Measuring economic activity

📚The economics

National income accounting

National income accounting measures the total economic activity of a country over a period, usually a quarter or a year. The circular flow model (1.1) shows why there are three equivalent ways to do it: every rupiah spent on output is received as income by someone who helped produce it.

• Expenditure approach: total spending on final goods and services: \( \text{GDP} = C + I + G + (X - M) \).
• Income approach: total factor incomes earned in production: wages, rent, interest and profit.
• Output approach: the value of all final output, or the sum of value added at each stage (counting only final goods avoids double-counting intermediate goods).

In practice the three estimates differ slightly because of statistical errors and the informal economy.

GDP and GNI

For countries with a lot of foreign investment (profits flow out), GNI is below GDP; Indonesia’s GNI is a few per cent below its GDP for this reason. Countries whose residents own many assets or work abroad may have GNI above GDP.

Nominal and real values

Nominal GDP is measured at current prices, so it rises when prices rise even if nothing more is produced. Real GDP is adjusted for inflation, measured at the prices of a base year, so it shows changes in the volume of output.

The price deflator is a price index with the base year = 100.

Per capita and purchasing power parity (PPP)

• Real GDP/GNI per capita = real GDP/GNI ÷ population. Total GDP is misleading for comparing living standards: India’s GDP is far larger than Singapore’s, but its GDP per person is much smaller.
• Purchasing power parity (PPP): converting at market exchange rates ignores that prices are lower in poorer countries (a haircut in Denpasar costs far less in US dollars than in Sydney). PPP exchange rates adjust for differences in the cost of living, so values at PPP compare what incomes can actually buy. Real GDP/GNI per capita at PPP is the best single income measure for comparing countries.

The business cycle

• The long-term growth trend shows potential output: what the economy can produce with full employment of its resources. It rises as the quantity and quality of resources grow.
• Expansion (recovery/boom): real GDP rises; unemployment falls; near the peak, inflation pressures build as actual output exceeds potential (an inflationary gap).
• Peak: the highest point before output starts to fall.
• Contraction: real GDP falls or grows more slowly; unemployment rises. A recession is usually defined as two consecutive quarters of negative real GDP growth. Output below potential is a deflationary (recessionary) gap.
• Trough: the lowest point, before recovery. Indonesia’s only full-year contraction since 1998 came in 2020, during the pandemic.

Is GDP a good measure of well-being?

Using GDP/GNI to compare over time requires real, per capita figures. Even then:

• Distribution: an average hides inequality; GDP per capita can rise while most people’s incomes stagnate.
• Non-market output: unpaid housework, childcare, volunteering and subsistence farming are excluded.
• The informal economy: unrecorded activity (street vendors, cash jobs) is underestimated, and it is large in developing countries.
• Quality of goods improves in ways prices do not capture (a smartphone today versus a phone in 2005).
• Negative externalities and depletion: pollution, deforestation and resource depletion are not subtracted; spending on cleaning up a disaster even adds to GDP.
• Leisure and working hours are ignored.
• Composition of output: spending on weapons and on schools counts the same.

Comparing between countries adds problems: different sizes of informal sector, different accounting practices and data quality, exchange rate distortions (hence PPP), and different needs (heating in cold climates).

Alternative measures of well-being

✏️Worked example

A country’s national accounts for one year ($ billion): consumption 520, investment 150, government spending 180, exports 210, imports 190. Income paid to foreign owners of factors exceeds income received from abroad by 30. The GDP deflator is 120 (base year = 100) and the population is 50 million.
(a) Calculate nominal GDP and nominal GNI.
(b) Calculate real GDP and real GDP per capita.
(c) Next year nominal GDP rises to $935 billion and the deflator to 125. Calculate the real growth rate.

(a)

\[ \text{GDP} = 520 + 150 + 180 + (210 - 190) = \$870 \text{ bn} \]

\[ \text{GNI} = 870 + (-30) = \$840 \text{ bn} \]

(b)

\[ \text{real GDP} = \frac{870}{120} \times 100 = \$725 \text{ bn} \]

\[ \text{real GDP per capita} = \frac{725\,000 \text{ million}}{50 \text{ million}} = \$14\,500 \]

(c) Real GDP next year = 935 ÷ 125 × 100 = $748 bn.

\[ \text{growth} = \frac{748 - 725}{725} \times 100 = 3.2\% \]

Nominal GDP rose by 7.5% (870 to 935), but most of that was inflation; real output grew by about 3.2%.

Check it. Real GDP should be below nominal GDP whenever the deflator is above 100 (prices higher than in the base year). Growth rates: 1.075 ÷ (125/120) = 1.032, confirming 3.2%.

Adding imports. Imports are subtracted: they are spending on output produced abroad, already included in C, I and G. And watch units: billions divided by millions gives thousands.