Economic Growth

Gross Domestic Product

The main measure of economic output is called Gross Domestic Product (GDP). It is defined as ‘the total value of all goods and services produced within a country in a given period of time’.

GDP is usually measured at _market prices, which means that the value of goods produced includes the value of indirect taxes, such as VAT, but does not include the value of subsidies received by some producers. _Taxes on goods increase market prices without any real change in output. Subsidies have the opposite effect of reducing prices. Strictly speaking, a more accurate measure of GDP is at factor cost, which subtracts taxes and adds in subsidies to GDP at market prices. GDP at factor cost is also called Gross Value Added.

Real and Nominal Values

When comparing one year’s GDP with that of other years, it is necessary to adjust for changes in prices. This is because a change in the price level (inflation or deflation) can lead to a change in the nominal value of GDP without there being any change in the real value of GDP.

Economic Growth, figure 1

Suppose for instance that a country’s GDP, (measured at market prices) in Year 1 was £100 million, and in the following year (Year 2) it was £110 million. Suppose also that prices increased on average by 10% between the two years.

In this case, the nominal value of GDP has increased by 10% (£110m compared to £100m). but the real value has not changed, because £110m in Year 2 will only buy the same quantity or volume of goods and services as £100m in Year 1.

We can adjust nominal GDP figures for inflation using index numbers. A price index measures the rate at which prices are changing over time. In the base year, the price index is 100 (a convenient round number). In the following years the price index is increased to reflect the changes in prices compared to the base year. So, for instance, if prices had on average doubled over a five year period, the price index at the end of the period, compared to the base year would be 200.

Example: Consider the following data in Table 1:

YearGDP £millions (at current prices)Price Index (PI)
Year 1 (Y1)500100
Year 2 (Y2)550105
Year 3 (Y3)580108

The figures for GDP are at nominal values, in other words recorded at current prices, which means that prices have not been adjusted for inflation. If we want to find out what has happened to real GDP, we need to convert GDP at current prices to GDP at constant prices.

So, if we wanted to compare the real GDP of Year 2 with Year 1, we can do so by converting Year 2 GDP at current prices to what it would have been if prices had not risen:

Y2 GDP at constant (Y2 prices) = Y2 GDP at current prices X (PI Y1/PI Y2)

= £550m X 100/105

= £550m X 0.952 (to 3 decimal places)

=__ £524.15m__

At Y1 constant prices, real GDP rose from £500m to just over £524m, which is about half as much as the increase in nominal GDP.

Note that if prices had fallen between the two years, then the figure for nominal GDP in Year 2 would be lower than the real figure.

Comparisons of National Income Over Time

There are also difficulties when making comparisons of national income figures for a particular country over a number of years:

  1. __Population change __– Remember it is per capita income that is important for living standards
  2. __Changing distribution of income __– This can change over time, but is not reflected in the per capita figures
  3. __Externalities __– These may increase or decrease over time. The improvement in air quality in Britain’s cities in recent decades for instance, is not captured in GDP data
  4. __Changing quality of goods and services __– GDP data does not capture changes in quality of goods and services over time. Cars, for instance are now quieter, more reliable and comfortable than those of the past
  5. Changes in prices – It is important to compare GP data from different years in terms of constant prices, not current prices
  6. Changes in the size of the shadow economy – he shadow economy tends to get bigger in a recession as people lose their jobs and work in the informal or black economy instead
  7. Changes in government spending – Changing priorities, such as war or counter terrorism may result in big increases in military and security services spending. This may boost GP but not living standards
  8. __Changes in investment and consumption __– Living standards will improve in the short term if households save less and spend more on consumption. But this will mean less spending on investment, which will harm living standards in the longer term

Gross National Income

__Gross National Income is equal to GDP + Net Property Income From Abroad (NPI) __

GDP only measures the value of domestically produced goods and services. It is a good measure of how the domestic economy is performing. But Gross National Income (GNI) is a broader measure of economic output as it includes the incomes earned overseas by a country’s assets. It is mainly comprised of the profits and interest earned abroad. For instance, the profits of a UK owned factory in Germany belongs to the UK owners. But equally, profits and interest earned by foreign owned businesses operating in the UK have to be subtracted. The ‘net’ figure for property income can therefore be positive or negative, depending on whether or not a country’s overseas earnings are greater, or smaller than the earnings of foreign owned businesses I the country.

Poorer, developing countries are likely to have a negative net property income as they often have large investments by multi-national companies attracted by cheap labour and low regulation. Rich countries are much more likely to have a positive NPI.

Uses of National Income Statistics

  1. __To measure economic growth – __Achieving an acceptable rate of economic growth is one of the most important goals for a government, as it affects living standards and the amount of tax revenue the government is able to raise to pay for public expenditure. GDP/GNI data is used to evaluate the performance of both the economy and how well it is being managed by the government. If the economy is growing too slowly (or too fast), the government may use demand or supply side policies to try bring growth back to the desired level
  2. __To measure living standards – __GDP/GNI statistics are one of the most important guides to what is happening to a country’s living standards. But it is important to remember that it is __income per capita __(per person), not total income of a country that matters here. This is calculated by dividing national income by size of population
  3. To make international comparisons – One way of measuring our economic performance is to compare it with that of other countries. Is our GDP growing at a faster or slower rate than that of other developed countries, such as those in Europe or North America. This can also help identify which government policies may improve the performance of our economy, if other countries are doing better, what are they doing differently?
  4. To make comparisons with the past – If the economy is growing at a faster/slower rate than in previous years or decades we may want to know why, as it can help to identify the most appropriate economic policies
  5. __Membership fees of international organisations – __A country’s contributions to bodies such as the United Nations, the World Bank and International Monetary Fund are based on the size of its economy, so that the burden is spread fairly between countries

Economic Growth, figure 1

How accurate are national income statistics?

