Commonwealth Executive Masters

in Business Administration / Public

Administration

CEMBA 552: Economic Environment

of Business

Block 2
Measures of Economic Activity
 Block Objectives

 After working through Block Two of this course, you should

be able to:
 Define Gross Domestic Product (GDP).
 Account for the different approaches to measuring GDP.
 Distinguish between nominal GDP and real GDP.
 State how the unemployment rate is defined, and describe how
it is determined.
 Explain the definition and construction of the GDP deflator
and the Consumer Price Index.
 Introduction

This block is designed to increase the accuracy

and power of your economic vocabulary by
spelling out the strict meaning of economic
measurement terms that you encounter often in
business reading.
 Management and Measurement

 This block focuses on the main measures of economic activity.

There are many measures and indicators of overall
(macroeconomic) activity such as the number of people with
jobs, the total income of persons, the output of factories, the
total quantity of goods and services produced in the economy,
the unemployment rate, the consumer price index, retail sales,
housing starts, etc.
 Such measures are regularly reported in newspapers and
television and radio news.
 A well-equipped business and public sector managers must
understand these economic indicators in order to be able to
make informed business decisions.
 1.2 Gross Domestic Product

 GDP is the value of the final goods and services produced in

the economy, by foreign or domestic firms, during a given
year.
 GDP is the most comprehensive measure of economic activity
and a broad measure of people’s income and well-being.
 The growth in real GDP is hence a measure of the growth of
people's real incomes and therefore the pace of improvement
in living standards.
 Differences in its growth rates produce large differences in
living standards between countries.
 GDP can be viewed from either the demand
side or the supply side.

 On the demand side, it provides insight into the

interaction of the various decision-making
sectors of the aggregate economy (households;
business firms; government entities; and
foreigners).

 The supply of goods and services requires

firms to bring together the factors of
production, particularly labour and capital, and
to employ the best available technology, in
order to produce output that meets demand.
 As a manager, you need to be aware of these limits
and any ongoing changes in them to manage your
resources efficiently.
 Sometimes economic growth is rapid and at other
times it is slow.
 There are even occasions when the economy stops
growing and actually shrinks for a period.
 A rapidly growing economy is one in which people
enjoy rapidly rising living standards and in which
good jobs are easy to find.
 In a slow-growing or shrinking economy, living
standards decline and unemployment becomes a
serious problem.
 1.3 Unemployment Rate

 Unemployment rate is the ratio of the

unemployed to working age (adult) population
 The unemployment rate is the key and the
most watched indicator. At times when the
unemployment rate is
 high, a person may take a long time to find a
job.
 Governments macroeconomic policy

Governments have set the following as goals of

macroeconomic policy:
• sustained income growth
• low unemployment
• mild fluctuations
• price stability
• exchange rate stability
• balance of trade surplus.
 2 Measuring Economic Performance:
Output and Income
2.1 GDP versus GNP
 GDP is total income earned domestically: all
economic activity that takes place within the
country.

 It includes income earned domestically by

foreigners, but it excludes income earned by
domestic residents on foreign ground.
 Since some income is received from
individuals owning capital equipment in other
countries, GDP is not a perfect measure of
total domestic income.

 Thus, statisticians also compute an

alternative measure of aggregate economic
activity, the gross national product (GNP).
 GNP is total income earned by nationals. It
includes the income that nationals earn
abroad.

 But it does not include the income earned

within a country by foreigners.

 The difference between GDP and GNP is,

therefore, known as “net investment
income from non-residents.”
 Most countries pay more attention to GDP than to
GNP for measuring aggregate economic activity.
 For the purpose of stabilizing employment, we are
interested in a broad measure of job-creating
activity within the nation. We use the GDP.
 For evaluating trends in the standard of living of
many nations, including the Organization for
Economic Cooperation and Development
(OECD) of nations, GNP is more appropriate.
 Methods (Ways) of measuring GDP
 There are three different ways measuring GDP.
They are:
 The production method/approach: ie the
production of each industry, agriculture, mining,
manufacturing, services and so on.

