Chapter 4 1/7/04 8:49 Page 1

C M Y CM MY CY CMY K

CHAPTER 4
Measuring economic progress
MEASUREMENT

Price Economic Employment Balance of Distribution

stability growth payments of income
stability

Inflation GDP Current and

Defined as official financial Lorenz curve
rate based calculated or expanded account, and Gini
on CPI, CPIX using the
foreign coefficient
or PPI production,
expenditure exchange
or income reserves,
method exchange
rates
Real vs Distinction by
nominal cause: frictional,
GDP Also derive seasonal, cyclical or
NDP, GDI, structural
GNI, NNP,
NNI, PI and
Yd

1. INTRODUCTION

In the first chapter we saw that countries can set themselves five macroeconomic objectives: high
economic growth, price stability, high employment, balance of payments stability and equitable
income distribution. Achievement of these objectives will bring a country ever closer to solving
its scarcity problem. To know how well they are achieving these objectives and to decide on the
best actions, countries need to be able to measure their economic progress. That is what this
chapter is about – explaining how one can measure progress toward the achievement of
macroeconomic objectives.

The saying "what gets measured gets done" is quite true in economics. Since economists measure
the achievement of the five macroeconomic objectives, governments use these results in deciding
on economic policies. Policy actions in turn will influence the achievement of the objectives.
The results of policy actions will be reflected in the changes of the measures, which will again
affect policy decisions. So economic policy actions are constantly adapted to what we think we
know about the economy, and what we think we know is captured in the various economic
measures.

56

Composite
Chapter 4 1/7/04 8:49 Page 2
C M Y CM MY CY CMY K

2. MEASURING PRICE STABILITY

To know whether we are achieving price stability, we need to have some measure of price changes.
This measure is the inflation rate. Inflation is a persistent increase in the general price level (i.e.
the prices of most products increase), and so the inflation rate is the percentage change in the
general price level.

Measures of inflation

We have two main measures of inflation – a measure of the prices that influence people’s cost of
living (called the Consumer Price Index or CPI) and a measure of the prices that influence firms’
cost of production (called the Production Price Index or PPI). The percentage change in the
CPI gives us consumer inflation, while the percentage change in the PPI gives us producer
inflation. Table 4.1 provides an example:

Table 4.1: Calculating consumer inflation

Year CPI Inflation rate
1998 90.2
1999 94.9 5.2%
2000 100.0 5.4%
2001 105.7 5.7%
2002 115.3 9.1%
Source: SA Reserve Bank

A percentage change is calculated as follows:

(Current value–Initial value) (90.2-94.9)

% change = = = 5.2% in 1999
Initial value 90.2

As you can see from table 4.1 above, the percentage change in the CPI gives us the consumer
inflation rate. The inflation rate of 5.2% in 1999 means that prices increased on average by 5.2%
during 1999. If the average product cost you R10 at the start of 1999, it would have cost R10.52
(R10+R10x0.052) at the end of 1999.

The CPI is an index. An index is a way to remove all the information from a variable so that you
can only see its change over time. The CPI therefore just shows us the change in average consumer
prices over time and removes everything else. An index always has a base year, against which all
other years are compared. The base year in table 4.1 is the year 2000, and you recognise the base
year by the fact that its value is always equal to 100. So, a value of 94.9 tells us that the average
price of products in 1999 was about 94.9% of the average price in 2000. For example, if the
average price of products was R50 in 2000, the average price in 1999 would have been about
R47,45 (R50x0.949) in 1999. We can do this for all the other years. For example, we can say that
the average price in 2002 was about 115.3% of the average price in 2000.

57

Composite
Chapter 4 1/7/04 8:49 Page 3
C M Y CM MY CY CMY K

We find the value of the CPI by watching what consumers spend their money on and then tracking
those prices. To be precise, the CPI is an index based on a weighted average of the prices of the
basket of goods that consumers spend their money on. Table 4.2 gives you an idea of what
consumers spend their money on in South Africa.

Table 4.2: The basket of goods used to calculate the CPI in 2000
Product category Weighting (%)
Food 25.44
Non-alcoholic beverages 1.16
Alcoholic beverages 1.62
Cigarettes, cigars and tobacco 1.24
Clothing and footwear 3.87
Housing 18.62
Fuel and power 4.08
Furniture and equipment 2.94
Household operation 4.75
Medical care and health expenses 6.46
Transport 13.22
Communication 2.71
Recreation and entertainment 3.11
Reading matter 0.34
Education 3.22
Personal care 4.04
Other goods and services 3.46
TOTAL 100

Source: Statistics SA

Since the CPI is based on a weighted average of prices, prices of products that consumers spend
most of their income on will have the greatest effect on the CPI. From table 4.2 you can see that
a 10% increase in the price of food will cause a much greater increase in the CPI than a 10%
increase in the price of clothing. So, the inflation rate does not only depend on price changes,
but also on how people spend their income. If people start spending their income on different
products, the inflation rate may change even if prices remained the same. The inflation rate will
also be different for each person, because every person spends his income differently. People who
spend nothing on cigarettes, but much more on reading matter than the average consumer, will
experience a different inflation rate. The purpose of the CPI-based inflation rate is not to give an
accurate reflection of each individual consumer’s cost of living. Inflation is a macroeconomic
indicator, so it only tells us the average cost of living of all consumers in a country.

It is difficult to accurately determine a country’s inflation rate. The statisticians who calculate
the inflation have to keep track of the prices of hundreds of products and be aware of new products
that are introduced to the country’s markets. They need to constantly interview consumers and

58

Composite
Chapter 4 1/7/04 8:49 Page 4
C M Y CM MY CY CMY K

producers to determine whether their spending patterns (which determine the weights) have
changed. Even a small mistake here can cause big inaccuracies in the calculation of the inflation
rate.