National income statistics have to be treated with caution and not just accepted at face value. Possible causes of inaccuracy include the following:

  1. __They are estimates __– Complete accuracy is impossible. The data is collected from surveys of businesses and tax returns. The data is subject to revision as more data comes to light
  2. The shadow economy __– A lot of economic activity goes unrecorded. The __informaleconomy __consists of activities that are perfectly legal, but for which there is no payment. It includes things like DIY and housework. If we pay others to do the work it is counted as part of GDP, but not if we do it for ourselves. The ‘__black economy’ includes activities that are legal, but which are not declared to the tax authorities. For instance many small trades people may ask to be paid in cash. This tax evasion is illegal. The black economy also includes activities that are illegal, such as selling drugs, sex work (illegal in some countries) and forced labour of people who are trafficked
  3. __State provided services __– There is a problem of valuing public services such as health and education because they are not traded services, but provided free to users. They are valued instead in terms of the amount spent by the government in providing them (i.e. on nurses’ and doctors’ salaries). This can have a perverse consequence. For instance, if there are efficiency gains due to better management, so a hospital can deliver the same service with fewer staff, this shows up in the GDP statistics as a fall in output, when there hasn’t actually been one. Equally, a pay rise for public sector workers shows up in an increase in GDP, regardless of any change in their output.

International Comparisons of National Income

Economic Growth, figure 2

Comparing the national income data of countries is difficult for the following reasons:

  1. __The size of the shadow economy __– This varies enormously between countries. In less developed countries, a large % of output does not show in GDP because it is not traded. For instance, farmers may grow food for themselves. In some developed countries there may be a much larger black economy than in others. In Italy, for instance the mafia controls a lot of illegal economic activity
  2. __Differences in distribution –__Per capita income can be a very poor guide to typical living standards. It is a crude average (the mean value). If income is very unequally shared, it is likely that there are will be more poor people compared to a country with similar per capita income, but where it is more equally shared
  3. __Geography __– In cold countries more is spent on heating than warmer ones, which raises GDP but not living standards compared to a warmer country. Equally, in large countries more has to be spent on roads and travel compared to small countries
  4. __The nature of government spending __– The government of North Korea spends a vast % of the country’s income on defence. This contributes to GDP but impoverishes the population
  5. __The integrity and reliability of government statistics __– In some countries, official statistics are under political control of governments that use them for propaganda purposes, and cannot be taken at face value. Many poor countries don’t have the resources to collect full and accurate economic data, so estimates of national income may be unreliable
  6. Externalities – Rapidly industrialising countries like China and India have some of the world’s worst pollution problems as well as the fastest growth rates. National income statistics do not capture the harmful impact on health and living standards of these externalities
  7. __Quality of goods and services __– This can vary considerably between countries but is not necessarily reflected in how much is spent on them. Rail travel may be fast, comfortable and cheap in one country and slow, overcrowded and expensive in another
  8. __Exchange rates __– GDP figures for different countries have to be expressed in the same currency to make comparisons possible. We can do this by using the market rates of exchange. Suppose for instance that the market rate for Sterling is £1 = $2. Suppose also that UK GDP is £2000 billions and USA GDP is $16000 billions. We can convert UK GDP into dollars by multiplying the Sterling value by 2, so it is $4000 billions

Does that mean that the USA economy is 4 times bigger than that of the UK? (16000/4000 = 4)

Not necessarily, because the market exchange rate may not reflect the purchasing power of a pound compared to a dollar. Suppose for instance that a Big Mac costs £1 in London but $3 in New York. If this is typical of most prices, the Purchasing Power Parity (PPP) rate of exchange is £1 = $3, meaning that the PPP value of UK GDP in dollars is $6000 billions, not $4000 billions. In the real world market exchange rates fluctuate for all sorts of reasons and can diverge significantly from PPP rates. In general the PPP rates of exchange of developing countries is much higher than market rates, as prices of goods and services are much lower than in richer countries.

The U.K. National Well-being Programme

Launched in 2010, it attempts to get a much wider view of ‘national progress’ than can be captured in national income statistics. Alongside data on household incomes it also includes:

  1. Levels of crime
  2. Unemployment
  3. Health
  4. The environment
  5. Personal relationships
  6. Subjective feelings of happiness and wellbeing
  7. Skill levels and educational achievement

National Income and Happiness and Well-being

A number of studies have shown that the relationship between income and happiness is not straightforward. More income does not always mean greater happiness.

The __Easterlin paradox __refers to a study in the 1970s that suggested higher income increases happiness when incomes are very low, but not when they are already high. If you can’t afford to eat higher income ma make you happier, but being able to afford caviar may not make any further difference.

Other economists have suggested that __relative income __can be important in determining happiness. Those with higher than average incomes may be happier than those with below average incomes because of its effect on their ability to demonstrate success and status. Other studies have shown that countries with a more equal distribution of income are generally happier than those with greater inequality.