Economics notes

GDP and the circular flow of income.

Q1. Explain the different ways of measuring GDP, naming the problems and
respective solutions of each method of calculation
GDP is the total output produced by an economy over a given period of time by resources
located within the country. There are three ways of measuring GDP; the output method, the
expenditure method and the income method. Each measure should be equal because each
method is simply a different way of looking at the same thing.

The output measure adds up the total value added of output produced in real terms or at
constant prices i.e that is adjusted for inflation using the prices of the base year. In this method
it is important to avoid double counting and this occurs because the output of some industries
is the input of others. Thus double counting of output will result. There are two possible ways
of correcting the problem; either by adding up the output in its final stage of production or by
adding up the value added from one stage to another of production.
Another problem is that the output must be corrected for any increase in price resulting due to
increases in the general price level or inflation. This deduction is called stock appreciation in the
official tables.

The income method measures the GDP from the perspective of the personal incomes gained or
factor payments paid to produce the output. This includes any salaries, wages, profits, interests,
dividends and rent.
In the income method it is important to reduce transfer payments since these do not represent
factor payments and there is no output which corresponds to this sort of income.

The expenditure method measures GDP from the perspective of the total expenditure paid to
buy the output produced. The expenditure method includes as well as consumption
expenditure, government expenditure, investment and NET exports (exports – imports) any
taxes must be reduced and subsidies included.

The problem with this method is that not all expenditure must be included. Government
expenditure on transfer payments such as pensions, children’s allowance, and unemployment
benefits must be reduced. One must also reduce expenditure on intermediate goods since
these would be double counted if taking into consideration the final expenditure of the final
output.

The GDP is often used as an economic indicator to show if there has been economic growth. An
increase in GDP shows economic growth but not necessarily economic development, an
improvement in the standard of living or a better quality of life. The GDP per capita is the GDP
divided by the population of the country.

Q2. Illustrate the difference between the GDP measured by current prices
(nominal) and the GDP measured at constant prices (real GDP).
GDP at current prices or in money terms does not take into consideration the increase in prices
resulting due to inflation. It is therefore an incorrect measure of value and may over estimate
the value of output resulting in the input, expenditure and output methods not matching. GDP
at constant prices or at real terms is GDP adjusted for inflation and is measured by using the
prices of the base year. This establishes a common denominator of measurement and allows
for the income, expenditure and output values to match.

Therefore real GDP = Nominal GDP adjusted for inflation

Q3. Why is GDP not necessarily a good measurement of the standard living in a
country? Explain.
Although GDP gives a measure of the material output of an economy there are a number of
reasons why this does not necessarily equate with a better standard of living within a country.

The first consideration that has to be taken is that if the population of a country increases at a
faster rate than GDP itself the GDP per capita may actually have fallen and therefore the
standard of living. Another problem is that GDP per capita is an average measure while in
reality income may be unevenly distributed among the population. Some may have increased
their wealth while others may have remained the same or even have become poorer.
The composition of output produced must also be taken into consideration. An increase in
capital goods at the expense of consumer goods does not lead to a better standard of living
since consumers have less goods to buy. This was often the case in communist economies.
Economic growth and the quality of life are not synonymous. If the increase in output comes at
the expense of less leisure time, social problems, etc… the increase in GDP has resulted in a
poorer more hectic quality of life.
In the process of producing output positive and negative externalities are not taken into
consideration or cannot be measured financially. Pollution, traffic congestion, stress, etc… are
negative externalities which impact negatively on the standard of living. The happiness and
fulfillment that come with increased income are also not measurable but affect positively the
quality of life. A final important consideration is that relating to the hidden economy or black or
grey economy. Some people do not declare their income and therefore this does not show in
GDP figures, however, this improves their financial situation and results in more consumption
and results in a better standard of living. With this one must include un-paid jobs such as
housekeeping, taking care of children, DIY jobs at home which improve one’s standard of living
and carry no income.

As a result of the above problems with GDP in measuring the standard of living/ quality of life
there exist other methods such as the Human Development Index(HDI), the Measurable
Economic Welfare Index(MEW),the Happiness Index, the Human Poverty Index (HPI) and the
Purchasing Power Parity(PPP).
Q4. What is the use of measuring real GDP figures?
GDP figures are used for two main things.

1. To calculate the productivity of the economy and give a rough indication of economic
growth in comparison to previous years.
2. It allows for economic comparisons with other countries.
3. It helps economists to develop models of the economy and make forecasts about the
future.
4. It is a ‘report card’ for the country and the effectiveness of economic policies taken.
5. It is a rough indicator of the standard of living.

Q5. What is Green GDP?

Green GDP is a measure of the GDP that takes into account any environmental costs incurred
from the production of the goods and services included in GDP figures.

Therefore Green GDP = GDP – environmental costs of production.

Q5. What is the business cycle?

The business cycle is an illustration of the periodic fluctuations in the economic activity
measured in real GDP changes. The phases of the cycle are known as the boom, recession,
trough and recovery.

A recession is defined as a two consecutive quarters of negative GDP (or AD). During a recession
AD is falling which will lead to an increase in unemployment as less workers are ‘demanded’.
Inflation rates are low and there might even be deflation.
A boom is the culmination of the recovery, GDP is at its peak and AD is rising. There is low
unemployment but high inflation. This is because the economy is reaching its potential output
levels.

