TOPIC 2

Measuring the economy

P R E PA R E D B Y M A R Y G R A H A M A N D M A R G A R E T M C K E N Z I E FOR THE UNIT TEAM

Contents
Introduction Objectives Learning resources Textbook Further resources Economic data resources Modelling the economy Stocks and flows Leakages and injections Measurement of the economy Measurement of GDP Nominal GDP and Real GDP Economic growth and cycles Cyclical indicators GDP and wellbeing Economic performance Summary 1 1 1 1 1 2 2 3 3 4 5 6 6 7 8 9 10

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Introduction
In order to evaluate economic performance we must decide what measures to use. An important measure is that of wellbeing, and we can use the level of economic activity as an important proxy for that. An important measure that is traditionally used is gross domestic product (GDP), the total output of goods and services in the economy. GDP is a standard measure of economic activity but it has limitations as a measure of economic wellbeing. GDP can be supplemented with a variety of other data to indicate the performance of an economy. We will use these measures to see how the Australian economy performs in comparison with other economies.

Objectives
At the completion of this topic you should be able to: explain the three ways in which GDP is measuredthe expenditure approach, the income approach and the production approach explain why national expenditure, income and product are equal toeach other (the national income accounting identity) describe the circular flow of expenditureand income in the economy understandthe concepts of real and nominal GDP describe the four expenditure components of GDP explain the concept of the business cycle calculate the growth rate of GDP and real GDP using the GDP deflator explain the ways in which GDP is not an ideal measure of economic wellbeing.

Learning resources
Textbook
Hubbard, G, Garnett, A, Lewis, P&OBrien, A 2011,Macroeconomics,2nd edn, Pearson Australia, Frenchs Forest, NSW, Ch.4.

Further resources
Jackson, J & McIver, R 2011,Macroeconomics, 9thedn, McGraw-HillAustralia, North Ryde, NSW, Ch.4. McTaggart, D, Findlay, C &Parkin, M 2010, Economics, 6thedn, Pearson Australia, Frenchs Forest, NSW, Ch.18. Deutsche Bank Research 2006, Measures of well-being: There is more to it than GDP, September 8.

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Economic data resources

Australian Bureau of Statistics 2011, Key National Indicators Australian Bureau of Statistics 2011, Australian System of National Accounts Both of these data sources are available at ABS, retrieved 17January 2012, <http://www.abs.gov.au>. (Select Key National Indicators on left hand side of page and then National Accounts). OECDn.d., Better Life Initiative, retrieved 17 January 2012,<http://www.oecdbetterlifeindex.org> Steketee,M 2011, We shouldn't judge wellbeing by GDP alone,The Australian,22 January, retrieved 17 January 2012, <http://www.theaustralian.com.au/news/opinion/we-shouldnt-judge-wellbeing-bygdp-alone/story-e6frg6zo-1225992491496> Raghavendran,S& Jain N, 2011, GDP metric: Time for a makeover?,Global Economic Outlook, 3rd quarter 2011, retrieved 17 January 2012, <http://www.deloitte.com/view/en_GX/global/a4682f183ed21310VgnVCM3000001c 56f00aRCRD.htm>. Marks, N 2011,GDP growth is no measure of societal progress,27 May,Aljazeera, retrieved 17 January 2012, <http://english.aljazeera.net/indepth/opinion/2011/05/2011526135338692723.html>. Cronin D 2007, GDP poor gauge of well-being,Inter Press Service, 22November, retrieved 17 January 2012, <http://ipsnews.net/news.asp?idnews=40180>.