Inflation is an average, and tells us nothing about the cost of living of specific groups in the
economy. Since inflation is only a measure of the price level, it cannot tell us anything about
changes in the quality of products. For example, if car manufacturers started building safer cars
without increasing car prices, consumers would be better off, but this will not be taken into
account in the calculation of the CPI. Another problem is that the CPI is based on advertised
prices. However, firms sometimes offer discounts which change the price that is actually paid.

The importance of measuring inflation

Despite all these problems, knowing what inflation in an economy is, is important for understanding
the real situation in an economy. If we want to know whether people are really better off in an
economy, we need to distinguish between nominal and real variables. This is where having a
measure of inflation helps.

A nominal variable is a variable measured only in terms of money. For example, if you earn R2
000 per month as a worker, your nominal wage as expressed in money terms is simply R2 000.
A real variable takes into account price changes and measures value not in terms of money, but
rather in terms of buying power. For example, if your wage is R2000 per month and the average
price of products in a country is R25, how many products can you buy with your wage? You can
calculate this by dividing your wage by the average price (R2000/R25 = 80). So you can buy 80
products with your wage, and your real wage is 80. Real variables are clearly more reliable than
nominal variables, because they tell us what some variables are really worth. The following formula
summarises how you turn a nominal variable into a real variable:

Nominal variable
= Real variable
Price level

You can see why this distinction between real and nominal variables is important from the
following example. Let’s say your wage increases from R2 000 to R3 000 per month. Are you really
richer? You cannot say whether you are better off unless you look at the real wage – that is after
you have taken price changes into account. Suppose the average price in this economy increased
from R25 to R40 over the same period, what is you real wage now? It has declined from 80
(2000/25) to 75 (3000/40), so you are in fact poorer. You would not have known this if you had not
known about the difference between real and nominal variables.

You could also have divided the nominal variable by the CPI% (that is CPI/100), as shown in the
next formula:

Nominal variable
= Real variable (at constant prices)
CPI%

The following table shows how you can use CPI to convert a nominal variable (wage in this case)
into a real variable.

59

Composite
Chapter 4 1/7/04 8:49 Page 5
C M Y CM MY CY CMY K

Table 4.3: Conversion from nominal to real variable

CPI
Year CPI CPI% = /100 Nominal wage Real wage
2000 100.0 1 R4 500 R4 500
105.7 5000
2001 105.7 1.057 ( /100) R5 000 R4 730 ( /1.057)
2002 115.3 1.153 R5 250 R4 553

When you divide a nominal variable by the CPI%, you find what the value of that variable would
have been if prices remained as they were in the base year. In table 4.3 the base year is 2000 (i.e.
the year in which CPI = 100). If prices had stayed constant since the year 2000, and you earned
a nominal wage of R5 250 in 2002, you would be able to buy R4 553’s worth of goods in 2000.
Are you better off? In 2000 your real wage was R4 500, which means that if prices did not change,
you were able to buy more with your wage in 2002 (R4 553 is more than R4 500).

Other kinds of inflation

When it comes to talking about inflation, economists make finer distinctions. Some of the
distinctions are disinflation, deflation, hyperinflation, and CPIX-based inflation.

Consumer inflation is normally based on the CPI. The inflation rate based on the CPI is sometimes
called headline inflation. The calculation of the inflation rate can also be based on the CPIX. The
CPIX is the CPI after the effect of interest rate changes has been excluded. Since interest rate
changes mainly affect the value of mortgage payments by consumers, you can see from table 4.2
that the CPIX would mainly change the weighting of the category of housing.

Disinflation is what happens when the inflation rate declines. Suppose the inflation rate this year
is 9%, next year it is 4% and the year thereafter it is 3%. This means that prices of products are
still increasing, but that the increase is getting smaller – this is disinflation. Hyperinflation
occurs when the inflation rate increases so fast that money becomes worthless. An inflation rate
of more than 1000% per year is generally regarded as hyperinflation, and it is a clear sign that
inflation is out of control. Deflation happens when there is a persistent decrease in the general
price level. Some call it negative inflation. For example, if the average price of products in a
country is R90 this year and R85 next year, you have deflation. The deflation rate is expressed as
a negative percentage, in this case -5.6% (90-85
90 ).

3. MEASURING ECONOMIC GROWTH

To know whether we are reaching the macroeconomic objective of high and sustained economic
growth, we use a system of measurement called national accounting. Economic growth shows
the percentage change in a country's total output (production). It is easy to understand why
growth in output (production) is so important. Without output, there will be no products to
satisfy people’s needs. We need output to solve the scarcity problem.

60

Composite
Chapter 4 1/7/04 8:49 Page 6
C M Y CM MY CY CMY K

We measure a country’s output by its Gross Domestic Product (GDP). GDP is the value of the
final goods and services produced (hence the word “Product”) within the borders of a country
(hence the word “Domestic”) during one year. But GDP on its own doesn’t tell us much about
a country’s economic performance. For an economy to be healthy, GDP should not remain stable,
it will have to grow, especially if there is a growing population in the country. That is why we
want to know the economic growth rate. The economic growth rate is the percentage change
in a country’s real GDP from year to year. If real GDP increases, the country experiences positive
economic growth and can be said to be in a boom phase. If real GDP declines, a country experiences
negative economic growth and can be said to be in a recession.

