in terms of savings and investments as follows:</p>



<div class="wp-block-group has-background" style="background-color:#fff9b1"><div class="wp-block-group__inner-container">
<p>(G – T) = (S – I) – (X – M)</p>



<p>G – T represents government deficit</p>



<p>S – I represents excess of private savings over private investments</p>



<p>X – M represents trade surplus. A negative (X – M) represents trade deficit.</p>
</div></div>



<p>From the above equation we can conclude that:</p>



<p>Trade deficit (G – T &gt;0) must be finance by:</p>



<ol type="1"><li>Excess of private savings over private investments (S – I > 0), or</li><li>Trade deficit (X – M &lt; 0), or</li><li>Combination of both</li></ol>

Relationship Between Saving, Investment, Fiscal Balance, and Trade Balance

<p>The IS curve shows all the combinations of interest rates i and outputs Y for which the goods market is in equilibrium.</p>



<p>To derive the IS curve, we equate the aggregate income with the aggregate expenditure:</p>



<div class="wp-block-group has-background" style="background-color:#fffac5"><div class="wp-block-group__inner-container">
<p>Aggregate Income = Aggregate Expenditure</p>



<p>C + S + T = C + I + G + (X – M)</p>
</div></div>



<p>This can be simplified as follows:</p>



<p class="has-background" style="background-color:#fffac5">(S – I) = (G – T) + (X – M)</p>



<p>This means that the excess savings minus investments goes towards funding government deficit and it also helps in supporting a trade surplus. This equation can be used to derive the IS Curve.</p>



<p>We will work with two graphs.&nbsp;</p>



<p>The first graph plots Income (Y) with (S – I). When income (Y) increases, savings (S) also increase. Investments (I) also increase, however, the increase in investments is less than the increase in savings. This means that S – I goes up. This will result in an upward sloping (S - I) curve.&nbsp;&nbsp;</p>



<p>The second curve plots expenditure (G – T) + (X – M) with Income Y. When income increases, the government deficit will generally go down, i.e., G – T will go down. People will also spend more money on imports, so X – M also goes down. So, when income (Y) goes up the sum (G – T) + (X – M) goes down.</p>



<p>The intersection of these two graphs represents the equilibrium level of income (Y*).&nbsp;</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/is1.png" alt="" class="wp-image-28488" width="544" height="368"/></figure></div>



<p>Let’s say this equilibrium level of income is 100. Let’s also say that at this equilibrium, the interest rate was r = 5%. If interest rates go down to 4%, the savings will go down, but the investments will go up because of the decrease in their cost of capital. Overall, S – I will go down.   The S – I curve will shift towards the right/downwards leading to an increase in the equilibrium level of income.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/is2.png" alt="" class="wp-image-28489" width="541" height="369"/></figure></div>



<p>From the above graph we can conclude that when real interest rates decrease, the income increases. This is the IS curve, the graph of real interest rates (r) vs. income (Y).</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/is3.png" alt="" class="wp-image-28490" width="487" height="348"/></figure></div>



<p>Note: In this context both output and income refer to the same thing (Y) and will be used interchangeably.</p>

The IS Curve

<p>To plot this curve, we make an assumption that the real money supply is held constant. To derive the LM curve we set:</p>



<p class="has-background" style="background-color:#fffac5"><strong>Real Money Supply = Real Money Demand</strong></p>



<p>According to Quantity of Money Theory:</p>



<p class="has-background" style="background-color:#fffac5"><strong>MV = PY</strong></p>



<p>Here, M is the money supply, V is the velocity of money in transactions (how often money is used to make purchases), P is the price level, and Y is the real GDP or real output. The above equation can be rewritten as follows:</p>



<p class="has-background" style="background-color:#fffac5"><strong>M/P = (1/V)*Y</strong></p>



