1. Chapter 5 Aggregate Output, Prices, and Economic Growth
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2. 1. Introduction
The focus of this chapter is on macroeconomics, which is the theory and analysis of a nation’s
income and output;
competitive and comparative advantages;
productivity of the labor force;
price levels and inflation; and
government and central bank actions.
Macroeconomics enables understanding of the effect that a nation’s economy, government actions, and economic trends have on industries and companies.
Copyright © 2014 CFA Institute

3. 2. Aggregate output and income
The aggregate output of an economy is the value of all the goods and services produced in a period of time (e.g., one year or one quarter).
The aggregate income of an economy is the value of all the payments earned by the suppliers of factors used in the production of goods and services in a period of time. Forms of payment include the following:
Compensation to employees
Rent (payment for the use of property)
Interest (payment of the use of funds)
Profit (return for the use of capital and the assumption of risk)
The aggregate expenditure is the total amount spent on goods and services in an economy.
LOS: Calculate and explain gross domestic product (GDP) using expenditure and income approaches.
Pages 198–204
Note to the presenter:
The purpose of this slide is to establish some of the definitions needed later in calculating and explaining GDP.
Copyright © 2014 CFA Institute

4. Gross domestic Product
Gross domestic product (GDP) is the market value of all final goods and services produced within the economy in a period of time.
Expenditures approach: The amount spent for all goods and services
Income approach: Aggregate income earned by all households, companies, and the government within the economy
Key elements of GDP:
Represents all goods and services produced during the period
Excludes transfer payments from the government (e.g., welfare)
Excludes capital gains
Determined by being sold in a market
Includes only final goods, not intermediate (i.e., items to be resold)
Measurement alternatives (for an example, see Exhibit 5-2)
Receipts from the final customer
Value added at each stage of production to customer
LOS: Calculate and explain gross domestic product (GDP) using expenditure and income approaches.
Pages 198–204
Using the expenditures approach, gross domestic product (GDP) is defined as the amount spent on goods and services produced within the economy in a period of time.
Using the income approach, GDP is defined as the aggregate income earned by all households, companies, and the government within the economy.
Copyright © 2014 CFA Institute

5. Methods of calculating GDP
Consider the manufacture and sale of a doll using both the expenditures method and the value-added method of measuring gross domestic product.
Sales value
Value added
Stage 1: Produce materials
Plastic
Textile
$1.50
0.25
$1.75
Stage 2: Assemble dolls
$4.00
2.25
Stage 3: Sell to wholesaler
$7.00
3.00
Stage 4: Sell to retailer
$10.00
Total expenditures
Total value added
LOS: Compare the sum-of-value-added and value-of-final-output methods of calculating GDP.
Pages 201–204
The sum-of-value-added method of calculating GDP starts with the initial raw materials and then adds the incremental value from each stage from production to the eventual sales to the consumer. The value-of-final-output (or sales value) method uses the value of the good as sold to the eventual user (e.g., consumer).
Notes to the presenter:
The extent to which a nation has an underground economy may make measured GDP less accurate (Exhibit 5-4).
Copyright © 2014 CFA Institute

6. Nominal and real GDP
Real GDP is GDP calculated as if the price level did not change.
Real GDP per capita is often used as a measure of the standard of living.
Nominal GDP is GDP unadjusted for any price-level change.
Relationships:
Nominal GDPt = Pt × Qt
Real GDPt = PB × Qt
where
Pt is the price in year t
PB is the price in the base year B
Qt is the quantity in year t
LOS: Compare nominal and real GDP, and calculate and interpret the GDP deflator.
Pages 205–207
The nominal GDP is the value of goods and services measured using current dollars, whereas the real GDP is the value of goods and services valued as if the price level did not change.
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7. GDP deflator
The GDP deflator or the implicit price deflator reflects the amount of the GDP that is associated with the change in the price level: GDP deflator = Value of current−year output at current−year prices Value of current−year output at base−year prices × 100 Real GDP = Nominal GDP GDP deflator 100 Nominal GDP = Real GDP × GDP deflator 100 Example: If nominal GDP is 16,988.3 billion and the GDP deflator is , what is real GDP? Real GDP = 16,988.3 billion =15, billion
LOS: Compare nominal and real GDP, and calculate and interpret the GDP deflator.
Pages 206–208
The GDP deflator is the ratio of nominal GDP to real GDP and is a measure of the extent to which prices have changed relative to some benchmark period.
Notes to the presenter:
The GDP deflator is used to translate real GDP into nominal GDP, and vice versa.
The deflator conveys how much a base-year unit of currency can buy relative to the year t unit of currency.
For the United States, the benchmark is currently 2009 (deflator for 2009 = 100).
Example: For third-quarter 2013, the US GDP deflator was and the GDP was $16,890.8 billion. This means that
a US dollar in 2009 would buy 6.775% more than in 2013.
real GDP = $16,890.8/( /100) = $15, billion.
Copyright © 2014 CFA Institute