National accounting and economic growth

To find the GDP on which we base economic growth, we use a system called national accounting
or national accounts. A country's national accounts are systematic records of the economic
transactions in a country and their results over various time periods. The national accounts show
the sum totals of these transactions, so that we can clearly see changes in economic activity.
When we deal with sum totals or combined wholes we refer to such things as aggregates. For
example, GDP is an aggregate because it is a total of the production by every firm in the economy.

The national accounts also show what components the aggregates consist of, which allows us to
see the relationships and structure of economic activity. For example, the GDP in a country is
further divided into the production of the different sectors of the economy. So, if there is an
increase in the country's GDP, we can see which sectors of the economy contributed to this
growth. Table 4.4 provides an example of such a breakdown.

Table 4.4: Real GDP in South Africa (R million, constant 1995 prices)
2001 2002
Agriculture, forestry and fishing 24 602 26 212
Mining and quarrying 33 240 33 356
Primary sector 57 842 59 568
Manufacturing 117 637 123 873
Electricity, gas and water 21 148 21 526
Construction 17 673 18 435
Secondary sector 156 458 163 834
Wholesale and retail trade, 80 128 82 407
catering and accommodation
Transport, storage and communication 66 979 71 472
Financial intermediation, insurance, 113 855 118 200
real estate and business services
Community, social and personal services 111 952 113 146
Tertiary sector 372 914 385 225
GROSS VALUE ADDED (GDP) AT BASIC PRICES 587 214 608 627
Source: SA Reserve Bank

61

Composite
Chapter 4 1/7/04 8:49 Page 7
C M Y CM MY CY CMY K

From table 4.4 we can see that the tertiary sector of the South African economy contributed the
most to the country's GDP. We can also see what the country's economic growth rate was in 2002
(the percentage increase in aggregate output from 2001 to 2002). The growth rate in South Africa
was 3.6% in 2002, calculated as a percentage change in GDP from 2001 to 2002.

National accounting is similar to business accounting because it is also based on a double-entry

system – where the entry for every credit transaction must be matched by a debit transaction.
Any economic transaction involves the use of resources (debit), but these resources must also
have a corresponding source (credit). Both sides must always be recorded, and both sides must
therefore balance.

You may have noticed the double entry nature of national accounting in Chapter 3. The equations
you saw in Chapter 3 form the basis of much of a country's national accounts. For example, the
equation S+T+Z = I+G+X shows that for every use of money there needs to be a source of an
equal amount, and that for every leakage there must be an injection. So, if the government wants
to spend more money (G), the exact amount needs to come from somewhere (for example an
increase in T) or spending elsewhere in the economy must fall by the exact amount (for example
less investment (I) or exports (X)). One can explain why the national accounts should balance
by means of the diagram in figure 4.1 (which is similar to the circular flow model).

Aggregate
Expenditure

Aggregate Aggregate
Income Production

Total
Employment
Figure 4.1: Why the national accounts should balance

Figure 4.1 explains why expenditure in a country will be equal to the production that occurs in
a country, which in turn will be equal to the total income earned in a country. If firms wanted
to produce more products, they would have to employ more production factors, such as labour,
to help them do so. The more people firms employ, the more income these people will earn. The
more income people earn, the more they can spend, and demand for most products will increase.
If people demand more products because they have more income to spend, firms will obviously
produce more to satisfy this higher demand. An increase in any one element in figure 4.1 depends
on the others. For example, there can be no expenditure if there is no income to spend or no
production to spend money on. If any one of the elements increased, all the others would also
increase, until all three were equal again.

One can explain it another way. Before anyone can spend any money, they need to get that money
from somewhere, in the form of income. So, aggregate expenditure will equal aggregate income.

62

Composite
Chapter 4 1/7/04 8:49 Page 8
C M Y CM MY CY CMY K

Spending cannot occur if there is nothing to spend money on – something must be produced so
that it can be bought. Therefore, aggregate expenditure will equal aggregate production. When
firms produce goods and services, they have to employ production factors (for example labour)
and pay them wages, rent, interest and profit. Aggregate income comes from employment. The
amount that firms pay production factors will be equal to the value of their production, so that
aggregate production equals aggregate income.

If we wanted to measure the GDP of a country, we could simply measure aggregate production.
Given the equality of aggregate expenditure, production and income, we could just as easily
measure GDP in a country by measuring aggregate expenditure or aggregate income. We therefore
have three methods to determine GDP – the production method, expenditure method and income
method:

• The production method: With this method we sum the contribution that each sector of the
economy made to the country's production – as you have seen in table 4.1. To calculate the
value of each sector's contribution to production, we use the value-added approach. This
means we only sum the value that every firm or sector in the economy added to the value of
production. Suppose a cloth producer bought cotton from a farmer for R120, processed the
cotton and made it into cloth, and then sold that cloth to a shirt producer for R180. The cloth
producer did not contribute the full R180 to the value of production, because included in that
R180 is the R120 that the farmer contributed. How much extra value did the cloth producer
add over and above the farmer's contribution? The value added by the cloth producer is the
value that is left after the farmer's contribution is taken into account, that is R60 (R180-
R120). Totalling the value that every firm added, gives us the GDP according to the production
method. But remember that GDP only looks at the value of final products produced. Final
products are those bought by the end user. Compare this against intermediate products that
are still in the process of becoming final products. For example, a shirt bought by a consumer
is a final product while the cloth that goes into the production of that shirt is an intermediate
product. The shirt is bought by the end user and is not used to produce any other products,
while the cloth is part of the process of producing a shirt. Table 4.5 provides a more detailed
example of how the production method works:

Table 4.5: Calculating value added

Cost Sales price Value added
Farmer - 120 120
Cloth maker 120 180 60
Shirt maker 180 250 70
Clothing shop 250 300 50
Consumer 300 - -
TOTAL 1 150 300

If we added together the prices of all the intermediate products (i.e. the cotton and the cloth)
and the final product (the shirt) we find that the total value is R1 150. But can this be true?
If we do this, how many times did we count the value of the cotton? We counted the cotton

63

Composite
Chapter 4 1/7/04 8:49 Page 9
C M Y CM MY CY CMY K

when the farmer sold it, we counted it when the cloth maker sold the cotton as part of the
cloth, we counted it again when the shirt maker sold the cotton as part of the shirt and finally,
we counted the cotton again when the clothing shop sold it as part of the shirt. We counted
the cotton four times, so surely the R1 150 overstates aggregate output.

