Unit 3 Aggregate demand and the multiplier model

3.14 Summary

• GDP is an imperfect but important measure of how much an economy produces. It omits household production and the illegal and shadow economies.
• A system of national accounts is used to measure GDP based on spending by households, firms, the government, and foreigners on final output, the incomes received by producers as wage, salaries, and profits, and the contribution of each industry to the value added in production.
• GDP per capita is an imperfect but important indicator of a country’s living standards. It neglects important aspects of well-being, including the enjoyment of leisure time, the quality of the physical and social environment, and the extent of inequality.
• To make comparisons of GDP and GDP per capita over time and between countries, account must be taken of how prices for goods and services change and differ.
• Fluctuations in the total output of a nation (GDP) over the business cycle are caused by shifts in the aggregate demand for goods and services. They affect unemployment, and unemployment is a serious hardship for people.
• Households respond to shocks by saving, borrowing, and sharing to smooth their consumption of goods and services.
• Due to limits on people’s ability to borrow (credit constraints) and their present bias, these strategies are not sufficient to eliminate fluctuations in their consumption.
• Unlike consumption, spending on investment projects is often clustered. Investment spending therefore fluctuates more than consumption. Business investment depends positively on expected post-tax profits and negatively on the interest rate.
• The multiplier model is used to study the business cycle. It consists of the equation for goods market equilibrium and the equation for aggregate demand. Solving the two equations gives the formula for the multiplier, which in this model has a value greater than one.