<p>We can say that real money is directly proportional to output and inversely proportional to interest rate (r). The demand for money is inversely proportional to interest rates because when interest rates are high then we are better off investing money in stocks and bonds reducing our demand for money.&nbsp;&nbsp;When real interest rates increase, the demand for money decreases and when real income increases, the demand for money increases.</p>



<p>Therefore, if we keep the real money supply constant, any increase in demand for real money due to increase in real income must be offset by an increase in interest rates to keep the demand for real money constant. This means that in equilibrium income and real interest rates have a positive relationship provided the real money supply is constant. This relationship is called the LM curve.</p>



<p>This LM curve is at a certain level of real money supply (M/P). If M/P increases, which can happen if nominal money supply increases, or price levels fall, then the LM curve shift to the right, and vice versa. </p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/lm-curve-1.png" alt="" class="wp-image-28497" width="585" height="449"/></figure></div>

The LM Curve

<p>We can use the IS curve and the LM curve to derive the aggregate demand curve. The following curve shows the IS curve and the LM curve with equilibrium at point A where IS intersects with LM. We have assumed that at this equilibrium point the real interest rates are 4%.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/demandcurve1.png" alt="" class="wp-image-28501" width="531" height="369"/></figure></div>



<p>Let’s assume that at equilibrium level A, the price levels are P1. What will be the impact of increase in price levels to P2? If price levels rise, the real money supply will decrease. Recall that real money supply M/P will decrease if P increases. This will result in a shift of the LM curve to the left. The new equilibrium point will now be B, with a higher real interest rate level and a lower income level, as shown in the graph below.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/demandcurve2.png" alt="" class="wp-image-28502" width="483" height="354"/></figure></div>



<p>The aggregate demand curve shows the relationship between the quantity of real output demanded (Same as real income) and the price levels. In the above graph we can observe this relationship, i.e., when price levels go up, the real income goes down. The prices and income levels are inversely proportional to each other, as shown in the graph below:</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/demandcurve3.png" alt="" class="wp-image-28503" width="496" height="375"/></figure></div>

Aggregate Demand Curve

<p>Aggregate supply (AS) refers to the total amount of goods and services produced by an economy’s businesses.&nbsp;</p>



<p>Aggregate supply curve shows the quantity of goods and services that firms choose to produce and sell (quantity of real GDP supplied) at each price level.</p>



<p>We are concerned about the aggregate supply curve under three time frames, namely, very short run aggregate supply (VSRAS), short run aggregate supply (SRAS), and long run aggregate supply (LRAS).</p>



<p>In the&nbsp;<strong>very short run</strong>, wages, input costs as well as prices are assumed to be constant. The firms can increase and decrease their output without affecting the prices. The VSRAS curve is perfectly elastic.</p>



<p>In the&nbsp;<strong>long run</strong>, the aggregate supply curve (LRAS) is perfectly inelastic. This is because in the long run it is assumed that the real output of the economy is at its full potential with full employment. The price levels will have no effect on the aggregate supply because wages, input costs, etc. will change proportionally with a change in the price levels.&nbsp;</p>



<p>In the <strong>short run</strong>, aggregate supply curve (SRAS) is upward sloping. The firms are willing to produce and supply more at higher price levels. This assumes that in the short-run wage rates and input prices are unchanged. They are sticky in the short run and do not adjust fast enough to the changes in price levels.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/supplycurve1.png" alt="" class="wp-image-28507" width="518" height="355"/></figure></div>

Aggregate Supply Curve

<p>Aggregate demand is the sum of all expenditure in the economy over a period of time. An increase in aggregate demand shifts the aggregate demand curve to the right indicating that at any given price level, the total quantity of goods and services demanded in the economy is now greater.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/shift-demand-curve.png" alt="" class="wp-image-28510" width="439" height="320"/></figure></div>



<p>Recall that from the expenditure side, the GDP is represented as below:</p>



<p class="has-background" style="background-color:#fffac1"><strong>GDP = C + I + G + (X – M)</strong></p>