We can prevent counting the same intermediate product more than once, by simply counting
the value of the final product only (R300 for the shirt sold to the end user). Another way is
to add together the value that every producer added to the intermediate products. The cotton
bulbs would have had no value if a farmer didn’t harvest them. The farmer made those cotton
bulbs more valuable by harvesting them and therefore a weaver was willing to buy them from
him. By paying the farmer R120 for the cotton bulbs, the cloth maker recognises that the
farmer added R120 of value to those cotton bulbs. The cloth maker then takes the cotton
bulbs that were worth only R120 and makes them more valuable by weaving them into cloth.
Because of what the cloth maker did, a shirt maker is willing to pay R180 for the cotton made
into cloth. Is the R180 of value all due to the cloth maker? No, because the farmer was
responsible for R120 of that value. The weaver added R60 of value (180-120) to the cotton.
And so we can calculate the value for each producer. If we sum the value that every producer
added, we should always get exactly the same value as the value of the final product. So the
value of the final product actually tells us how much value all producers created together.

• The expenditure method: Here we add together the value of all spending on final products
produced within the borders of a country (i.e. domestic production). Economists categorise
a country's aggregate expenditure into consumption spending by individual consumers and
households (C), investment expenditure by (I), consumption expenditure by the government
(G), export expenditure (X) and spending on imports (Z). We add C, I, G and X together,
because all four make up the spending on a country’s products. We deduct import spending,
because when people buy imports, they are spending their income on other countries’ products.
Using this method, we calculate GDP as follows:

GDP = C + I + G + (X – Z)

• The income method: Here one sums the value of the income that production factors earn
while involved in the production inside the country’s borders. We divide a country's aggregate
income into remuneration of employees (total wages paid) and gross operating surplus (made
up of total rent, interest and profit). Using this method, we calculate GDP as follows:

GDP = Remuneration of employees + gross operating surplus

Real and nominal GDP

We have to base our calculation of economic growth on real GDP. Nominal GDP includes the
effect of inflation, so we cannot say whether the value of production increased due to more
products being produced, or simply because their prices increased. For example, suppose that

64

Composite
Chapter 4 1/7/04 8:49 Page 10
C M Y CM MY CY CMY K

in 2003 a country produced 1 000 products at an average price of R12 each. This country's nominal
GDP in 2003 was therefore R12 000 (1 000x12). Let's say that the nominal GDP in that country
increased to R15 000 in 2004 – did aggregate output in that country really increase? We cannot
say unless we know what happened to the average price. Suppose the country experienced an
inflation rate of 25%, and that the average price increased from R12 to R15, while the number
of products produced stayed at 1000. In that case, the country's nominal GDP will have increased
to R15 000 (1 000x15) even if it did not produce more. The increase in GDP was caused only by
an increase in prices, not because the number of products had increased. If the country's actual
production does not increase, its real GDP will also not increase. We can see this by converting
the nominal GDP into real GDP, by dividing the nominal GDP either by the average price or by
the CPI% for 2003 and 2004 (see table 4.6).
Table 4.6: Example of calculating real GDP
Year Nominal Average Real GDP CPI% Real GDP
CPI
GDP price (actual output) ( 100) (constant prices)
4000 4000
2000 4 000 5 800 (= /5) 1.00 4 000 (= /1.00)
8100 8100
2001 8 100 9 900 (= /9) 1.80 4 500 (= /1.80)
2002 10 500 10 1 050 2.00 5 250
2003 12 000 12 1 000 2.40 5 000
2004 15 000 15 1 000 3.00 5 000

As you see from table 4.6, when you divide a nominal variable by the CPI%, you get a different
kind of real variable than when you divide by the average price. Dividing the nominal GDP by
the average price tells you the number of products that were produced. Dividing nominal GDP
by the CPI tells you what GDP would be if prices remained constant at the price level of the base
year. Dividing directly by the price level removes the price completely from a nominal variable,
while dividing by the CPI only removes the effect of price changes (or inflation). In table 4.6,
dividing by CPI tells us that if we had the same prices in 2004 as we had in 2000 (our base year),
the value of production would have been R5 000. That is why, when we divide nominal GDP by
the CPI, we say that we have GDP at constant prices. Whether we divided by the average price
or the CPI, you can see that the real GDP did not change between 2003 and 2004.

We normally calculate economic growth by using the percentage increase in the GDP at constant
prices. We can see from table 4.6 that the economic growth rate in 2004 was 0%, while in 2003
it was -4.8% (5000-5250
5250 ).