8. Components of GDP
GDP = 𝐻𝑜𝑢𝑠𝑒ℎ𝑜𝑙𝑑 𝑆𝑒𝑐𝑡𝑜𝑟 ↓ Consumer spending on goods and services + 𝐵𝑢𝑠𝑖𝑛𝑒𝑠𝑠 𝑆𝑒𝑐𝑡𝑜𝑟 ↓ Gross private domestic investment + 𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝑆𝑒𝑐𝑡𝑜𝑟 ↓ Government spending on goods and services 𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝑜𝑟 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝑆𝑒𝑐𝑡𝑜𝑟 ↓ Exports − Imports
GDP=𝐶+𝐼+𝐺+(𝑋 −𝑀)
Page 208
Notes to presenter:
The purpose of this slide is to establish
That the four sectors contribute to GDP.
The notation, which is used in the remainder of this chapter.
X – M is the balance of trade.
If X > M, there is more selling to foreign nations than importing.
If X < M, there is a balance of trade deficit (importing more than exporting).
GDP is often represented as Y (see Equation 5-1).
Copyright © 2014 CFA Institute

9. GDP and other income measures
National income is the income received by all factors of production used in the generation of final output in an economy less a capital consumption allowance.
Sum of compensation of employees, business and government enterprise profits, interest income, rent, and indirect business taxes less subsidies.
Capital consumption allowance (CCA) is an estimate of the depreciation of capital stock attributed to the production of goods and services.
Personal income is a measure of household income.
A measure of the ability of consumers to make purchases.
A measure of national income to households.
Equal to national income less indirect business taxes, corporate income taxes, and undistributed corporate profits, and plus transfer payments.
Personal disposable income (PDI) is personal income less personal taxes.
A measure of what is available for spending.
Household saving is PDI less consumption expenditures, interest paid by consumers to businesses, and personal transfer payments to foreigners.
LOS: Compare GDP, national income, personal income, and personal disposable income.
Pages 211–217
GDP is the sum of all factors of production, which includes individuals, businesses, the government, interest income, and the net receipts from government to individuals and businesses (e.g., transfer payments).
The primary difference between GDP and national income is that we subtract a capital consumption allowance (e.g., depreciation) from GDP to arrive at national income.
Personal income is the income in national income that is attributed to households, whereas personal disposable income is personal income less taxes.
Notes to the presenter:
Personal income also includes income to non-profit corporations (some participants may remember this from their economics training).
Basically (ignoring statistical discrepancy):
GDP – Capital consumption allowance = National income
and
Personal income – Personal taxes = Personal disposable income
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10. The Fiscal balance
The fiscal balance is the difference between government expenditures (G) and taxes (T):
Fiscal balance = G – T
If G > T, the fiscal balance is a deficit (spending more than taking in).
If G < T, the fiscal balance is a surplus (taxing more than spending).
The role of automatic stabilizing:
As income declines, the deficit grows.
As income increases, the deficit shrinks or becomes a surplus.
LOS: Explain the fundamental relationship among saving, investment, the fiscal balance, and the trade balance
Pages 221–222
Notes to the presenter:
The purpose of this slide is to establish the definition of a fiscal balance so that we can then understand its role as a stabilizing factor.
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11. Trade balance = Exports – Imports = X – M
The trade balance
The trade balance is the net position in trade with other countries:
Trade balance = Exports – Imports = X – M
If exports > imports, Exports – Imports = Current account surplus
This is also referred to as a positive trade balance.
If exports < imports, Imports – Exports = Trade balance deficit
LOS: Explain the fundamental relationship among saving, investment, the fiscal balance, and the trade balance.
Pages 221–222
Notes to the presenter:
The purpose of this slide is to establish the definition of a trade balance so that we can then understand its role as a stabilizing factor.
The trade balance is also referred to as the balance of trade.
The trade balance is a stabilizing factor: In a recession, countries want a current account surplus to help improve the economy, and in an expansionary phase of the economy, a country may import more, which would provide more competition with domestic goods (to keep inflation in check).
Copyright © 2014 CFA Institute

