-Aggregate Demand: A schedule or curve that shows the amounts of real output (real GDP) that buyers collectively desire to purchase at each possible price level.
-In other words, AD = C + I + G + NX
-Graphing aggregate demand: A downward sloping curve with the price level on the Y-axis and real GDP (Y) on the X-axis.
-Demand for an individual good or service slopes downward because of the income effect and substitution effect. These don’t apply to the explanation of aggregate demand because we’re talking about price levels, not individual prices. (Substitution effect is based on a similar product being cheaper than another; doesn’t work if everything becomes cheaper when price levels fall. Income levels in general fall as well, so there is no income effect).
-Aggregate demand is downward sloping because of 3 effects: the real balances effect, the interest rate effect, and foreign purchases effect.[break]
Real Balances Effect
Real Balances Effect
-Rising price levels (inflation) decreases the purchasing power of assets with fixed dollar values like savings accounts, bonds, and annuities. This decreased purchasing power means that the public is now poorer, which leads to decreased consumption, which leads to a lower level of aggregate demand (AD (down) = C (down) + I + G + NX).[break]
Interest Rate Effect
Interest Rate Effect
-Assuming a fixed level of money supply, when price levels go up, the demand for money goes up (as people now need more dollars to purchase the same amount of goods). This increase in money demand leads to an increased interest rate. Higher interest rates means that firms now have a smaller portfolio of projects that have a high enough expected rate of return to borrow against, so they will undertake fewer projects and consequently have lower investment spending. At the same time, consumer related purchases that are dependent on interest levels (like buying a home or a car) also decrease because it is now more expensive to purchase the same good. This decrease in consumption and investment spending leads to a lower level of aggregate demand (AD (down) = C (down) + I (down) + G + NX).[break]
Foreign Purchases Effect
Foreign Purchases Effect
-When domestic price levels rise relative to foreign price levels, domestic goods become relatively more expensive and foreign goods become relatively cheaper. This leads to fewer domestic goods being exported and more foreign goods being imported, leading to decreased net exports which lower the level of aggregate demand (AD (down) = C + I + G + NX (down)).

-An economy is analogous to a complex machine; there are a lot of moving parts, many of which depend on each other. If one part breaks down, then the whole machine breaks down.
-This concept can easily be seen in the circular flow model.
-To keep things simple, we’ll look at a private closed economy so there are only two parts: households (consumers) and businesses (firms).
-There are two types of flows in this model: real flows (goods, services, and resources) and monetary flows (money).[break]
Real Flows
Real Flows
-Starting with households: Households are the keepers of resources (land, labor, capital, and entrepreneurial ability). They offer up their resources for use in the resource market.
-Businesses take the resources from the resource market and transforms them into goods and services, which they offer up in the product market.
-Households consume the goods and services from the product market.[break]
Monetary Flows
Monetary Flows
-Opposite of the real flows are the monetary flows, which is money that gets exchanged for the goods, services, and resources.
-Households spend their money in the product market to consume goods and services (consumption expenditures).
-The money that businesses get from offering goods and services in the product market is known as revenue.
-Businesses take the revenue that they get to pay for the costs of buying resources from the resource market.
-The money that is spent by businesses in the resource market translate into income for households.[break]
Circular Flow Diagram
Circular Flow Diagram
-Combing the two together gives you the circular flow diagram. With this you can easily see how one part of the economy is dependent on the other.
-For example, if households consumed less goods and services then businesses won’t make as much revenue which leads to them purchasing fewer resources which means less income for households which means fewer goods and services are consumed, so on and so forth.
-The opposite is also true: increased spending in one part would lead to increased spending in the other, cycling back and forth.