Going beyond GDP

GDP is a first step in calculating a country’s aggregate output, expenditure and income. More
accurate measures of a country’s economic performance can be derived from GDP:

• To get an idea of the average standard of living in a country, we need to compare GDP against
a country’s population. We therefore need a measure called GDP per capita:

GDP
GDP per capita = Population

65

Composite
Chapter 4 1/7/04 8:49 Page 11
C M Y CM MY CY CMY K

• One problem with GDP is that it does not take into account the fact that assets lose their value
as they are used (or consumed). We therefore need to deduct consumption of fixed capital
(called depreciation on fixed assets in accounting) from GDP. A variable that includes
consumption of fixed capital is called a gross variable. When we deduct consumption of fixed
capital, we turn a gross variable into a net variable. So, to find the Net Domestic Product we
have to deduct consumption of fixed capital from Gross Domestic Product:

NDP = GDP – Consumption of fixed capital

• Another problem with GDP is that it considers the output, income and expenditure that occur
inside a country's borders, but cannot tell us how much of this can be attributed to a country's
own residents. How do we know how much has been produced by a country’s own residents?
First, we have to eliminate the income generated by foreigners in our country (primary income
to the rest of the world), so we deduct the wages and profit earned by foreign workers and
firms inside our country. We then have to add the income generated by our own residents in
foreign countries (primary income from the rest of the world), so we add wages and profits
earned by our own workers and firms in foreign countries. When we take primary income to
and from the rest of the world into account, we turn a domestic variable into a national
variable. To find the Gross National Product we therefore have to deduct primary income to
the rest of the world and add primary income from the rest of the world to Gross Domestic
Product. (In South Africa GNP is called Gross National Income or GNI):

GNI = GDP – Primary income to the rest of the world + Primary income from
the rest of the world

• A further problem with GDP is that it only tells us the market value of output and expenditure.
Market values are determined by multiplying the total number of products sold by their market
price. But market values are often distorted by indirect taxes and government subsidies, so
that we do not know what the actual costs of production were. For example, without indirect
taxes or subsidies, a firm may have sold a book at R100. But that is not what the market price
of the book will end up being. If the government pays firms a R5 subsidy for every book they
produce, it will allow firms to reduce the price of the book by R5. If there is an indirect tax
(like 14% VAT) this will increase the price of the book by R14 (14% of R100). The original
R100 is the factor cost of the book producer, since out of this R100 the wages, rent, interest
and profit are fully paid to the production factors. The factor cost therefore also tells us how
much income the production factors earn. So, to turn a variable valued at market prices into
a variable valued at factor cost, we add back subsidies that reduce the market price and deduct
the indirect taxes that increase the market price. To find the Gross Domestic Income (at factor
cost) we therefore have to deduct indirect taxes and add subsidies to Gross Domestic Product
(at market prices):

GDI = GDP + Subsidies – Indirect taxes

You are now in a position to derive a wide range of indicators from GDP. Some of the commonly
used indicators are:

66

Composite
Chapter 4 1/7/04 8:49 Page 12
C M Y CM MY CY CMY K

• Net National Product (at market prices):

NNP = GNI (at market prices) – Consumption of fixed capital

• Net National Income (at factor cost):

NNI = NNP (at market prices) – Indirect taxes + Subsidies

• How much of all this Net National Income is actually received by people? For this we need
to determine personal income (PI) which is calculated as follows:
PI = NNI (at factor cost) – Corporate taxation and undistributed profit + Transfers to
households from the government and foreign sector

• Since the government takes it share of the income that people earn, we need to find out how
much of this income is left for people to spend. For this we need to determine personal
disposable income (Yd) which is calculated as follows:
Yd = PI – Direct personal taxes

The following table shows the calculation of some of the aggregates in South Africa's national
accounts in 2002:

Table 4.7: Some South African national accounts aggregates in 2002 (at current prices)

R millions
GDP at market prices (C+I+G+X-Z) 1 120 895
Plus: Primary income from the rest of the world 18 193
Less: Primary income to the rest of the world 47 201
Gross National Income (GNI) at market prices 1 092 607
Less: Taxes on production and imports 128 366
Plus: Subsidies 6 693
GNI at factor cost 970 934
Less: Consumption of fixed capital 145 139
Net National Income (NI) 825 795

Source: SA Reserve Bank

In table 4.7 you may notice that the aggregates are expressed in current prices. This means that
the values are expressed in terms of the prices of the time. A variable expressed in terms of current
prices is a nominal variable. Contrast that with real variables that are expressed in terms of
constant prices.

Problems with measuring economic growth

Like all economic indicators, the calculation of GDP and economic growth suffers from certain
problems and limitations. A few of these limitations are explained below:

67

Composite
Chapter 4 1/7/04 8:49 Page 13
C M Y CM MY CY CMY K

• If economic activity does not occur on a market, no prices will have been negotiated. If we
don’t know what prices were involved in transactions, we cannot know what the value of the
transactions were, and thus we will be unable to include those transactions in our calculations.
For example, the services that a mother renders to her family (e.g. preparing food) has
economic value. However, if that mother does not sell her services to her family, we do not
know what the value is, and it won't be included in the country's GDP. If that same mother
offered her services to another household as a domestic servant and she is paid for it, only
then could the value of her services be added to the GDP.

• Even if economic activity occurs on a market, it is not necessarily recorded. If economic

activity is not recorded somewhere, no one can really know whether it really took place.
Unfortunately, there is a large part of the economy – the informal sector – whose economic
activity is not recorded because the firms in this sector don’t register themselves as employers
or taxpayers. To calculate GDP, government statisticians have no choice but to estimate the
size of the informal sector, and these estimations are likely to be incorrect.

• Mistakes (such as the two mentioned above) can easily creep into calculations of the GDP.
Government statisticians are therefore forced to constantly review and revise the data and
their calculations. This gets one in the situation where the GDP for the same year is different
after every revision. In such cases GDP changes not because the actual GDP has changed, but
because of data revisions.