12. Aggregate Savings
Aggregate savings (AS) = National savings + Current account surplus = I Savings S = Investment I + Fiscal balance G – T + Net exports (X – M) National savings = Private savings + Government savings Government savings = Taxes – Government spending – Transfer payments – Interest on government debt Personal savings = GDP + Transfer payments + Interest on government debt − Taxes − Consumption
LOS: Explain the fundamental relationship among saving, investment, the fiscal balance, and the trade balance.
Page 222
The savings of a country includes private and government savings as well as the trade balance; trade balances may absorb some of the domestic private savings.
A net-export position in a trade balance supplements national savings to produce aggregate savings; a net-import position in a trade balance reduces aggregate savings.
Notes to the presenter:
To see the relationships, consider rearranging the equation for aggregate income:
Fiscal balance (e.g., deficit)
Fiscal balance G – T = Investment I − Savings S + Net exports (X – M)
Trade balance (e.g., net exporter)
Net exports (X – M) = Investment I − Savings S + Fiscal balance G – T
Copyright © 2014 CFA Institute

13. Savings and investment
Rearrange the GDP equation to equate expenditures and income:
Savings 𝑆 − Investment 𝐼 = Fiscal balance 𝐺 – 𝑇 + Net exports (𝑋 – 𝑀)
As income increases, the fiscal balance and net exports decline.
If the effect of income on savings is greater than the effect on investment, the net savings (S – I) increases.
Dealing with an imbalance:
If (S – I) > (G – T) + (X – M), there is excess savings.
If (S – I) < (G – T) + (X – M), there is excess planned investment.
The balance between expenditure and income is the result of a changing real interest rate:
If there is excess savings, the real rate will decline.
If there is excess planned investment, the real rate will increase.
LOS: Explain the fundamental relationship among saving, investment, the fiscal balance, and the trade balance.
Pages 222–226
The difference between savings and investment is equal to the fiscal balance plus the net exports.
If there is an imbalance between income and expenditures, the real rate of interest changes so that expenditures and income are equal.
Notes to the presenter:
This relationship can be viewed from many perspectives (government policies, trade policies, investment incentives).
Question for discussion:
Suppose the government operates at a deficit (that is, G > T). What may happen?
Answer: The deficit may fall on the trade balance, on the difference between investment and savings, or both. The globalization of financial markets ensures that private savings would not necessarily equal domestic investment and government borrowing, so any fiscal policy may affect either the trade balance or investment less savings—likely both.
Copyright © 2014 CFA Institute

14. Aggregate demand, aggregate supply, and equilibrium
Aggregate demand represents aggregate income and price level.
Aggregate expenditures = Aggregate income
This results in the investment–savings (IS) curve, which is the relationship between savings less investment (S – I) and income, Y.
The IS curve represents the demand for money from the goods market.
If we assume that planned expenditures equals actual income,
there is equilibrium in the money markets, represented by the liquidity– money supply (LM) curve.
The LM curve illustrates the supply of money/funds available for investing (that is, equilibrium in the money market):
MV = PY
where M = money supply
V = velocity of money
P = price level
Y = income
LOS: Explain the investment–saving (IS) and liquidity preference–money supply (LM) curves and how they combine to generate the aggregate demand curve.
Pages 222–227
The IS curve is the investment savings curve that represents equilibrium between planned expenditures and income.
The LM curve is the liquidity preference–money supply curve and represents the equilibrium in the money market.
The intersection of the IS and LM curves is the interest rate–income combination that is consistent with equilibrium in the money market and the goods market.
Notes to the presenter:
The IS curve is often referred to as the set of equilibria for the goods market.
Fiscal policy affects the IS curve, whereas monetary policy affects the money supply.
Copyright © 2014 CFA Institute