<p>This is what comprises aggregate demand.</p>



<p>Any change in the price levels is a movement along the aggregate demand curve and does not cause the demand curve to shift. The shift can be caused by a change in any of the above factors.</p>



<ul><li>A change in consumption can lead to a shift in aggregate demand curve. Consumption is a function of disposable income. An increase in disposable income will lead to an increase in consumption, which will lead to an increase in aggregate demand.</li><li>A change in investments will also shift the aggregate demand curve. Investments depend on interest rates. If interest rates decrease, investments will increase as the cost of capital for the firms decrease. An increase in investment will increase the aggregate demand.</li><li>The third factor affecting the shift in aggregate demand curve is the government spending (G). The government spending is changed through fiscal policy. An increase in government spending increases aggregate demand and vice versa.</li><li>Net exports (X – M) will also affect the aggregate demand. An increase in exports or a decrease in imports will increase the aggregate demand and vice versa. Exports and imports are affected by policies that affect real exchange rates. Any policy that increases the real exchange rate will cause the net exports to fall leading to a decrease in aggregate demand and shift the aggregate demand curve to the left. The change in export and import can also happen for reasons other than change in exchange rates.</li><li>Higher capacity utilization: Companies can increase their capacity utilization and produce more. In such a case they will invest more in capital equipment, thereby increasing the investments which results in an increase in aggregate demand.</li><li>Expansionary monetary policy: In an expansionary monetary policy, the money supply increases, banks lend more, and interest rates fall. This increases investments by corporates leading to an increase in aggregate demand.</li></ul>

Shifts in Aggregate Demand Curve

<h3>Shift in Short-run Aggregate Supply (SRAS) Curve</h3>



<p>Aggregate supply curve shows the quantity of goods and services that firms choose to produce and sell (quantity of real GDP supplied) at each price level. When the aggregate supply increases, the SRAS shifts to the right and the quantity supplied at each level increases. The level output can be affected by many factors which will shift the aggregate supply curve. Note that in the short run, the wage rates and input prices are considered to be stick. Any change in the price levels is a movement along the supply curve and does not cause the shift in the supply curve.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/shift-supply-curve.png" alt="" class="wp-image-28513" width="487" height="348"/></figure></div>



<p>Following are a few factors that cause the SRAS to shift:</p>



<p><strong>1. Changes in input prices:&nbsp;</strong></p>



<p>If input prices such as wage rates decrease, then firms can increase production at the same cost, leading to an increase in short-run aggregate supply.</p>



<p><strong>2. Changes in resource prices</strong></p>



<p>If the price of oil and other factors of production decrease (those that are not sticky) then firms will seek to produce more. This will cause a rightward shift in the SRAS curve.&nbsp;</p>



<p><strong>3. Technology changes</strong></p>



<p>If technology makes it cheaper to produce something, then firms will again be able to expand their production and therefore, it will cause a rightward shift in SRAS.&nbsp;</p>



<p><strong>4. Expectation of future prices&nbsp;</strong></p>



<p>If a firm expects greater demand in the future, it will be more likely to expand production in the present to prepare for such a situation. This too will shift the SRAS curve to the right.</p>



<p><strong>5. Exchange rates</strong></p>



<p>Even changes in exchange rates can affect short-run aggregate supply. If the currency of a country appreciates, its imports will become cheaper. Any imports which are productive inputs will help the company reduce production cost or increase their output, thereby increasing SRAS.</p>



<h3>Shift in Long-run Aggregate Supply (LRAS) Curve</h3>



<p>In the&nbsp;<strong>long run</strong>, the aggregate supply curve (LRAS) is perfectly inelastic. This is the potential level of real GDP (at full employment). This is the highest level of GDP that can be sustained over the long run. Since at this point all the resources in the economy are used optimally, the only factors that can cause a shift in the long run aggregate supply are capital, labour and technology. These factors can affect the natural rate of output causing the LRAS to shift. An increase in labour, capital, supply of natural resources or improvement in technology increases the output and shifts the LRAS to the right. Similarly a decrease in these factors will shift the LRAS to the left.</p>