• GDP calculations treat all kinds of production as contributing equally to a country’s total
wealth, but this is not a reasonable assumption to make. Is producing 100 million rand’s
worth of landmines really equivalent to producing 100 million rand’s worth of houses for the
poor? Clearly, some kinds of production are more important to the economy, but GDP
calculations only consider the value of transactions and not the purpose or social value of
these transactions.

• In the process of producing a country’s GDP, many undesirable effects are created. Production
often leads to firms polluting the air and water, and may lead to further problems such as
global warming. Production requires people to work in stressful jobs and also leads to people
having to stay in cramped cities with crime and traffic congestion. All of these negative side-
effects of production actually reduce the value of that production, but in our calculations of
GDP this is not taken into account, simply because we cannot measure it. In fact, it leads to
the strange situation where these negative side-effects actually increase the GDP. For example,
if greater stress causes people to spend more on medication, this side-effect increases the
GDP.

4. MEASURING EMPLOYMENT
To know whether we are reaching the macroeconomic objective of high employment, we use the
unemployment rate. The unemployment rate, simply stated, is the percentage of people in a

68

Composite
Chapter 4 1/7/04 8:49 Page 14
C M Y CM MY CY CMY K

country who are willing and able to work, but cannot find jobs. The unemployment rate, being
the converse of the employment rate, gives us an indication of how much employment there is
in a country.

Measures of unemployment
To be more precise, the unemployment rate is the percentage of the economically active population
that is jobless. To be part of the economically active population, a person must be between 15 and
64 years of age, and must be willing and able to work.

Depending on how you define 'jobless', you could have two definitions of unemployment – the
strict or official definition and the expanded definition. To meet the expanded definition of
unemployment, an economically active person: (1) must want to work; (2) must have been without
a job (employed or self-employed) for more than 7 days; and (3) must be available to start in a
job within the next week. The expanded definition may include discouraged job seekers - people
who have given up on trying to find a job even though they still say that they want to work. Such
people are excluded from the official definition of unemployment. To be part of the strict or official
definition of unemployment, an unemployed person must meet the conditions of the expanded
definition of unemployment, and must also have taken active steps in the last 4 weeks to look for
a new job or to become self-employed. The official unemployment rate for South Africa will always
be less than the expanded unemployment rate, as table 4.8 shows .

Table 4.8: Unemployment in South Africa

1994 1998 2003
Expanded unemployment rate 30.9% 37.5% 41.8%
Official unemployment rate 19.2% 25.2% 28.2%
Source: Statistics SA

Table 4.9 shows the calculation of the unemployment rate, together with two other indicators.
The labour force participation rate tells us what percentage of the working age population is
willing and able to work. The labour absorption rate tells us what percentage of the working age
population has a job.

Table 4.9: Labour market situation in South Africa (September 2003)

Millions
A Total employed 11 622
B Total unemployed (official definition) 4 570
C Total economically active (A+B) 16 192
D Total not economically active 13 725
E Total aged 15 to 65 years (C+D) 29 917
B
F Official unemployment rate ( /C x100) 28.2%
C
G Labour force participation rate ( /E x100) 54.1%
A
H Labour absorption rate ( /E x100) 38.8%
Source: Statistics SA – Labour Force Survey

69

Composite
Chapter 4 1/7/04 8:49 Page 15
C M Y CM MY CY CMY K

Not all employment is equally desirable. Employment in the formal sector is preferred to
employment in the informal sector. The formal sector includse those organisations registered
for tax and employment purposes. The informal sector consists of those organisations that don’t
register themselves as employers or tax payers and the government is often not aware of them.
People employed in the informal sector sometimes engage in socially unacceptable activities such
as burglary, prostitution or drug dealing. Most often though, the informal sector is made up of
previously unemployed people who are now self-employed in socially acceptable ways just to
survive. Examples include hawkers, shebeen owners, backyard mechanics or shoeshiners. While
these people are employed, their employment is often insecure and yields a very low income. In
South Africa about 30% of people with jobs are employed in the informal sector.

In most countries people can register as being unemployed, but very few people in developing
countries actually register. So, we normally don’t know who all the unemployed people are. In
this country Statistics South Africa uses the so-called Labour Force Survey (LFS) to determine
the number of unemployed people. The LFS interviews a representative sample of the country's
population and uses the results to estimate total unemployment.

Kinds of unemployment
One can distinguish between four kinds of unemployment, which will be discussed in order of
seriousness. Every kind of unemployment implies different remedies for unemployment. It is
therefore important to know which kind of unemployment a country is facing before trying to
solve it.

Frictional unemployment is caused by people who are between jobs. An example of frictional
unemployment is when a person resigns his job because he wants to move to a different part of
the country. Such a person is unemployed out of choice, and is frictionally unemployed while he
is searching for a new job. If a frictionally unemployed person struggles to find a new job, it is
usually because that person doesn't have sufficient information on the available job opportunities.
A possible solution to frictional unemployment is for the government to establish information
agencies that distribute information about available vacancies.

Seasonal unemployment occurs because some parts of the economy only need labour during
certain times of the year. For example, farmworkers are only needed during harvesting times.
If these farmworkers don’t have jobs at times when there is no harvesting, they are part of the
seasonally unemployed. While this kind of unemployment can cause hardship for people, they
are generally sure of being employed when the season of employment arrives again. There is little
the government can do about this kind of unemployment, except perhaps paying these workers
to work on community projects during the off-season.