15. The IS and LM Curves
The IS and LM curves illustrate the relationship between the real interest rate, r, and income, Y.
LM with an increase in M
Real Interest
Rate (r) LM
IS with an increase in G
LOS: Explain the investment–saving (IS) and liquidity preference–money supply (LM) curves and how they combine to generate the aggregate demand curve.
Pages 222–227
The IS and LM curves describe the relationship between interest rates and aggregate demand but also can be used to describe what may happen to demand or interest rates if any of the components to income change.
Notes to the presenter:
This graph is similar to Exhibit 5-12.
The IS–LM model can be used to examine what may happen when there is a shock to the economy (e.g., change in consumer confidence).
Questions for discussion:
What would happen if the money supply were contracted?
Answer: Reduction in interest rates and an increase in income
What would happen if the government reduced spending?
Answer: Reduction in interest rates and a reduction in income IS
Income (Y)
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16. IS, LM, and aggregate demand
Real interest
rate (r)
LM1
LM2 r1 r2 IS Y1 Y2
Income (Y)
Price
level P1
LOS: Explain the investment–saving (IS) and liquidity preference–money supply (LM) curves and how they combine to generate the aggregate demand curve.
Pages 222–227
Changes in the IS or the LM curve will be reflected in aggregate demand (AD) through the effect on the price level.
Notes to the presenter:
Fiscal policy will shift the IS curve (e.g., expansionary fiscal policy shifts the IS curve to the right).
Monetary policy will shift the LM curve (e.g., increased money supply shifts the LM curve to the right, as shown in the graph on this slide). P2 AD Y1 Y2
Income (Y)
Effects when the central bank increases the money supply
→ increased aggregate demand
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17. Aggregate Supply SRAS LRAS Price level VSRAS Output
The aggregate supply (AS) curve represents the level of domestic output that companies produce at each price.
In the short run,
Suppliers can change the supply at the current price in the very short term (very short-run aggregate supply, or VSRAS).
Suppliers can increase profits by increasing supply in the short run if they are covering their variable costs (short-run aggregate supply, or SRAS).
The long-run aggregate supply curve is vertical (long-run aggregate supply, or LRAS).
SRAS
LRAS
Price level
LOS: Explain the aggregate supply curve in the short run and the long run.
Pages 230–232
The aggregate supply (AS) curve represents the level of domestic output that companies produce at each price.
Suppliers can change the supply at the current price in the very short term, and the suppliers can increase profits by increasing supply in the short run if they are covering their variable costs.
In the long run, the AS curve is vertical.
Notes to the presenter:
This graph is also in Exhibit 5-14, where the very short-run aggregate supply (VSRAS) curve is horizontal, the short-run aggregate supply (SRAS) curve is angled upward, and the long-run aggregate supply (LRAS) curve is vertical.
VSRAS
Output
Copyright © 2014 CFA Institute

18. Shifts in Aggregate demand and aggregate supply curves
Shifts in aggregate demand result from changes in the following:
Household wealth
Consumer and business expectations
Capacity utilization
Monetary policy (reserves and interest rates)
Exchange rate
Growth in global economy
Fiscal policy (taxes and government spending)
Shifts in aggregate supply result from changes in the following:
Supply of labor
Human capital (quality of labor)
Supply of natural resources
Supply of physical capital
Productivity and technology
LOS: Explain the causes of movements along and shifts in the aggregate demand and supply curves.
Pages 227–244
Shifts in aggregate demand can be caused by price, household wealth, monetary policy, the exchange rate, expectations, growth in the global economy, and fiscal policy.
Shifts in short-run aggregate supply can be caused by input prices, wage costs, expectations of future costs and price levels, taxes and subsidies, and the exchange rate.
Shifts in long-run aggregate supply can be caused by the supply of labor, other inputs, capital, productivity, and technology.
Movements in the aggregate demand and aggregate supply curves are caused by a change in the price level.
Notes to the presenter:
Exhibit 5-18 is a list of factors that cause shifts in the aggregate demand curve.
Exhibit 5-20 is a list of factors that cause shifts in the aggregate supply curve.
Productivity is the combined effect of the supply of labor and human capital.
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19. Effects of a shift in aggregate demand and Aggregate supply on business cycles
Equilibrium is the price level and output at which the aggregate demand and aggregate supply curves intersect.
A business cycle consists of expansion and contraction.
Shifts in aggregate demand and aggregate supply determine changes in the economy.
A recession is an economic situation in which the growth in GDP is negative.
Typical definition: two or more quarters of negative GDP growth
Sensitivity of investments to the economy:
A cyclical company is one in which the earnings are likely to decline in the event of an economic slowdown.
A defensive company is one in which earnings may increase during an economic slowdown.
LOS: Describe how fluctuations in aggregate demand and aggregate supply cause short-run changes in the economy and the business cycle.
Pages 245–254
Expansion and contraction in an economy are determined by shifts in aggregate demand and aggregate supply.
Notes to the presenter:
It is recommended that you establish what is meant by a recession and a business cycle before discussing the effects of the AS and AD fluctuations on the business cycle.
Example 5-12 reviews the effects on AD and AS from the recession of 2007–2009.
Note: the National Bureau of Economic Research (NBER) identifies the recession in this period extending from December 2007 through June 2009 (fourth-quarter 2007 through second-quarter 2009):
Copyright © 2014 CFA Institute