Modelling the economy

The level of income of a person or household might be considered a rough guide to wellbeing, which is a difficult concept to define, let alone measure. Higher income levels are usually associated with higher standards of living, indicating greater wellbeing. Similarly, the wellbeing of an economy, as the sum of individual people, is even more difficult to measure, and the total level of income is used as an indicator of how well the economy is doing. Gross domestic product (GDP) measures both the total expenditure on the economys output of goods and services and the total income of everyone in the economy. For any economy as a whole, income equals expenditure. To see why this holds true, imagine a gardener is employed to mow lawns. The gardener is paid $20 for this service.The gardener is the seller of the service and owner of the garden is the buyer. The gardener earns $20 and the garden owner spends $20. The transaction contributed equally to the economys income and to its expenditure. GDP, regardless of whether it is valued by the expenditure or the income created, rises by $20. This can also be seen with a circular flow diagram, as shown in Figure 4.1 of Hubbard et al. (2011, p. 93). Households are paid for the inputs (factors) they supply to firms, labour, land, capital and funds. Households receive incomein the form of wages for labour they supply, interest for lending funds, rent for land they own, and profits fromowning and managing firms. In turn, households purchase final goods and services from firms.Corresponding to the value of the goods and services being exchanged, money flows continuously from the households to firms and back to households. The value of final goods and services produced and sold in the end must equal the income received for producing them. This is known as the national income accounting identity.

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Stocks and flows

Distinguishing the concepts of a stock and a flow are important in understanding the circular flow diagram. A stockis a store of something. A flow is the change in that something over a given period; for example, a rate of change in the stock measured over a year. Consider the storage or stock of water in a tank, the level of which changes depending on the flow in from rain and flow out from usage and evaporation. Wealth is a stock or store of value, and the changes in that value over time, per year, are flows. Income is a flow gained over a year from owning or utilising wealth. In the case of the circular flow diagram, the factors of production, land, labour and capital are stocks of productive resources. They provide flows of inputs for combination in the production of final goods and services. The flows of services from each of these factor stocks are combined in order to produce flows of goods and services over the year.

Leakages and injections

In reality, households do not spend all their income. Some income is paid to the government in the form of tax; some is saved and leaves the circular flow as a leakage. Investment by firms, the addition to their physical capital stock, enters the circular flow as an injection. In addition, government and firms (domestic and overseas firms) purchase goods and services, and borrow and lend money. The model of the economy can more correctly be represented as a four sector economy (households, firms, government and the overseas sectors), with both goods and services and money transactions occurring between the sectors. Figure 2.1 presents the open economy model. F ig u re 2.1 T h e o p en ec o n o m y m o d e l

Source: McTaggart et al. 2006, p. 416.

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However, regardless of whether a household, firm or government, domestic or international, buys the good or service, the transaction always has a buyer and a seller. Thus, for the economy as a whole, expenditure and income are equal. Aggregate expenditure is equal to aggregate income in the simplified economy(illustrated inFig.4.1 on page 93 of Hubbard et al. 2011), and in the more complicated open economy (illustrated in Fig. 1 above). Aggregate expenditure (AE) is made up of: consumption expenditure (C) by households investment expenditure (I) by firms, including stocks of unsold goods, which we will later see is important government expenditure (G) expenditure by the overseas sector in the form of net exports (NX) i.e. exports (EX) minus imports (IM). AE= C + I + G + NX Firms use revenue from the sale of goods and services that they produce to pay the owners of factors of productionlabour and capitalin the form of wages, rent, interest and dividends. Income thus equals expenditure, that is: Y= AE Hence, Y= C + I + G + NX
READINGS Please read: Hubbard et al. (2011), pp. 8795, noting Fig. 4.1, which illustrates how expenditure equals income equals production Jackson and McIver (2011), pp. 102115 McTaggart, Findlay and Parkin (2010), ch. 18.