<p>As we noticed, some factors affect both LRAS and SRAS while some affect only SRAS. Let’s review these factors.&nbsp;</p>



<p>Factors that affect both LRAS and SRAS:</p>



<ul><li>Labour</li><li>Capital</li><li>Technology</li></ul>



<p>Factors that affect only SRAS:</p>



<ul><li>Changes in wage rates</li><li>Changes in cost of other inputs</li></ul>

Shifts in Supply Curve

<p>We can combine the aggregate demand curve and the aggregate supply curve to determine the macroeconomic equilibrium in the short-run and the long-run. The two graphs are shown below:</p>



<figure class="wp-block-gallery alignwide columns-2 is-cropped"><ul class="blocks-gallery-grid"><li class="blocks-gallery-item"><figure><img src="https://financetrain.com/wp-content/uploads/equi-1.png" alt="" data-id="28519" data-full-url="https://financetrain.com/wp-content/uploads/equi-1.png" data-link="https://financetrain.com/?attachment_id=28519" class="wp-image-28519"/></figure></li><li class="blocks-gallery-item"><figure><img src="https://financetrain.com/wp-content/uploads/equi2-1.png" alt="" data-id="28521" data-full-url="https://financetrain.com/wp-content/uploads/equi2-1.png" data-link="https://financetrain.com/?attachment_id=28521" class="wp-image-28521"/></figure></li></ul></figure>



<p>In the short run the equilibrium point is the point where the Aggregate Demand (AD) curve and Short Run Aggregate Supply (SRAS) curve intersect. It reflects the equilibrium output and the price level in the short run.&nbsp;</p>



<p>Let’s say that the economy is not in equilibrium and supply is more (somewhere towards the upper right side on the green line). In that case the price levels the producers expect are higher and at that price level the supply is much more than the demand. Then the producers will curtail their production and we will move back towards the equilibrium point shown above.In the long run, the macroeconomic equilibrium point is the point where the Aggregate Demand (AD) curve intersects with the Long Run Aggregate Supply (LRAS) curve. Even the SRAS intersects at the same point. The output level is the potential GDP at full employment.&nbsp;</p>

Macroeconomic Equilibrium

<p>We can explain economic growth and inflation using the Aggregate Demand and Long Run Aggregate Supply curves.</p>



<p>Economic growth is the persistent growth in potential GDP, while inflation is the persistent increase in general prices as shown in the graph below:</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/economic-growth.png" alt="" class="wp-image-28524" width="598" height="369"/></figure></div>



<p>As you can see both AD and LRAS have shifted to the right. Increase in LRAS brings economic growth. This happens due to increased labour, more capital, or better technology. However, there is a bigger increase in Aggregate Demand (AD), which causes inflation.</p>

Economic Growth and Inflation

<p>If the Aggregate Demand (AD) curve, SRAS and LRAs all intersect at one point, then the economy is in long run and short run equilibrium. However, there could be situations where the economy is in short-run equilibrium but not in long-run equilibrium. Consider the following three figures:</p>



<figure class="wp-block-image size-large"><img src="https://financetrain.com/wp-content/uploads/business-cycle-1-1024x294.png" alt="" class="wp-image-28528"/></figure>



<p>The output at the long run equilibrium is the potential GDP while the output at the short run equilibrium is the actual GDP.</p>



<p>In the first graph, the actual GDP is above the potential GDP, i.e., the full employment GDP. This is called expansion or inflationary gap.&nbsp;</p>



<p>In the second graph, the AD, SRAS as well as LRAS intersect at the same point. The economy is in short-run as well as long-run equilibrium and real GDP is equal to potential GDP.&nbsp;</p>



<p>In the third graph, the real GDP is less than potential GDP. The above three graphs related to different phases in business cycle, as shown below:</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/business-cycle-2.png" alt="" class="wp-image-28527" width="616" height="156"/></figure></div>