20. Effects of a shift in aggregate demand and Aggregate supply on business cycles
At long-run full employment, the economy is at potential GDP, and equilibrium output is at an equilibrium where LRAS = SRAS = AD
Price
level
LRAS
SRAS P1
LOS: Describe how fluctuations in aggregate demand and aggregate supply cause short-run changes in the economy and the business cycle.
Pages 245–254
At long-run full employment, the economy is at potential GDP, and equilibrium output is at an equilibrium where LRAS = SRAS = AD (Exhibit 5-21). AD
Income, Output, Y
Copyright © 2014 CFA Institute

21. Effects of a shift in aggregate demand and Aggregate Supply on business cycles
A short-run recessionary gap exists when the economy is in a recession and equilibrium output is less than potential GDP.
Price
level
LRAS
SRAS P1 P2
LOS: Describe how fluctuations in aggregate demand and aggregate supply cause short-run changes in the economy and the business cycle.
Pages 245–254
A short-run recessionary gap exists when the economy is in a recession and equilibrium output is less than potential GDP (that is, short-run production is less than full-employment production). See Exhibit 5-22.
Notes to the presenter:
A recessionary gap is also referred to as a contractionary gap.
The short-run aggregate supply curve is often drawn as a curve (compared with a straight line in this text).
Real GDP < Potential real GDP
AD1
AD2
Income, Output, Y Y2 Y1
Copyright © 2014 CFA Institute

22. Effects of a shift in aggregate demand and Aggregate supply on business cycles
A short-run inflationary gap exists when the economy drives GDP beyond the potential GDP. When price levels increase, short-run supply increases and the economy returns to the long-run equilibrium.
LRAS
SRAS P2 P1
LOS: Describe how fluctuations in aggregate demand and aggregate supply cause short-run changes in the economy and the business cycle.
Pages 245–254
A short-run inflationary gap exists when the economy drives GDP beyond the potential GDP. When price levels increase, short-run supply increases and the economy returns to the long-run equilibrium.
Notes to the presenter:
Real GDP > Potential GDP
Unemployment rate < Natural rate of unemployment (that is, job seekers < job openings), so employers must raise wages to attract workers.
AD2
AD1
Income, Output, Y Y1 Y2
Copyright © 2014 CFA Institute

23. Effects of a shift in aggregate demand and Aggregate supply on business cycles
Short-run stagflation occurs when there is high unemployment and increased inflation brought on by a drop in aggregate supply. The downward pressure on wages and input prices eventually brings long-run full employment.
LRAS
SRAS P2 P1
LOS: Describe how fluctuations in aggregate demand and aggregate supply cause short-run changes in the economy and the business cycle.
Pages 245–254
Short-run stagflation occurs when there is high unemployment and increased inflation brought on by a drop in aggregate supply.
The downward pressure on wages and input prices eventually results in long-run full employment.
Notes to the presenter:
This graph is similar to what is in Exhibit 5-25.
Another way of describing stagflation is that it occurs when prices are increasing but the economy is not.
Stagflation is evident when both prices and unemployment are rising.
AD1
Income, Output, Y Y2 Y1
Copyright © 2014 CFA Institute