 The income method/approach: ie the income

that production generates in the form of wages,
salaries, profits, rent, interest and so on.
 The expenditure method/approach: ie the
expenditure on the goods and services
produced spending by households, firms,
governments, in the form of consumption
(C), Investment (I) and Government
expenditure (G)
2.3 Income, Expenditure, and the Circular Flow

 Figure 2-1 illustrates all the economic

transactions that occur between households
and firms in this economy.
 2.4 Value Added and Intermediate Goods

 Several difficulties arise when output is measured. Let us

explore two of them. Suppose a farmer produces $5 worth of
wheat, which he sells to a baker. The baker exerts $20 worth
of effort to turn the wheat into bread, which she sells for $25.

 At the end of the day, what has been produced? The answer is
just $25 worth of bread. But if we ask the farmer and the baker
to report their output for the day, the farmer says, ‘I produced
$5 worth of wheat,’ and the baker says, ‘I produced $25 worth
of bread."
 A statistician who naively adds these numbers might
think that there has been $30 of output in the economy.
 The statistician is led astray by counting the wheat,
which is not a final good but rather an intermediate
good that disappears after it is used to produce the
bread.
There are two ways to avoid this measurement pitfall:
1. Ask the farmer and the baker to report the value of
their sales of final goods to consumers. The baker
reports $25 and the farmer reports $0, because his
wheat is not a final good.
2. Ask the farmer and the baker to report the
contribution of each made to the total.
 The farmer reports $5 worth of wheat, and the
baker reports $20 worth of effort, for a total value
of $25 worth of output.
 We call the baker's contribution to output her value
added, which the baker calculates by
subtracting her costs, $5, from her revenue, $25.
 The baker's value added is thus $20. The farmer's
value added is $5: in our example, the farmer had
no costs.
 When businesses report their output to the
government, they subtract their costs, so they are
reporting value added.
 The government then sums the value added by all
businesses to arrive at GDP.
 3 Several Measures of Income

 To obtain GNP from GDP, we subtract the net

income of foreigners who own factors of
production employed in Ghana:
 GNP = GDP - Net Income of Foreigners.
 To obtain net national product (NNP), we
subtract the depreciation of capital,
 i.e., the amount of the economy's stock of
plants, equipment, and residential structures
that wear out during the year:
 NNP = GNP - Depreciation.
 In the national accounts, depreciation is
called the capital consumption allowances
 The next adjustment in the national accounts is
for indirect business taxes, such as sales
taxes and subsidies.
 These taxes place a wedge between the price that

consumers pay for a good and the price that firms

receive. Because firms never receive this tax
wedge, it is not part of their income.
 Once we subtract indirect business taxes from

NNP, we obtain a measure called national

income at factor cost:
 National Income at factor cost =

NNP - Indirect Business Taxes.

 3.1 Potential GDP

 Potential GDP, indicates what the economy could

produce if labour and machines were fully used up.
 Although it is true that actual GDP usually falls short
of its potential, sometimes it could exceed it.
 This happens when the rate of utilization of the
labour force and that of other factors of production
exceeds their normal rates.
 Strong upward fluctuations are called booms and
downwards ones are called recessions .
 Severe downturns are referred to as depressions.
The last depression, called the Great Depression
because of its length and depth, began in 1929. The
economy did not fully recover from it until four
years later.

 There is no technical definition of a boom, but

there is one of a recession; a recession is said to
have occurred when GDP falls for at least two
consecutive quarters.
 The economy's fluctuations are sometimes
called business cycles but the term ‘cycle’
suggests a kind of regularity that cannot be
found between one downturn and the next.

 Economists call the bottom of a recession a

trough and the top of a boom a peak
 4 Real versus Nominal GDP

 To keep the comparisons of different years

straight, economists adjust GDP for changes in
the average level of prices.
 Unadjusted GDP is known as nominal GDP
($Yt).
 The term real GDP (Yt) is used for inflation-
adjusted GDP figures, which are true year-to-
year measurements of what the economy
actually produces.
 To calculate real GDP, economists take the
nominal value of GDP the money value of
all the goods and services produced in the
economy and divide it by a measure of the
price level.