Cyclical unemployment is caused by changes in the business cycle. All market economies go
through cycles of booms and recessions. During booms there are more spending and more
production, so we would expect unemployment to fall. During recessions there are less spending
and less production, so one would expect unemployment to rise. When production falls, firms

70

Composite
Chapter 4 1/7/04 8:49 Page 16
C M Y CM MY CY CMY K

will retrench workers, hopefully to employ them again when the economy starts to grow again.
This kind of unemployment is more serious than the previous two, since one can never be sure
when the economy will enter a boom again and how long people will remain unemployed.
Governments can attempt to reduce cyclical unemployment by means of expansionary economic
policy.

Structural unemployment is caused when there is a lasting change in the demand for labour in
many sectors of the economy. For example, when gold mines close down (as is happening in
South Africa now) the demand for labour in the mining sector declines compared to other sectors,
like information technology or financial services. Mine workers lose their jobs and will not be
able to find new jobs in the mining sector. Jobs will be available in the other sectors, but the mine
workers will often not have the appropriate skills for those jobs. For example, to get a job in the
information technology sector one needs to have a good understanding of computers and
programming, while mine workers are trained to do mainly manual labour. Structural unemployment
can also happen when people lose their jobs because of technological change which makes certain
products obsolete (e.g. when cars replaced horse-drawn carts) or when consumers change their
tastes permanently (e.g. as people switch from paraffin to electricity). This is the most serious
unemployment a country can experience and the only way to fix it is to fill the skills gap in the
country. Governments need to focus on education and training to ensure that the skills the
unemployed have to offer, match the skills that employers require.

5. MEASURING BALANCE OF PAYMENTS STABILITY

To know whether we are reaching the macroeconomic objective of balance of payments stability,
we need measures that tell us something about our economic relationships with the rest of the
world. A country that has no economic relationships with foreign countries is called a closed
economy, and one that has relationships with foreign countries is called an open economy.

South Africa is regarded as a small open economy. An open economy can have economic relationships
with the foreign sector either through trade or investment. Trade happens either when we sell
products to foreign countries (exports or X) or buy products from foreign countries (imports or
Z). But it is not only products that can move across borders. Foreigners can also buy or sell South
African assets (for examples businesses, land, bonds and shares). Sometimes foreign firms want
to buy South African businesses or even establish branches of their firms here in South Africa.
Foreign individuals may buy shares on the JSE Securities Exchange or buy holiday homes in Cape
Town. When foreigners buy South African assets, there is an inflow of foreign investment, and
when they sell South African assets, there is an outflow of foreign investment.

The balance of payments

A country's balance of payments is a systematic record of a country's transactions with the rest
of the world. The balance of payments consists of two main accounts – the current account and
the financial account. The current account comprises mainly exports and imports of goods and

71

Composite
Chapter 4 1/7/04 8:49 Page 17
C M Y CM MY CY CMY K

services. The financial account is mainly a record of trade in assets, specifically the inflow and
outflow of foreign investment.

A simplified current account could be calculated as follows:

Balance on current account = Exports of goods and services – Imports of goods and services

If exports are greater than imports, the country will most likely have a surplus on the current
account. If exports are less than imports, the country will probably experience a deficit on the
current account.

A simplified financial account could be calculated as follows:

Balance on financial account = Net inflow of portfolio investment + Net inflow of

foreign direct investment

Foreign investment (also called foreign capital flows) is divided into two categories. Portfolio
investment is investment in financial assets, for example when a foreign firm buys/sells shares
or bonds or simply deposits money in, or withdraws money from a South African bank account.
Negative net foreign portfolio investment means that there is an outflow of money from South
Africa. This could happen when foreign firms sell more financial assets than they buy in South
Africa, or when more South African firms invest their money in financial assets in foreign countries.
Positive net foreign portfolio investment means there is an inflow of money through investment
(either through foreigners investing more in SA financial assets, or through SA firms selling more
of their foreign financial assets and bringing the money back to SA). Foreign direct investment
(FDI) is investment in real assets, for example when a foreign firm establishes a branch in South
Africa, builds a new factory here or takes ownership of an existing local firm. Like portfolio
investment, a positive net FDI shows an inflow of direct investment to SA, while a negative net
FDI shows outflow of direct investment from SA.

If inflows of foreign investment are greater than outflows of foreign investment, the country will
have a surplus on the financial account. If inflows of foreign investment are less than outflows
of foreign investment, the coutry will experience a deficit on the financial account.

When we export, we get paid in foreign currency. Foreign currency also flows into SA when there
is an inflow of investment or when foreign tourists visit the country. All the foreign currency goes
to the South African Reserve Bank (SARB), which keeps this foreign currency in reserve. Together
with our store of gold, foreign currency holdings make up South Africa's gold and foreign reserves.
When we import, we have to pay foreign firms with foreign currency (usually US dollars) and we
get this foreign currency by drawing on South Africa's gold and foreign reserves. Foreign reserves
also get used up when SA citizens need foreign currency to go on an overseas trip or when SA
firms want to invest in foreign countries. So, exports and inflows of foreign investment increase
South Africa's reserves, while imports and outflows of foreign investment reduce our reserves.

72

Composite
Chapter 4 1/7/04 8:49 Page 18
C M Y CM MY CY CMY K

Ceteris paribus, when there is a surplus on any of the accounts foreign reserves will increase,
while deficits will reduce foreign reserves. We can therefore simplify the balance of payments as
follows:

Change in gold and foreign reserves = Balance on the current account + Balance on
the financial account

Exchange rates
When we import products from foreign countries, we have to pay them in foreign currency –
usually US dollars. Suppose I want to buy a pen from a US supplier for $1. To get the needed US$,
I need to convert the SA rands that I own into US$ at the current exchange rate. If the exchange
rate is $1=R5, I would have to sell R5 in order to get the $1 in exchange. When we export to
foreign countries, we get paid in foreign currency as well (usually US$). If, for example, I sold
100 staplers to a US firm at $2 per stapler, I would receive $200. By law I am required to sell any
foreign currency to the South African Reserve Bank (SARB) within 90 days. If the exchange rate
is $1=R5, I will sell the $200 and get R1 000 (200x5) in exchange. If exchange rates did not exist,
international trade and investment would be a lot more difficult.