-Use our limited resources to produce a mix of goods and services.
-The production possibilities model shows us all the various combinations of output an economy can achieve.[break]
Simplifying Assumptions
-Two good economy: Keeps us from drawing crazy graphs and avoids tough mathematics while still getting the key concept across. We’ll say that there is a capital good and a consumer good.
-Fixed resources: The quality and amount of resources available to an economy (land, labor, capital, and entrepreneurial ability) do not change.
-Fixed technology: The productive efficiency of this economy does not change, i.e. they cannot produce more output using the same number of resources.
-Full employment: For now, this economy is utilizing all of its available resources to the best of its ability.
-Time period of one year: Economic analysis are meaningless without time frames attached to them. We’ll arbitrarily pick one year.
-Closed economy: No trading with others.[break]
Graphing the Model
Production Possibilities Model
-Taking our assumptions into account, we can create the productions possibilities curve (PPC).
-The PPC shows us all the different combinations of output we can have, given our resources and technology.
-The full employment of resources means that this economy can produce anywhere on the line.
-Note: We cannot tell with the given information what combination of goods will be produced; we only know the different combinations that could be produced. The actual mix of output will be determined by the society and their preference for consumer and capital goods.
-If we strip away the full employment assumption, i.e. an economy is not utilizing all of its available resources, then the point in which this economy will produce will lie somewhere inside the curve.
-It is not possible for an economy to produce outside of its production possibilities curve.
-Note the concave nature of the curve: as more and more consumer goods are produced, fewer and fewer capital goods are produced and vice versa. This is due to increasing opportunity costs.
PPM - Increasing Opportunity Costs
-For each successive unit of good X this economy wants to produce, it has to give up more and more units of good Y. For each successive unit of good Y this economy wants to produce, it has to give up more and more units of good X.
-This is because certain resources are better producing one thing than another. Some land is better suited for farming rice while other land is better suited for corn. Some people are better artists while others are better accountants. The more of one good or service that is produced, the fewer suitable resources there are to produce it, so it will take more resources to produce the next successive unit.
-The only way for an economy to produce more of one good without giving up some of the other is for it to be inside the PPC, in other words when this economy is not fully utilizing its resources.
PPM - Unemployment
-For example, in this case this economy can choose to produce more X, more Y, or more of both.
-As it was mentioned earlier, an economy cannot produce outside of its PPC. However, this does not mean that an economy is forever limited to its current output potential.
-Over time, the resources an economy has will change, as well as the technology available.
-If one or both of these factors change for the better, the PPC will shift to the right increasing the output potential.
-If one or both of these factors change for the worse, the PPC will shift to the left, decreasing the output potential.
-Another way for an economy to change its productive capabilities is by opening itself up to trade and specializing in production, but that’s a whole other subject on its own.

-Aggregate Expenditures: The sum of the total spending in the economy.
-AE = C + I + G + NX
-Slope of the aggregate expenditures line is the marginal propensity to consume (MPC).
-The curve shows for any given level of income, what we as an economy are willing to consume.
-Savings is the leakage that causes AE to be less than GDP.
Aggregate Expenditures
-The equilibrium is where spending is equal to output. In other words, we as an economy consume what we produce.
-That’s where the significance of the 45 degree line comes in. At every point on the line, Y = X, so in this case the 45 degree line shows where spending is equal to income.
Aggregate Expenditures 2
-This is a short run model, so prices are sticky (they do not change). So instead of react to changing prices, firms react to changing inventory levels.
-If aggregate expenditures is greater than income (Y1, AE1), then spending is greater than production. We are buying more than we make. Firms will have to sell off their inventory, reducing inventory. Firms will react by hiring more workers and increasing output.
-If aggregate expenditures is less than income (Y2, AE2), then spending is less than production. We are buying less than we make. Firms will have to add on to their inventory, increasing inventory. Firms will react by laying off workers and decreasing output.