24. Effects of a shift in aggregate supply and aggregate demand on the economy: Summary
Change
Change in GDP
Unemployment rate
Aggregate price level
↑ AD ↑ ↓
↓ AD
↑ AS
↓ AS
LOS: Describe how fluctuations in aggregate demand and aggregate supply cause short-run changes in the economy and the business cycle.
Pages 245–254
Notes to the presenter:
This is a table representation of the conclusions on p. 253.
You may also want to point out Exhibit 5-26, which summarizes the combined changes of AD and AS.
Copyright © 2014 CFA Institute

25. 4. Economic growth and sustainability
The production function indicates the relationship between output and the inputs of technology, labor, and capital:
Y = A×F L,K
where
Y is the level of aggregate output
A is the technological knowledge
F indicates a functional relationship
L is the quantity of labor
K is the capital stock (that is, property, plant, equipment, and land) used to produce goods and services
We use the production function to link output in an economy to the inputs.
A is the total factor productivity (TFP), which is the growth in output not attributed to K or L.
LOS: Describe the sources, measurement, and sustainability of economic growth.
Pages 257–259
Notes to presenter:
There is a need to establish the production function before looking at sources of economic growth, even though there is no specific learning outcome regarding the production function.
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26. Sources of Economic growth
Capacity to Supply Goods and Services
Labor Supply
Human Capital
Physical Capital
Technology
Natural Resources
LOS: Describe the sources, measurement, and sustainability of economic growth.
Pages 259–270
The sources of growth are the quantity and quality of the resources (labor, capital, and natural resources).
Human capital refers to the quality of the labor resources, whereas technology affects the quality of the physical capital and labor.
Notes to the presenter:
The purpose of this slide is to draw attention to the different factors that affect the ability of an economy to produce goods and services.
The quality dimension of both labor and how resources are put to use is an important element of economic growth.
Copyright © 2014 CFA Institute

27. Sources and Measures of Economic growth
The labor force is the portion of the working age population (that is, above age 16) that is employed or available for work.
Human capital reflects the education, training, and life experience of the labor force.
Labor productivity is the quantity of goods and services that a worker can produce in one hour of work:
Labor productivity = Real GDP Aggregate hours
Labor productivity is affected by
education and skill of workers,
investments in physical capital, and
improvements in technology.
LOS: Describe the sources, measurement, and sustainability of economic growth.
Pages 259–270
A key measurement of economic growth is labor productivity, which captures the quantity and quality of the labor resource.
Notes to presenter:
The production function is presented in an earlier section (p. 257).
The bottom line is that the productivity of labor is a function of total factory productivity (TFP) and the mix of inputs (K and L)
Copyright © 2014 CFA Institute

28. Sustainability of Economic growth
Sustainable growth is the rate of growth that is achievable given the resources (labor and capital); it depends on productivity and the size of the labor force:
Potential growth rate of GD = (adjusted for inflation) Long−term growth rate of labor force + Long−term labor productivity growth rate
Example: If the labor force of a nation is expected to grow at a rate of 4% per year and the labor productivity is expected to grow at a rate of 1% per year, the expected rate of growth in potential GDP = 4% + 1% = 5%.
We can derive the degree of slack in an economy by comparing actual growth in GDP with potential growth in GDP:
If actual growth > potential growth → inflationary pressures
If actual growth < potential growth → resource slack and low inflationary pressure
LOS: Describe the sources, measurement, and sustainability of economic growth.
Pages 266–270
Sustainable growth is the rate of growth that is achievable given the resources (labor and capital), and it depends on the productivity (i.e., quality) and the size of the labor force.
Notes to the presenter:
This simple relationship originates from potential GDP as the product of aggregate hours worked and labor productivity.
Given a growth rate in GDP and either the labor force growth or the productivity growth, we can solve for the other growth rate.
Additive relationship shown in Example 5-15.
The degree of slack in the economy indicates the availability of resources (slack → availability). If there is not slack, there may be inflationary pressures.
Copyright © 2014 CFA Institute