In South Africa, exchange rates are normally given in the form of a direct quotation, for example
$1=R6,28 or R6,28/$. With a direct quotation, the rand is the unit of account, while the dollar
is the commodity being traded.

Most exchange rates change all the time, because foreign currencies are bought and sold worldwide,
24 hours a day. Exchange rates that change all the time are generally determined by the market
forces of demand and supply. Such exchange rates are called floating exchange rates, and the
rand is regarded as a floating currency.

If the rand becomes more expensive in terms of a foreign currency, we say that the rand has
appreciated. Appreciation of the rand occurs, for example, when the exchange rate is R12/$ (or
$0.08=R1) and then changes to R8/$ (or about $0.13=R1). We now need more US$ to buy R1, so
the rand is more valuable than before. If a specific currency becomes cheaper in terms of a foreign
currency, then that specific currency has depreciated. Depreciation of the rand occurs, for example,
when the exchange rate is R6/$ (or about $0.17=R1) and then changes to R9/$ (or $0.11=R1). We
now need fewer US$ to buy R1, so the rand is less valuable.

6. MEASURING INCOME DISTRIBUTION

To know whether we are reaching the macroeconomic objective of an equitable distribution of
income, we need to determine how income is distributed in the country.

73

Composite
Chapter 4 1/7/04 8:49 Page 19
C M Y CM MY CY CMY K

Measures of income distribution

An easy way to show income distribution is graphically by means of the Lorenz curve. By using
the Lorenz curve, you can establish what percentage of the country's total income is earned by
a certain percentage of the population. Figure 4.2 gives an example of a Lorenz curve.
B
100
Percentage of total income

60%

25%

A C

0% 60% 100
Percentage of total population

Figure 4.2: The Lorenz curve

The straight line that connects points A and B shows what the situation would be if income was
perfectly equally distributed amongst the population. Equal distribution implies that every
proportion of the population will earn an equal proportion of the country's income. For example,
the straight line in figure 4.2 indicates that 60% of the population will earn 60% of the total
income. In reality, one will never find income to be perfectly equally distributed, and the Lorenz
curve is more likely to look like the curved line connecting points A and B.

The curved line between points A and B shows an unequal distribution of income. Reading from
the Lorenz curve in figure 4.2, one can see that in this particular case, 60% of the population
earn only 25% of the total income. So the 75% of the income that remains, is earned by the
richest 40% of the population. This is clearly an unequal distribution of income.

The more curved the Lorenz curve becomes, the more unequal the distribution of income, and
the bigger the shaded area between the curved and straight line becomes. If income is distributed
in a perfectly unequal way (i.e. only one person earns all the income in the country), then the
shaded area would fill the whole triangle ABC.

One can express the degree of income inequality shown by the Lorenz curve in terms of a single
number – the Gini coefficient. The Gini coefficient is the area of the shaded part (between the
straight line and the Lorenz curve in figure 4.2) divided by the area of the triangle ABC. So, if

74

Composite
Chapter 4 1/7/04 8:49 Page 20
C M Y CM MY CY CMY K

the area of the shaded part is 0.3, and the area of the triangle ABC is 0.5, then the Gini coefficient
is 0.3/0.5 = 0.6.

The more unequal the distribution of income, the more curved the Lorenz curve becomes, and
the bigger the shaded part becomes. As the shaded part becomes bigger, the value of the Gini
coefficient will increase. The greater the Gini coefficient, the more unequal the distribution of
income in a country. A Gini coefficient of 1 indicates perfect income inequality. If income was
perfectly equally distributed, the Lorenz curve would be a staright line, so there would be no
shaded part, and the Gini coefficient would be 0.

According to a recent United Nations study, the Gini coefficient in South Africa was 0.596 in 1995
and 0.635 in 2001. This means that income distribution in South Africa is not only one of the
most unequal in the world, it has also worsened over the last few years.

It is also possible to show income distribution quantitatively, by dividing the population into
income groups and then showing what percentage of the total income they earn. Table 4.10 gives
an example of such a representation.

Table 4.10: Quantitative income distribution for selected African countries (1986-97)
Share of income earned by the following population groups:
Richest 10% Richest 20% Poorest 10% Poorest 20%
Tanzania 30% 46% 3% 7%
Mozambique 32% 47% 3% 7%
Zambia 39% 55% 2% 4%
Kenya 35% 50% 2% 5%
Lesotho 43% 60% 1% 3%
Zimbabwe 47% 62% 2% 4%
South Africa 46% 65% 1% 3%

Source: WAfrican Development Indicators (2001)

7. SUMMARY
• Price stability is measured by changes in the inflation rate. Calculation of the inflation rate
can be based on the CPI, CPIX or PPI
• High and sustained economic growth is measured by changes in real GDP. GDP can be
calcaluted by any of three methods: the production, expenditure or income method
• High employment can be measured by changes in the unemployment rate using either the
official or expanded definitions
• Balance of payments stability is measured by looking at changes in the current account and
financial account of the balance of payments account of a country
• The distribution of income is measured by using the Lorenz curve, Gini coefficient or a
quantitative measure of income distribution.

75

Composite