-The multiplier effect: a small change in spending will yield a much larger change in GDP.
-If someone increased their spending by $1, the economy’s GDP would increase by more than $1.
-To understand the logic behind this, let’s take a look at an example.[break]
Multiplier Effect Rationale

-Suppose a firm decided to increase their investment spending by $5.00. Let’s say that they chose to put that $5.00 towards constructing a new building. That means a construction worker is going to get $5.00 in income that he didn’t have before (change in income).
-Of this new $5.00, this construction worker is going to spend some of it and save some of it. If his marginal propensity to consume is 0.80, then of this new $5.00, he will spend $4.00 (change in consumption) and save $1.00 (change in savings).
-Suppose this construction worker takes the $4.00 and spends it at the liquor store down the street from his house. That means that the store owner now has an extra $4.00 in income that he didn’t have before.
-The store owner is going to spend 80% of it ($3.20) and save 20% of it ($0.80).
-The $3.20 that the store owner spends is going to turn into someone else’s income, which in turn leads to more spending which leads to more income.
-If we execute this over many transactions and sum all the numbers, we find that in this scenario, a $5.00 initial increase in spending will lead to a total of a $25.00 change in income, aka GDP.
-The reason why the multiplier effect exists is because one person’s spending is another person’s income
-Opposite scenario: If spending was cut by $5, GDP decreases by $25.[break]
-MPC + MPS = 1
Multiplier = \frac{1}{1-MPC} or Multiplier = \frac{1}{MPS}
-Change in GDP = Multiplier  x Initial Change in Spending
-Multiplier = Change in GDP / Initial Change in Spending

-To economists, there really only two things you can do with your money: spend it or save it.
-In other words, Disposable Income = Consumption + Savings
-If your disposable income changes, then your consumption, savings, or a combination of both will change.
-We use the terms marginal propensity to consume and marginal propensity to save to analyze this topic.
-In economics, the word marginal means ‘change in’ or ‘addition to’. Propensity refers to the tendency for something to happen.
-So the marginal propensity to consume/save just refers to how we would alter our spending/savings when our income changes.
-The marginal propensity to consume (MPC) is the rate that consumption will change for a given change in disposable income. In other words, MPC = Change in Consumption / Change in Disposable Income.
-The marginal propensity to save (MPS) is the rate that savings will change for a given change in disposable income. In other words, MPS = Change in Savings / Change in Disposable Income.

Types of Unemployment
-We generally classify unemployment into one of three categories: frictional, structural, and cyclical.
Frictional Unemployment: Works are “between jobs.” Might voluntarily be moving from one job to the next. Might have been fired. Might have been laid off due to seasonal demand, etc.
Structural Unemployment: Caused by a change in demand for labor. Could be due to a change in demand for skills. Could be caused by a change in geography as firms move locations.
-The difference between frictional and structural unemployment isn’t always clear cut. The key difference is that frictionally unemployed workers have marketable skills and either live in areas where jobs exists or are able to move to areas where they do. Structurally unemployed workers find it hard to obtain new jobs without retraining, gaining additional education, or relocating.
Cyclical Unemployment: Caused by a decline in total spending. Follows the business cycle.
-It is impossible to have zero frictional unemployment and structural unemployment because firms are always changing and people are always quitting their jobs or getting fired. So when we say that the economy is full employed, we don’t mean that the unemployment rate is at 0%, we mean that there is zero cyclical unemployment.
-Full employment does not equal 100% employment.
-When an economy is operating at its full employment rate (or natural rate of unemployment) it is producing its potential output. [break]
Calculating the Unemployment Rate

-Employment Rate = \frac{\&hash;\ Employed}{Labor Force} \times 100\%

-Unemployment Rate = \frac{\&hash;\ Unemployed}{Labor Force} \times 100\%
-Alternatively, Unemployment Rate = 1 – Employment Rate
-Labor Force = Unemployed + Employed
-According to the Bureau of Labor Statistics, you are not considered part of the labor force if you are not looking for work, if you’re under 16, or if you’re institutionalized.
-A discouraged worker is someone who used to be employed, became unemployed, and then became discouraged from looking for work after not being able to find a job for a while. Once they are no longer looking for work, they are no longer considered unemployed. [break]
Total Population: 250 million
Number of People Not in the Labor Force: 150 million
Number of People Employed: 130 million
Number of People Unemployed: 20 million

Using the above information, calculate the labor force and the unemployment rate.