The difference between the actual output line and the potential output on the business cycle
diagram is known as the output gap. When the actual output is below the long-term trend
there is a negative output gap. When the actual output is above the trend, we say there is a
positive output gap.

Q6. Give appropriate definitions for GDP, GNP, NNP and GNI?
GDP (Gross Domestic Product) the total value of all final economic production in a country in a
given year. (This means within a country’s borders regardless of who owns the factors of
production)

GNP (Gross National product) measures the flow of income based on actual ownership of
factors of production. This is done by adding to GDP any payments to foreign factors of
production and adding any payments to domestic factors of production.

Therefore GNP = GDP + (net property income from abroad)

NNP (Net National Product) GNP overestimates the country’s production because it does not
take into account the replacement of capital goods that have been used or are wearing down.
Net national product can be calculated be deducting capital consumption from GNP.

Therefore NNP = GNP – capital consumption (depreciation)

GNI (Gross National Income) is gross domestic product (GDP) plus net receipts of primary
income (employee compensation and investment income) from abroad. GDP is the sum of
value added by all resident producers plus any product taxes (less subsidies) not included in the
valuation of output.

GNI per capita is gross national income divided by mid-year population.

Q7. How is real GDP calculated?

To measure real output it is necessary to use the price index to factor out any changes in prices
hidden by nominal GDP. The GDP deflator is used because it measures prices across the
economy. This index is used to adjust nominal GDP to get to real GDP.

The formula used to calculate real GDP is:

Real GDP = (nominal GDP / GDP deflator) x 100

Example:

Year 1 Nominal GDP = $500bn ; Index 100

Inflation rate between Year 1 and Year 2 = 3%

Year 2 Nominal GDP = $ 560bn ; Index 103 (100 + 3)

Therefore Real GDP in year 2 = 560/ 103 x 100 = $543.6bn

Nominal GDP thus must be deflated to 543.6 bn to arrive at real GDP.

Some additional reading:

Using GDP as a measure of welfare has well-known problems, which are among the first things
macroeconomics principles courses cover. But the point of the discussions at Davos is that in
the digital age, those problems are even deeper. Standard GDP statistics miss many of
technology's benefits, so we need to rethink how we measure the typical person's well-being.

The textbooks generally point out five problems with using GDP as a measure of well-being:

• GDP counts "bads" as well as "goods." When an earthquake hits and requires rebuilding,
GDP increases. When someone gets sick and money is spent on their care, it's counted as part
of GDP. But nobody would argue that we're better off because of a destructive earthquake or
people getting sick.

• GDP makes no adjustment for leisure time. Imagine two economies with identical
standards of living, but in one economy the workday averages 12 hours, while in the other it's
only eight. Which country would you rather live in?

• GDP only counts goods that pass through official, organized markets, so it misses home
production and black market activity. This is a big omission, particularly in developing countries
where much of what's consumed is produced at home (or obtained through barter). This also
means if people begin hiring others to clean their homes instead of doing it themselves, or if
they go out to dinner instead of cooking at home, GDP will appear to grow even though the
total amount produced hasn't changed.

• GDP doesn't adjust for the distribution of goods. Again, imagine two economies, but this
time one has a ruler who gets 90 percent of what's produced, and everyone else subsists --
barely -- on what's left over. In the second, the distribution is considerably more equitable. In
both cases, GDP per capita will be the same, but it's clear which economy I'd rather live in.
• GDP isn't adjusted for pollution costs. If two economies have the same GDP per capita,
but one has polluted air and water while the other doesn't, well-being will be different but GDP
per capita won't capture it.

The Davos discussion, however, is pointed at a different flaw in measured GDP: its inability to
fully capture the benefits of technology. Think of a free app on your phone that you rely upon
for traffic updates, directions, the weather, instantaneous information and so on. Because it's
free, there's no way to use prices -- our willingness to pay for the good -- as a measure of how
much we value it.

As a result, GDP statistics won't capture the benefits we gain from free apps, just as it has
difficulties accounting for changes in the quality of goods over time.

How can this be fixed? Catherine Rampell provides a nice summary of the alternative measures
that have been proposed, including China's "green GDP," which attempts to adjust for
environmental factors; the OECD's "GDP alternatives," which adjust for leisure; the "Index of
Sustainable Economic Welfare," which accounts for both pollution costs and the distribution of
income; and the "Genuine Progress Indicator," which "adjusts for factors such as income
distribution, adds factors such as the value of household and volunteer work, and subtracts
factors such as the costs of crime and pollution."

Finally, there are more direct measures of well-being such as the Happy Planet Index, Gross
National Happiness and National Well-Being Accounts.

However, none of these alternatives deal with the main problem discussed in Davos -- how to
measure the full impact of technology on our lives. The problem is that GDP assigns a zero value
to goods with a zero price, but those goods aren't valued at zero and as they become more
prominent, we'll need to find a way of including the benefits they provide in our measures of
the standard of living.

None of the measures proposed so far are perfect, and they won't replace the current GDP
yardstick anytime soon.

But there's still something to be gained from this work. When you hear that your standard of
living has gone up, ask yourself what has happened to leisure time -- are you working more or
less for the same income? How much of technology's benefits might have been missed -- how
often do you use Wikipedia? And how was the additional GDP distributed across the population
-- did it mostly go to the 1 percent?
In the end, economists -- and the public -- don't care about GDP by itself; they care about the
happiness they receive from the goods and services they consume. We've made some progress
on measuring the well-being of individuals within an economy, but not enough. More research
is needed.