Measurement of the economy

In the case of Australia, the Australian Bureau of Statistics (ABS), the government statistical body, collects data on the level of economic activity on a monthly, quarterly or annual basis. Data is more readily obtained for some variables than others. The data is published in Australian National Accounts, National Income and Expenditure (ABS catalogue nos. 5204.0 and 5206.0) and related publications. Most economies have a system of National Accounts in order that the various transactions that occur in an economy may be systematically recorded. The various data collected and recorded in the National Accounts enable the level of gross domestic product, GDP, to be calculated. GDP refers to the market value of all final goods and services produced in a country in a given period of time. Imagine how difficult it is to develop an accounting system that captures all the details of a complex and dynamic economy in order to estimate GDP. To make the system clear

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and relatively simple, some features of the economy are neglected; others are given a great deal of emphasis. Despite the limitations and the inaccuracies associated with the official GDP estimates, the trend of GDP over time provides a fairly reliable picture of the overall movement of the Australian economy. The production of goods has to take place within a countrys borders to be part of its GDP. Gross national production (GNP), by contrast, measures the value of production of the nations residents, regardless of the country in which the activity took place. Thus the profit accruing to an Australian firm from its factory in China is part of Australias GNP accounts but not GDP. We will generally use GDP here as the measure of the level of economic activity. We referred above to the four main components of expenditure on GDP: consumption (C), investment (I), government expenditure (G), and net exports (NX), exports of goods and services minus the imports of goods and services. Consumption expenditure is generally the largest component, making up approximately 60% of GDP, with government purchases and investment expenditure each making up approximately 20% and net exports the rest.
READING Hubbard et al. (2011), p. 95, Fig. 4.1 shows the relative size of each expenditure type in Australia, 2010. QUESTION 2.1 Define and give an example of each type of expenditure. Explain why the purchase of a new house is regarded as investment rather than as consumption expenditure. Why are government transfer payments not included as part of government expenditure? Explain why the figure for Australias net exports is currently a negative figure.

Measurement of GDP
The circular flow of income and expenditure is used by most countries to measure GDP. In Australia, the Australian Bureau of Statistics (ABS) collects data reflecting the measures of GDP identified in the circular flow model under the following headings: The expenditure approach The income approach The production approach (value-added).

The expenditure approach measures GDP by adding together the main expenditure items of consumption (C), investment (I), government (G) and net exports (NX). The income approach measures GDP by adding together all the income paid by firms to households, such as wages and salaries, and the net operating surplus (profits) earned by firms. Note that the term statistical discrepancy is used as a balancing item. If expenditure and income do not add up due to data collection problems, then the statistical discrepancy makes up the difference. The production oroutput or value added approach measures GDP by calculating the value added byfirms in each stage of production of a final good.
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Nominal GDP and Real GDP

Gross domestic product is a measure of the total value of everything that is produced in the country. Once we have measured the GDP we need to know how to put it to use. We could calculate: 1 2 the change in this years GDP from last years GDP or the GDP of two years ago; that is to compare the value of GDP in one period with that in another howthe GDP of one country compares with the GDP of other countries.

We will focus on the first measure here and look at the relationship between Australias GDP and that of other comparable countries in Topic 3. Hubbard et al.(2011, p. 100) show how to calculate the growth rate in GDP as the percentage change in real GDP from one year to another, or as the percentage change in the amount of goods and services produced in the country over that time. In order to compare GDP in two time periods, we will have to express the GDP in real terms, taking out the effects of changes in the price level. The aim is to obtain a volume measure of the output of goods and services for comparison over time. If we do not take out the effect of price increases (falls) then the increase in GDP could be overstated (understated). For example if we produced exactly the same quantity of everything from one year to the next but price of everything went up by 10%, then the (nominal) GDP as measured would also rise by 10%. To overcome this we normally convert all measures of the gross domestic product to the same price level before making comparisons. This is referred to as real GDP (constant prices), to differentiate from nominal GDP (current prices). We make use of the GDP deflatoras given on page100 of Hubbard et al. (2011).
READING Hubbard et al. (2011), p. 99101; Jackson and McIver (2011), pp. 116119. QUESTION 2.2 Explain the meaning and importance of the GDP deflator.

