Kindle Notes & Highlights
The macroeconomic concepts of aggregate demand (AD) and aggregate supply (AS) pertain to the economy-wide demand and supply for all items. The sum of the quantities of all these items is aggregate output or GDP, which we will denote as y. The average price at which these are sold is denoted as P, the aggregate price level.
aggregate demand is denotes as AD, aggregate supply is denoted as AS and p is the inflation rate,
p =
aggregate demand is real GDP growth or g(y).
Aggregate Supply is gy* or potential GDP growth, i.e., the growth rate when the economy is making full use of its resources. It is important to note that this potential GDP is unobservable.
gy = gy* ± Deviations from gy* (structural or potential) (due to cyclical demand fluctuations) When the economy remains in Long-Run Equilibrium, yt = y*t and hence gy = gy* for all those periods.
Analysis of the macro-economy can be broken down into two major components: (i) analysis of the long-run factors that influence gy* or potential GDP growth, and (ii) analysis of the factors that influence short-run fluctuations of actual growth gy around gy*. The latter component—analysis of short-run fluctuations—is highly relevant to the world of business and finance.
In Long-Run Equilibrium (LRE), gy converges to, or is at gy*.
The term ADSGAP has been chosen to best capture what it represents: the AD–AS gap.
Aggregate Demand Aggregate Supply gap to ADSGAP.
Based on theoretical and factual considerations, we can postulate: 1. When ADSGAP > 0, AD exceeds AS. The economy is overheated and inflation tends to rise. 2. When ADSGAP < 0, AD is less than AS. The economy has slack and inflation ten...
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basic GDP accounts we know that: Y = AD = C + I + G + X – M where C is consumption, I is investment, G is government expenditure, X is exports and M is imports.
The economic factors affecting GDP or Aggregate Demand can be grouped into four categories: (a) Fiscal Policy: Government spending, taxes and subsidies, which are determined by the Treasury or the Finance Ministry. Higher government spending raises G and may stimulate C or I, while higher taxes (whether by changing tax rates or exemptions) lowers consumption, or C. (b) Monetary Policy: This is determined by the central bank, such as the US Federal Reserve or the Reserve Bank of India. Higher interest rates (and/or other factors such as the cash reserve ratio imposed on banks) lowers investment
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Real business cycle factors: These comprise technological innovations that lead to rapid spurts of growth, usually followed by a collapse.
(iii) Other miscellaneous factors that we may have left out.
When it comes to real business cycle factors, although they are classified here as affecting the AD, it is not that clear as to whether they should be classified as a part of AD or AS.
Conventional Approach to Growth for Developing Economies In this approach, GDP growth depends only upon (i) investment in machines and (ii) how efficiently these machines or capital stock is used.
assumed that labour supply is always available
g(y) =
DK is the change in the capital stock, i.e., investment (ignoring depreciation), as defined in macroeconomics, which also equals savings, from national income accounting. Hence, DK = I = S.
g(y) =
S/y is the savings rate or savings ratio or small ‘s’, while (DK/Dy) is the incremental capital output ratio (ICOR), i.e., the extra amount of capital needed to produce one extra unit of output.
The Solow growth framework is an accounting decomposition of actual growth into three factors or inputs; (i) capital, (ii) labour and (iii) technical progress.
Total Output = Labour Input (Total Hours) × Output per Hour, i.e., Labour Productivity. Based on that,3 g(Output) = g(Hours) + g(Labour Productivity)
Higher productivity per worker can come from more capital stock per worker or from pure technical progress.
Firms choose the ratio of capital to labour to equal the ratio of the rental price of capital to the wage rate.4 Thus, if capital is scarce and expensive relative to labour, firms will use labour intensive techniques, i.e., individual worker operated machines to produce the output. On the other hand, if labour is scarce relative to capital, firms may use robots for production. Output is the outcome of sophisticated optimising decisions in the Solow growth model.
Real Output y = f (Capital Stock, Labour, Technology). Now gy can be decomposed into the sum of growth contributions (gc): gy = gc (Capital Stock) + gc (Labour Hours) + gc (Total Factor Productivity)
Total factor productivity, henceforth abbreviated as TFP, is calculated as the residual item, subtracting gc (Capital Stock) and gc (Labour Hours) from total growth. TFP is what corresponds to pure technical progress. It represents the extra output per unit of labour input after taking into account the contribution of more capital stock. Basically, it captures the contribution to output of factors other than the measured inputs of capital and labour.
Output per person hour is labour productivity.
only one-eighth of this total increase in labour productivity was due to more capital stock and the reminder seven-eighth was due to TFP.
When there is diminishing marginal productivity, as in the Solow model the growth contributions of labour and capital will be less than growth in the respective inputs.
The alternative new approach discussed in this section is not formulaic. It instead tries to identify the underlying policies that lead to growth. It focuses upon law and order and property rights in general and, more specifically, on the ease of doing business (EDB).
how rule of law and EDB affect growth. More specifically, how can a robust rule of law and an improved EDB affect the GDP growth contributions in the Solow framework of total factor productivity (TFP), labour and capital respectively, and of the choice of technique? First, with regard to TFP, the property rights approach implies that implementing stringent Intellectual Property Right (IPR) laws and patent protection will facilitate innovation and new products and processes.
Second, with regard to labour supply (not just wage labour but more so self-employed persons and entrepreneurs), it is obvious that individuals have incentives to work harder and produce more when they are guaranteed ‘the fruits of their labour,’
If tax rates are too high, that is also likely to reduce labour supply.
clear title to land and real estate (Khatha in Hindi) is vital for capital accumulation.10 Mapping areas and creating land records is very important.
The legal infrastructure to enforce payment is far more crucial.
EDB Survey. The number of days and procedures for the following activities are separately recorded for: (i) starting a business, (ii) dealing with construction permits, (iii) getting electricity, (iv) registering a property, (v) paying taxes, and (vi) enforcing contracts. A reduction in the number of days and/or number of procedures obviously increases the EDB and pushes up the GDP growth.
relative, and not the absolute EDB.
in any given year, the growth rate of a country may be unrelated to its EDB conditions.
we should be looking at growth over a longer period which is likely to broadly correspond to potential GDP growth.
per capita income is positively correlated with greater EDB
average growth rate is negatively correlated with per capita income
the average GDP growth is negatively correlated with a greater EDB
why are rich countries (those with a high per capita income) rich? Consider the first correlation—between per capita income and EDB rank. This can be explained as follows. Countries with an improved rule of the law and greater EDB have prospered and developed over decades and even centuries, and this has resulted in a high per capita income. Their EDB is high, and their EDB rank is also high.
other things being equal, a higher population growth raises the GDP growth.
in rich countries, the average hours of work per worker is usually lower than in emerging economies.
From a sales or business point of view, developed economies with high per capita incomes have relatively saturated markets.
No economy is ever saturated as long as new products are devised, or customers like to frequently replace existing models with new, higher value models, such as smartphones, and have the income to purchase them.