Labor Force = Employed + Unemployed = 130 million + 20 million = 150 million
(Can also take Total Population – Number of people Not in the Labor Force)

Unemployment Rate = \frac{20\ million}{150\ million} \times 100\% = 13.33% [break]
Problems with This Measure of Unemployment
-A few problems arise with the way the Bureau of Labor Statistics measures unemployment.
-It is potentially understated because the statistic excludes people who hold part time jobs.
-It is potentially understated because it excludes workers who are under 16 years of age.
-Changes in the unemployment rate can come about without any actual changes in the total number of jobs. For example, suppose that this month there is currently a labor force of 100,000, with 95,000 people employed (5% unemployment rate). 18,750 discouraged workers hear about this low unemployment rate and become inspired to look for work again. Suppose the total number of jobs in the economy stays fixed at 95,000. Then the next month, the reported unemployment rate will jump up to 20% (= 1 - \frac{95,000}{118,750} \times 100\%). While the absolute number of jobs have not changed, this sudden increase in the unemployment rate makes the economy look worse than it really is, which can cause people to panic.
-It is also easy to imagine a scenario where the number the total number of jobs does not change, but the number of people who are actually looking for work, decrease, causing the unemployment rate to drop, making the economy look better than it really is.

Now that we have a better understanding of what GDP is and the various ways it’s calculated, let me present a scenario to you.

Suppose we have this economy, and in year 1, this economy’s GDP measured out to be $2,500. In year 2, the value of GDP rose to $5,000. Based on this information, what can you tell me about this economy?

“Well, it seems to me that this economy doubled its production going from year 1 to year 2, but it’s not that simple, is it? This is probably a trick question, otherwise you wouldn’t be asking me this, you say.

Your intuition is spot on. Since GDP is the measurement of an economy’s output one might think that if the value of GDP rose, it must mean production has risen as well, but that isn’t always the case. You have to remember that GDP is measured with money and the value of money changes over time due to inflation or deflation.

Let me show you what I mean. Pretend this economy is a one item economy; all they produce are toys. In year 1, this economy manufactured 250 toys and sold them for $10 apiece. That would give us our first year GDP value of $2,500 $(= \$10 x 250 toys). So far so good. Then let’s say that in year 2, this economy still produced 250 toys, but the price doubled to $20 apiece, doubling GDP to $5,000 $(= \$20 x 250 toys).

If GDP is supposed to be a measure of production, shouldn’t it remain the same between year 1 and year 2, since this economy produced the same number of toys each year?”

Indeed it should and therein lies the problem with what we call nominal GDP which is GDP that has not been adjusted for inflation. When we’re talking about GDP, the only thing we’re concerned about is output, but nominal GDP has prices as an added factor. The changing prices disguises any potential change in output.

Trying to compare nominal GDPs is like trying to compare distances that have been measured with a ruler that keeps on changing its mind about how long a foot is. You’re not going to get a meaningful result.

Economists realized this was a problem and the solution they came up with was a way to standardize prices across every time. That way, the value of $1 holds the same amount of weight now as it did 100 years ago. In other words, economists adjust GDP for inflation and that adjusted value is referred to as real GDP. With real GDP, we eliminate prices as a variable for change, so changes in real GDP reflect actual changes in output.

The easiest way to explain this is with an example, so follow along.

Nominal GDP and Real GDP Example
Here I have a two item economy that produces hotdogs and hamburgers. I have the quantities they produced each year along with the corresponding prices. Note how output falls going from year 3 to 4, but nominal GDP still increases, due to higher prices. The decrease in output however, is accurately captured in the real GDP, which falls from $170 to $110.