29. Production Function and Growth
Economic growth depends on labor productivity.
We can see the relation between production in an economy and labor productivity by starting with the production function:
𝑌=𝐴×𝐹 𝐿,𝐾
and divide each side by 1/L:
𝑌 𝐿 =𝐴×𝐹 1, 𝐾 𝐿
Therefore, the productivity relative to labor depends on the level of the labor force, the level of capital investment, and the mix of labor and capital.
LOS: Describe the production function approach to analyzing the sources of economic growth.
Pages 264–266
The production function is the relationship between output and technology, labor, and capital.
If we restate the production function in terms of productivity (that is, output per unit of labor), we see the importance of productivity on an economy’s growth.
Notes to the presenter:
The productivity of labor affects the potential GDP (Y), but we also must consider the mix and level of inputs.
A in the function is technology, and F indicates the functional relationship between Y and K and L.
Copyright © 2014 CFA Institute

30. Input growth and the growth of total factor productivity
Referring back to the production function,
𝑌=𝐴×𝐹 𝐿,𝐾 ,
we see that any growth in the output (that is, Y) depends on the inputs, but also the scale factor, A.
A captures technology or total factor productivity (TFP), which is sometimes referred to as an index of the output per unit input.
TFP is often viewed as the growth in GDP that is not explained by the growth in labor or capital.
Therefore, growth in Y may come from growth in the inputs (K and L) but also from growth in TFP:
Growth potential in GDP = TFP growth + 𝑊 𝐿 Growth in labor + 𝑊 𝐶 Growth in capital
LOS: Distinguish between input growth and growth of total factor productivity as components of economic growth.
Pages 261–262
Growth in GDP may come from growth in the inputs (K and L) but also from growth in TFP. Growth potential in GDP = TFP growth + 𝑊 𝐿 Growth in labor + 𝑊 𝐶 Growth in capital 𝑊 𝐿 Growth in labor + 𝑊 𝐶 Growth in capital
Growth in TFP reflects technological change (e.g., IT, research and development).
Notes to the presenter:
TFP is A in the production function that was introduced on p. 257.
The amount of growth attributed to TFP is an empirical issue; measuring it is difficult.
The equation is presented on p. 262 in terms of TFP growth as the difference between potential GDP growth and the weighted average growth in labor and capital.
Copyright © 2014 CFA Institute

31. Conclusions and Summary
GDP is the market value of all final, newly produced goods and services within a country in a given time period; valued by looking at either the total amount spent on goods and services produced in the economy or the income generated in producing those goods and services.
Nominal GDP is the value of production using the prices of the current year.
Real GDP measures production using the constant prices of a base year.
Households earn income in exchange for providing the factors of production (labor, capital, and natural resources, including land).
Businesses produce most of the economy’s output/income and invest to maintain and expand productive capacity.
The government sector collects taxes from households and businesses and purchases goods and services from the private business sector.
Capital markets provide a link between saving and investing in the economy.
From the expenditure side, GDP includes personal consumption, gross private domestic investment, government spending, and net exports.
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32. Conclusions and Summary
National income is income received by all factors of production used in the generation of final output: GDP minus the capital consumption allowance.
Personal income reflects pretax income received by households, whereas personal disposable income equals personal income minus personal taxes.
Consumption spending is a function of disposable income, whereas investment spending depends on the average interest rate and the level of aggregate income.
Aggregate demand and aggregate supply determine the level of real GDP and the price level.
The aggregate supply curve is the relationship between the quantity of real GDP supplied and the price level, keeping all other factors constant. Movements along the supply curve reflect the impact of price on supply.
The long-run aggregate supply curve is vertical because input costs adjust to changes in output prices, leaving the optimal level of output unchanged.
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33. Conclusions and Summary
The long-run aggregate supply curve shifts because of changes in labor supply, the supply of physical and human capital, and productivity/technology.
The short-run supply curve shifts because of changes in potential GDP, nominal wages, input prices, expectations about future prices, business taxes and subsidies, and the exchange rate.
The business cycle and short-term fluctuations in GDP are caused by shifts in aggregate demand and aggregate supply.
Stagflation, a combination of high inflation and weak economic growth, is caused by a decline in short-run aggregate supply.
The sustainable rate of economic growth is measured by the rate of increase in the economy’s productive capacity or potential GDP.
Growth in real GDP measures how rapidly the total economy is expanding.
The sources of economic growth include the supply of labor, the supply of physical and human capital, raw materials, and technological knowledge.
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