Aggregate output is the total value of goods and services produced in the economy during a certain period, usually one year. Economists typically use the gross domestic product (GDP) as its measure.
The statistical bureau calculates it by adding up all the values of the final goods and services produced in one quarter or one year. Alternatively, we can also do the measurement by adding the added values at each stage of the production and distribution process.
Theoretically, the aggregate output must be equal to aggregate income and aggregate expenditure. All three represent various ways to measure the same number.
Why is aggregate output the same as aggregate income and expenditure?
Aggregate demand represents the total purchase of goods and services by four main sectors, including:
Meanwhile, aggregate income represents income by suppliers of factors of production, including:
- Wages for workers
- Rent for land
- Interest on capital
- Profit for entrepreneurs (business owners)
For ease of explanation, I will use household and business. Let’s say the business produces 5 outputs, each worth Rp100 (total output value of Rp500 = 5). About 5 households are buying the product (total expenditure of Rp500).
For businesses, Rp500 is their total income. They then use it to pay rent (say R100), labor (Rp120), capital (Rp90), and the rest for the owner. In total, income from suppliers of these factors of production is also equal to Rp500.
Short term vs. long term
Economic theory differentiates aggregate output into the short-run and long-run. The short-run is when some input costs, such as nominal wages are fixed.
In the graph, where the x-axis represents total output and the y-axis represents the price level, the short-run aggregate output curve is upward sloping. This shows that a higher price level encourages greater output.
The long-run refers to situations where input prices are variable. The long-run aggregate output represents the potential output of an economy. Sometimes we also call it full employment, that is, when the economy uses all its resources in full.
Determinants of aggregate output
To discuss influencing factors, you need to distinguish the two above concepts: short-runs and long-run.
Short-run aggregate output increases because of:
- Declining input prices (nominal wages, raw materials, and energy) – lower input prices reduce production costs.
- Expectations for higher prices in the future – Businesses increase supply in anticipation of higher profit margins in the future.
- Higher business subsidies – it reduces production costs and encourages output to grow.
- Lower business taxes – lower business tax rates reduce production costs, leading to an increase in output.
- Exchange rates – appreciation of the domestic currency makes input imports cheaper, encouraging businesses to increase production
- Increasing the quantity of production factors
- Improved the quality of production factors
- Technology improvements
The keyword that you need to pay attention to is the cost of production. The short-run output will increase as long as production costs fall. Apart from this, of course, the determinants of long-term output.
Meanwhile, long-run aggregate output depends only on the quantity and quality of production factors. Factors affecting production costs have no effect. Potential output can increase if:
- The supply of labor has increased, for example, because of the high birth rate
- Increased availability of natural resources
- Improving the quality and quantity of physical capital
- Increased productivity, for example through training
- More advanced technology, allowing more output with the same input.
Effects of changes in aggregate demand on aggregate output
Macroeconomic equilibrium occurs when the aggregate output curve intersects the aggregate demand curve. A decrease in aggregate demand can cause economic contraction. In this situation, the short-run aggregate output is below its potential output. As a result, total output and price levels incline to decrease. We call this condition the “deflationary gap.”
Conversely, when aggregate demand increases, the output could produce above its productive capacity (potential output). It will cause upward pressure on the price level in the economy. This condition we call “inflationary gap.”
Likewise, the inflationary gap does not necessarily produce inflation. When that happens, the economy may run a deflation (say -0.1%), but it is higher than before (for example, -2%).