Calculating Nominal GDP
To calculate the nominal values of GDP of any given year, all we have to do is take the price of a good and multiply it by the quantity in the same year and sum those numbers up across all the goods. So to calculate nominal GDP for year 3, we take the price of hotdogs in year 3 ($5) multiply that by the number of hotdogs produced in year 3 (11 hotdogs) and add that to the price of hamburgers ($9) multiplied by the quantity of hamburgers (21 hamburgers). That gives us a nominal GDP of $244 $(= \$5 x 11 hotdogs + \$9 x 21 hamburgers) for year 3. You would repeat that process for all the other years to find their corresponding nominal GDP values.

Calculating Real GDP: Fixing Prices
Since we only have a two item economy, we can use a very simple method of calculating real GDP. The first thing that we have to do is select a reference year or a base year that we’re going to compare every other year to. (You can select any year you’d like. Just keep in mind that choosing different base years will give you different numbers.)Then we say to ourselves, “What would GDP be like if prices never changed throughout the years?” In other words, we fix the price so only output can change.

In this example, I chose year 1 as my base year. I see the price of hotdogs in year 1 is $4 and the price of hamburgers in year 1 is $6. So I’m saying to myself, “Let’s look at every other year’s GDP using year 1’s dollars.” So if I wanted to find out what the real GDP in year 4 was, I would take the prices in year 1 and multiply them by the quantities in year 4. This gives me a real GDP value of $110 $(= \$4 x 8 hotdogs + \$6 x 13 hamburgers).

Special note: The nominal GDP and the real GDP for your base year is always the same.

Calculating Real GDP: GDP Deflator
In the real world, there would be far too many things to keep track of in order to compute real GDP by fixing prices, especially if you were doing it by yourself. Instead, we calculate real GDP by using the GDP deflator, which is calculated by the Bureau of Economic Analysis (in the United States, anyway). They come up with the GDP deflator by tracking a market basket of goods and using a chain weighted technique to come up with their price index. If that sounds complicated, that’s because it is. Don’t worry, we won’t be covering that today. Instead, we’ll just be referring to this very simple formula:

$Real GDP = (Nominal GDP/GDP Deflator) x 100
From which we can derive: $GDP Deflator = (Nominal GDP/Real GDP) x 100
As well as: $Nominal GDP = (Real GDP x GDP Deflator)/100

This means that as long as you’re given at least two variables, you can always calculate the third. For example, let’s say that the base year is still year 1 and we want to use the GDP deflator in year 5 to calculate the real GDP for year 5. To do that, we simply take the nominal GDP in year 5 ($376), divide it by year 5’s GDP deflator (241) and multiply the result by 100 to get $156 $(= (\$376/241) x 100). If you know the nominal GDP and the real GDP for a given year, you can calculate that year’s GDP deflator. To get the GDP deflator of 145 $(= (\$206/\$142) x 100) in year 2, just take the nominal GDP of year 2 ($206), divide that by the real GDP of year 2 ($142) and multiply the result by 100. You can also rearrange the formula to solve for nominal GDP, as I did above. I’ll leave that exercise up to you so this post isn’t cluttered up with too many numbers.

Special note: The GDP deflator for your base year is always 100.

So you can see that the GDP deflator takes the inflation and deflation of prices across all the goods and services in an economy and compresses it into one neat little number. It allows us to tell, at a glance, how prices have been acting within the economy. If the deflator increases in value, it means that in general, prices have risen. If the deflator falls, it means that in general, prices have fell. In fact, the GDP deflator is one of the metrics some people use to measure inflation in an economy, but that’s a discussion for another time.
Recap (tl;dr)
-Nominal GDP does not account for inflation.
-Nominal GDP can change because prices changed or because output changed or because of a combination of the two.
-Real GDP accounts for inflation and removes price as a factor.
-Changes in real GDP reflects real changes in output.
-Nominal GDP is calculated by taking prices in a given year and multiplying it with the output in the same year and summing those numbers up across all the goods and services.
-The first step to calculating real GDP is choosing a base year.
-Real GDP can be calculated by fixing base year prices or by using the GDP deflator.
-The nominal GDP and real GDP is always the same in the base year.
-The GDP deflator is always 100 in the base year.
McConnell, Campbell R., Stanley L. Brue, and Sean Masaki. Flynn. Macroeconomics: Principles, Problems, and Policies. Boston: McGraw-Hill Irwin, 2009. Print.
Previous economics post: Calculating GDP: Expenditures Approach