 Thus, real GDP is defined by the equation:

Real GDP = Nominal GDP/ Price level
 If, for instance, nominal GDP has risen 5%
in the past year but prices have also
increased by 5%, then real GDP is
unchanged.

 If nominal GDP has risen 5% in the past

year but prices have increased by 6%, real
GDP has actually decreased.
 Real GDP in year t (Yt) is the sum of the quantities
of goods and services produced in year t times the
prices of the same goods and services in some
particular year. This ‘particular year’ is called the
base year.
 To calculate Yt we must first choose a base year,
say, 1997.
 Then real GDP in any year is the value of that
year's final goods and services measured at
1997prices.
 Real GDP is also called GDP in terms of goods,
GDP in constant dollars or price, GDP adjusted for
inflation and, in the case of our example, GDP in
1997 dollars.
 Economists focus on real GDP since it
eliminates the effects of changing prices
on the measure of output.

For example, if real GDP in 2001

(measured at 1997 prices) increased by 2%
over the level of real GDP in 2001, we
know that total output increased.
 5 Price Indexes and Inflation

 In macroeconomics, the price level is the

average level of prices measured by a price
index.
 Two main price indexes that are used are the
Consumer Price Index and the GDP Deflator
 5.2 The Consumer Price Index (CPI)

 The CPI is a measure of the price level that considers

the price of a list of specific goods and services
purchased by a typical household at current prices.

 The nation’s statisticians starts with this ‘basket’ of

purchases and calculates this year's CPI by
expressing the cost of the basket in the current year as
a percentage of the cost of that same basket in the
base year.
 The CPI is the weighted average of price
movements of several thousands goods and
services grouped into several hundred
categories.
More precisely:
 Where the value of the basket represents total
expenditure on (or the cost of) the basket in any
period, month or year. The base year is an
arbitrary year employed by the nation’s
statisticians.

 Suppose the CPI in 2001 equals 107.6. This

suggests that the average price of goods and
services in 2001 is 7.6% higher than the average
price of the same basket of goods and services in
the base period (i.e., 1997).
 5.3 Implicit GDP Deflator

 Economists generally tend to prefer measures of the

inflation rate that are broader than the CPI.
 The GDP deflator is an average of the prices of all
goods in the economy, weighted by the quantities of
those goods that are actually purchased.

 It is equal to nominal GDP (expressed in dollars) as a

percentage of real GDP (expressed in the dollars of
the base year):
 5.4 Inflation Rate

 The percent change in the price level is called

the inflation rate. If the price level rises from
$20 per good to $22 per good over a period of
time, the inflation rate for the period is 10
percent. If the price level falls from $20 per
good to $18 per good, the inflation rate is -10
percent; that is, there is a 10 percent deflation.
 5.4 Inflation Rate

 The percent change in the price level is called

the inflation rate.
 If the price level rises from $20 per good to
$22 per good over a period of time, the
inflation rate for the period is 10 percent.
 If the price level falls from $20 per good to
$18 per good, the inflation rate is -10 percent;
that is, there is a 10 percent deflation.
 6 Unemployment Statistics

 Unemployment rate is the ratio of the number

of unemployed (those seeking employment) to
the total labour force
 6.1 Problems with Unemployment Statistics

 Economists believe that the statistics agencies’

unemployment surveys provide too high an estimate
of the true unemployment rate.
 Discouraged workers are those who do not have jobs
may have in fact abandoned hope of finding one.
 Statistics will not count them as unemployed, thus
will provide an underestimate of the number that
would choose to work if a job were available.
 Employment rate is the ratio of employment to
working age (adult) population:
Labour force participation rate is the fraction
of the working age population that is
employed or seeking employment.
Thank You