Economic growth and cycles

There are many forces at work influencing an economys level of economic activity over time. Changes in the resource base, labour force and technology of a country affect economic growth in the long run. Figure 5.1 in Hubbard et al. (2011, p. 111)shows real GDP for Australia over the period since 1901. The upward trend in GDP in the long run is shown. This will be examined in Topic 3. Movement in GDP over time is also cyclical. Upward movements in real GDP are followed by periods of declinewhich are associated with increased unemployment and falls in the standard of living. Some of these are deep, such as the Great Depression of the 1930s and the GFC starting in 2008, but shallower declines in GDP (recessions) occur frequently. Such fluctuations in the growth of real GDP give rise to the concept of the business cycle. Although the term cycle is associated with regular or predictable patterns, this is not necessarily the case,

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and the cyclical periods are very uneven. Figures 5.1 (p. 111) and Figure 5.6 (p. 125) of Hubbard et al. show the periods when the real GDP of Australia fell. Some periods show slower growth in GDP than others. The reasons for cyclical activity are still not well understood or agreed, and are debated by economists. Fluctuations in economic activity are observed to occur around a trend or average rate of growth. There is a cyclical pattern of expansion, peak, contraction and trough. A cyclical path means that real GDP expands, reaches a peak and then contracts, reaching a low point (a trough), before rising again. If real GDP experiences two successive periods of negative growth, the economy is said to be experiencing a recession, in which unemployment increases. You can investigate whether this has occurred in Australia through the GFC since 2008.
READING Hubbard et al. (2011), p. 109 and pp. 125132. The case study Growth and the business cycle at General Motors Holdenon p. 109 of Hubbard et al.(2011) illustrates the importance of economic growth and the business cycle.

QUESTION 2.3 Explain the difference between Figures5.1(p. 111) and Figure 5.6 (p. 125) of Hubbard et al.(2011).How many recessions were there inAustralia since 1901? What was the impact of the Global Financial Crisis (GFC)? What are the costs of recession?

Cyclical fluctuations in economic activity occur in all countries and showirregular and unpredictable fluctuations. Macroeconomic variables fluctuate together. Falling output is associated with increased unemployment and poverty. Most significantly, cyclical movements in economic activity tend to be reflected globally, across countries.

Cyclical indicators
There are indicators which turn in advance of GDP, called leading indicators, which can be used to predict upturns and downturns. Leading indicators in Australia include the real interest rate, the level of business confidence, the number of house building commencements, the level of consumer credit, the number of manufacturing orders, and the level of retail sales. Inventories of unsold goods also tend to increase approaching downturns and fall approaching upturns. Lagging indicators tend to peak after the level of GDP has peaked.These include the number of job vacancies, the level of unemployment and the growth in average weekly earnings.

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GDP and wellbeing

GDP measures both the economys total income and the economys total expenditure on goods and services. GDP per person tells us the income and expenditure of the average person in the economy and thus should indicate the wellbeing of individuals. The rate of growth of real GDP (that is in terms of the purchasing power) is recognised as a key indicator of improvement in economic wellbeing in a nation. However, GDP is seen to have many weaknesses as a measure of wellbeing. For instance, Senator Robert Kennedy, when he was running for US president in 1968, said the following, which is still relevant today:
We will find neither national purpose nor personal satisfaction in a mere continuation of economic progress, in an endless amassing of worldly goods. We cannot measure national spirit by the Dow Jones Average, nor national achievement by the GNP. For the GNP includes air pollution, and ambulances to clear our highways from carnage. It counts special locks for our doors and jails for the people who break them. The GNP includes the destruction of the redwoods and the death of Lake Superior. It grows with the production of napalm and missiles and nuclear warheads. It includes the broadcasting of television programs which glorify violence to sell goods to our children. And if the GNP includes all this, there is much that it does not comprehend. It does not allow for the health of our families, the quality of their education, or the joy of their play. It is indifferent to the decency of our factories and the safety of our streets alike. It does not include the beauty of our poetry, or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials the Gross National Product measures neither our wit nor our courage, neither our wisdom nor our learning, neither our compassion nor our devotion to our country. It measures everything, in short, except that which makes life worthwhile.