Business Cycle and Economics

<p>Let’s say that the economy is initially in short run and long run equilibrium as shown below:</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/Change1.png" alt="" class="wp-image-28531" width="503" height="340"/></figure></div>



<p>Now let’s say that the aggregate demand increases and the aggregate demand curve shifts to the right (AD’). A new short run equilibrium will be formed at point B. </p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/Change2.png" alt="" class="wp-image-28532" width="539" height="378"/></figure></div>



<p>In the new equilibrium, the real GDP is greater than potential GDP. At the new equilibrium the price levels are high, which means lower real wage rate. Now two phenomenons will take place: 1) Businesses will want to produce more to meet increased demand at higher price levels, and 2) They will need to hire new workers. Both these factors will lead to an increase in money wage rates. An increase in money wage rates and other resource prices means that businesses will be willing to supply less at each price level. Slowly, the SRAS will shift to the left and the long run macroeconomic equilibrium will be restored at point C.</p>



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<p>In the opposite situation, the aggregate demand falls and the aggregate demand curve shifts to the left, forming a new equilibrium at a lower price level. Slowly the SRAS will shift to the right to restore the long run macroeconomic equilibrium.</p>



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Impact of Changes in Aggregate Supply and Demand

<h3>Sources</h3>



<p>There are five important sources of economic growth:</p>



<ol type="1"><li>Increase in the supply of labour, i.e., the number of people working or available for work.</li><li>Along with the supply of labour, the knowledge and skill level of the labour also influences the economic output of a country.</li><li>Increase in the availability of physical stock due to increased investments.</li><li>Improvement in technology, increases productivity.</li><li>Increased availability of natural resources, both renewable and non-renewable, also accelerates economic growth.</li></ol>



<h3>Sustainability</h3>



<p>The economic growth occurs when real output in the economy increases over time. Sustainable economic growth rate is the rate of increase in an economy’s GDP that can be sustained for a long time without creating other significant economic problems.&nbsp;</p>



<p>We can state the potential GDP as follows:</p>



<p class="has-background" style="background-color:#fffac1"><strong>Potential GDP = Aggregate hours worked x Labour productivity</strong></p>



<p>We can estimate the sustainable growth rate of an economy by estimating the growth rate of labour force and growth rate of labour productivity.</p>



<p class="has-background" style="background-color:#fffac1"><strong>Potential growth rate = Long-term growth rate of labour force x Long-term labour productivity growth rate</strong></p>



<p>It is important for a country to achieve a sustainable growth rate because the economic growth directly affects the long-term equity returns.</p>

Sources, Measurement, and Sustainability of Economic Growth

<p>The quantity of real GDP supplied in an economy is a function of the quantity of labour (L), quantity of capital (K), and total factor productivity (A). This is called the production function.</p>



<p class="has-background" style="background-color:#fffac1"><strong>Y = A x F(L, K)</strong></p>



<p>Total factor productivity, A, is the production unaccounted for by capital or labour. It is related to the available production technology.</p>



<p>We can also express this function as output or real GDP per worker:</p>



<p class="has-background" style="background-color:#fffac1"><strong>Y/L = A x F(K/L)</strong></p>



<p>Y/L is the output per worker while K/L is the physical capital per worker. We can either increase physical capital per worker or improve technology to increase labour productivity.</p>



<p>The production function exhibits diminishing marginal productivity for every input. As we increase the quantity of an input, the output increases but at a decreasing rate. For example, as the amount of physical capital per labour increases, the output from additional unit of capital keeps decreasing. This is the reason why sustainable growth cannot be achieved just by investing more capital. Growth in all factors is necessary for long-term growth.&nbsp;&nbsp;</p>

The Production Function

This quiz is a part of the CFA Level 1 reading 'Aggregate Output, Prices, and Economic Growth'. 

Aggregate Output, Prices, and Economic Growth

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