There are several different methods of calculating an economy’s GDP. Theoretically, all the different techniques should give you the same number, but that’s rarely the case due to the massive amount of data that needs to be dealt with in addition to all the points in the process where errors can creep in. That being the case, the real world results still tend to be pretty similar to each other.

Last, but not least, we arrive at the expenditures approach to calculating GDP. Conceptually, this probably the easiest method to wrap your head around. We’ll be referring back to this a lot later on down the road. This method is on the opposite end of the spectrum from the income approach. The income approach looks at all the wages, rents, interest, and profits earned by producing an item while the expenditure approach looks at all the money spent on purchasing an item. We can compute GDP by summing up the economy’s total spending in four areas: personal consumption, investment spending, government purchases, and net exports.
Personal Consumption Expenditures (C)
This category sums up all the money that is spent by households, regular people like you and I, on goods and services. Buying groceries, buying a new car, eating out at a restaurant, all these things fall under the category of personal consumption. It’s denoted in the GDP equation by a C.
Investment Spending (I)
When economists talk about investment, they generally aren’t referring to the financial transactions people normally think of. They’re not talking about buying and selling stocks and bonds or saving money in an account. When we talk about investment, we’re referring to the money spent by firms (businesses) on capital goods, changes to a firm’s inventory, and the construction of buildings. Investment is denoted in the GDP equation with an I. [break]
Side Note: Inventory
Remember that GDP accounts for all goods and services produced in a year, regardless of whether or not anything was sold. Changes in inventory is how the expenditures approach accounts for unsold goods (positive change in inventory) or goods sold in excess of the year’s productions (negative change in inventory) so that GDP doesn’t become understated or overstated. [break]
Side Note: Construction
All construction is counted under investment when using the expenditures approach to calculate GDP. This is because buildings are considered to be capital, even residential homes and apartments. A home owner has the option of leasing out his home and creating rental income from it, just like a factory or equipment or any other capital good.
Government Purchases (G)
The government spends a lot of money providing public services (education, firefighters, military) and publicly owned capital (schools, parks, roads). The money they spend on these public goods, services, and capital counts towards GDP and is recorded under government purchases. Not all of the government’s spending is included here though; remember that public transfer payments are not a part of GDP. Government purchases are denoted with a G.
Net Exports (NX)
Goods and services that are produced don’t necessarily all stay in their home country; some of it may get sent abroad. In other words, these goods and services are exported (exports is denoted with an X). Since those goods and services are produced domestically, they need to be added to GDP. At the same time, we don’t obtain all of our goods domestically, we get some of it abroad. In other words, we import goods and services (imports is denoted with an M). The three previous categories, personal consumption, investment spending, and government purchases don’t distinguish whether or not those expenditures were domestic or foreign. They’re just the total sum of expenditures in each category. To avoid overstating GDP, we have to subtract out the amount that we import. To make things simpler on ourselves and so we have fewer numbers to deal with, we lump up our international trade expenditures into one category, net exports which is defined as exports minus imports. Net exports is denoted with an NX.

Thus, the expenditures approach to GDP can easily be summed up with a simple equation: GDP = C+I+G+NX.
McConnell, Campbell R., Stanley L. Brue, and Sean Masaki. Flynn. Macroeconomics: Principles, Problems, and Policies. Boston: McGraw-Hill Irwin, 2009. Print.
Next economics post: Nominal GDP vs Real GDP
Previous economics post: Calculating GDP: Income Approach