There are many problems in using GDP as a measure of wellbeing. It does not reflect the distribution of income or the proportion of people in poverty in the country. It does not measure the contribution to output of many services such as teaching or the legal system where outputs are not well valued in monetary terms. Such services are measured by the cost of providing them rather than the output. GDP does not include the contribution of many other activities which contribute to the economy and to wellbeing, such as unpaid housework. In this case GDP falls when someone marries their housekeeper! Crime is also recorded as making a positive contribution to GDP! Most importantly, the losses due to pollution and other environmental degradation are not properly measured in GDP. There are many projects to improve the measure of GDP to better reflect wellbeing through taking account of these factors. These include HDI and Green GDP. However it remains that GDP is the most accessible shorthand currently available.
READINGS Please read: Hubbard et al. (2011), pp. 9599 Jackson and McIver (2011), pp. 119121 Deutsche Bank Research (2006), Measures of well-being: There is more to it than GDP

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RESOURCES OECD n.d., Better Life Initiative, retrieved 17January 2012, <http://www.oecdbetterlifeindex.org> Steketee, M 2011, We shouldn't judge wellbeing by GDP alone, The Australian, 22 January, retrieved 17January 2012, <http://www.theaustralian.com.au/news/opinion/we-shouldnt-judge-wellbeing-bygdp-alone/story-e6frg6zo-1225992491496 > Raghavendran, S & Jain N, 2011, GDP metric: Time for a makeover?,Global Economic Outlook, 3rd quarter 2011, retrieved 17January 2012, <http://www.deloitte.com/view/en_GX/global/a4682f183ed21310VgnVCM3000001c 56f00aRCRD.htm>. Marks, N 2011, GDP growth is no measure of societal progress, 27 May, Aljazeera,retrieved17January 2012, <http://english.aljazeera.net/indepth/opinion/2011/05/2011526135338692723.html>. Cronin D 2007, GDP poor gauge of well-being, Inter Press Service, 22 November, retrieved 17January 2012, <http://ipsnews.net/news.asp?idnews=40180>.

QUESTION 2.4 Explain, using examples, why GDP is not an accurate gauge of economic progress.

Economic performance
When examining the performance of the economy, economistsmust identify the objectives that they are measuring performance against. GDP is only one indicator. Key indicators include growth of real GDP, unemployment level and the inflation rate (Topic 4). Also included are transactions with overseas countries as measured by the current account balance (exports minus imports) andthe ratio of imports and exports to GDP (Topic 8).Productivity (output per unit input), defined in Topic 3, is also an important performance indicator. In Australia, as well as the ABS, the Australian Treasury and the Reserve Bank of Australia are important government agencies which monitor and interpret economic data. Comparison of countries will be considered in Topic 3.
RESOURCES ABS 2011, Key National Indicators, retrieved 17 January 2012,<http://abs.gov.au/AUSSTATS/abs@.nsf/mf/1345.0>

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Summary
This topic introduced the circular flow of expenditure for an economy that includes households, firms, government and the overseas sector. The national income accounting identity is: aggregate income aggregate expenditure value of output (GDP) The value of output of the economy can be measured in a number of ways. The expenditure approach measures expenditure on the output of goods and services(C, I, G andNX);the income approach measuresthe payments to inputs into production: wages, salaries and profits. The output approach sums the value added to output at each stage of production by each firm in the economy. Gross domestic product is the fundamental measure that economists use as an indicator of the overall performance of the economy. Real GDP measures the output of goods and services in real or volume terms, whereas nominal GDP does not control for price changes. The GDP deflator is used to obtain real GDP. Economic growth and business cycles are also reflected in movements in GDP. Real GDP per capita serves as a measure of the standard of living of the citizens. While this is better than any other single number, it suffers from a number of important deficiencies. To overcome some of the deficiencies in real GDP per capita as a measure of welfare, there are projects to develop other measures, including ones that will take account of environmental degradation. GDP and other indicators can be used to measure a countrys performance over time, and to compare countries performance.

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