CFA® Program Curriculum, Volume 2, page 266 A well-known model (the Solow model or neoclassical model) of the contributions of
Study Session 5
Consider a developed country where WL = 0.7 and Wc = 0.3. For that country, a 1%
increase in the labor force will lead to a much greater increase in economic output than a 1% increase in the capital stock. Similarly, sustained growth of the labor force will result in greater economic growth over time than sustained growth of the capital stock of an equal magnitude.
Growth in total factor productivity is driven by improvements in technology.
Sometimes, the relationship between potential GDP, technology improvements, and capital growth is written on a per-capita basis2 as:
growth in per-capita potential GDP = growth in technology + Wc (growth in the capital-to-labor ratio)
With Wc = 0.25, for example, each 1% increase in capital per worker will increase GDP per worker by 0.25%. In developed economies, where capital per worker is already relatively high, growth of technology will be the primary source of growth in GDP per worker. At higher levels of capital per worker, an economy will experience diminishing marginal productivity of capital and must look to advances in technology for strong economic growth.
K ey C oncepts
LOS 17.a
Gross domestic product (GDP) is the market value of all final goods and services produced within a country during a certain time period.
Using the expenditure approach, GDP is calculated as the total amount spent on goods and services produced in the country during a time period.
Using the income approach, GDP is calculated as the total income earned by households and businesses in the country during a time period.
LOS 17.b
The expenditure approach to measuring GDP can use the sum-of-value-added method or the value-of-final-output method.
• Sum-of-value-added: GDP is calculated by summing the additions to value created at each stage of production and distribution.
• Value-of-final-output: GDP is calculated by summing the values of all final goods and services produced during the period.
LOS 17.c
Nominal GDP values goods and services at their current prices. Real GDP measures current year output using prices from a base year.
The GDP deflator is a price index that can be used to convert nominal GDP into real GDP by removing the effects of changes in prices.
LOS 17.d
The four components of gross domestic product are consumption spending, business investment, government spending, and net exports. GDP = C + I + G + (X - M).
National income is the income received by all factors of production used in the creation of final output.
Personal income is the pretax income received by households.
Personal disposable income is personal income after taxes.
LOS 17.e
Private saving and investment are related to the fiscal balance and the trade balance. A
Study Session 5
LOS 17.f
The IS curve shows the negative relationship between the real interest rate and levels of aggregate income that are equal to planned expenditures at each real interest rate.
The LM curve shows, for a given level of the real money supply, a positive relationship between the real interest rate and levels of aggregate income at which demand and supply of real money balances are equal.
The points at which the IS curve intersects LM curves for different levels of the real money supply (i.e., for different price levels, holding the nominal money supply constant) form the aggregate demand curve. The aggregate demand curve shows the negative relationship between GDP (real output demanded) and the price level, when other factors are held constant.
LOS 17.g
The short-run aggregate supply curve shows the positive relationship between real GDP supplied and the price level, when other factors are held constant. Holding some input costs such as wages fixed in the short run, the curve slopes upward because higher output prices result in greater output (real wages fall).
Because all input prices are assumed to be flexible in the long run, the long-run aggregate supply curve is perfectly inelastic (vertical). Long-run aggregate supply represents potential GDP, the full employment level of economic output.
LOS 17.h
Changes in the price level cause movement along the aggregate demand or aggregate supply curves.
Shifts in the aggregate demand curve are caused by changes in household wealth, business and consumer expectations, capacity utilization, fiscal policy, monetary policy, currency exchange rates, and global economic growth rates.
Shifts in the short-run aggregate supply curve are caused by changes in nominal wages or other input prices, expectations of future prices, business taxes, business subsidies, and currency exchange rates, as well as by the factors that affect long-run aggregate supply.
Shifts in the long-run aggregate supply curve are caused by changes in labor supply and quality, the supply of physical capital, the availability of natural resources, and the level of technology.
LOS 17.i
The short-run effects of changes in aggregate demand and in aggregate supply are summarized in the following table:
Type o f Change Real GDP Unemployment Price Level
Increase in AD Increase Decrease Increase
Decrease in AD Decrease Increase Decrease
Increase Decrease Decrease