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CEMBA 552: Economic EnvironmentCEMBA 552: Economic Environment of Business of Business

Block 2Block 2

Measures of Economic ActivityMeasures of Economic Activity

Block ObjectivesBlock Objectives

After working through Block Two of this course, you should After working through Block Two of this course, you should be able to:be able to:

Define Define Gross Domestic Product (GDP).Gross Domestic Product (GDP). Account for Account for the different approaches to measuring GDP.the different approaches to measuring GDP. Distinguish Distinguish between nominal GDP and real GDP.between nominal GDP and real GDP. State State how the unemployment rate is defined, and describe how how the unemployment rate is defined, and describe how

it is determined.it is determined. Explain Explain the definition and construction of the GDP deflator the definition and construction of the GDP deflator

and the Consumer Price Index.and the Consumer Price Index.

IntroductionIntroduction

This block is designed to increase the accuracy This block is designed to increase the accuracy and power of your economic vocabulary by and power of your economic vocabulary by spelling out the strict meaning of economic spelling out the strict meaning of economic measurement terms that you encounter often in measurement terms that you encounter often in business reading.business reading.

Management and MeasurementManagement and Measurement

This block focuses on the main measures of economic activity. This block focuses on the main measures of economic activity. There are many measures and indicators of overall There are many measures and indicators of overall (macroeconomic) activity such as the number of people with (macroeconomic) activity such as the number of people with jobs, the total income of persons, the output of factories, the jobs, the total income of persons, the output of factories, the total quantity of goods and services produced in the economy, total quantity of goods and services produced in the economy, the unemployment rate, the consumer price index, retail sales, the unemployment rate, the consumer price index, retail sales, housing starts, etc. housing starts, etc.

Such measures are regularly reported in newspapers and Such measures are regularly reported in newspapers and television and radio news. television and radio news.

A well-equipped business and public sector managers must A well-equipped business and public sector managers must understand these economic indicators in order to be able to understand these economic indicators in order to be able to make informed business decisions. make informed business decisions.

1.2 Gross Domestic Product1.2 Gross Domestic Product

GDP is the value of the final goods and services produced in GDP is the value of the final goods and services produced in the economy, by foreign or domestic firms, during a given the economy, by foreign or domestic firms, during a given year.year.

GDP is the most comprehensive measure of economic activity GDP is the most comprehensive measure of economic activity and a broad measure of people’s income and well-being. and a broad measure of people’s income and well-being.

The growth in real GDP is hence a measure of the growth of The growth in real GDP is hence a measure of the growth of people's real incomes and therefore the pace of improvement people's real incomes and therefore the pace of improvement in living standards.in living standards.

Differences in its growth rates produce large differences in Differences in its growth rates produce large differences in living standards between countries. living standards between countries.

GDP can be viewed from either the demand GDP can be viewed from either the demand side or the supply side.side or the supply side.

On the On the demand demand side, it provides insight into the side, it provides insight into the interaction of the various decision-making interaction of the various decision-making sectors of the aggregate economy (households; sectors of the aggregate economy (households; business firms; government entities; and business firms; government entities; and foreigners). foreigners).

The supply of goods and services requires The supply of goods and services requires firms to bring together the factors of firms to bring together the factors of production, particularly labour and capital, and production, particularly labour and capital, and to employ the best available technology, in to employ the best available technology, in order to produce output that meets demand. order to produce output that meets demand.

As a manager, you need to be aware of these limits As a manager, you need to be aware of these limits and any ongoing changes in them to manage your and any ongoing changes in them to manage your resources efficiently.resources efficiently.

Sometimes economic growth is rapid and at other Sometimes economic growth is rapid and at other times it is slow. times it is slow.

There are even occasions when the economy stops There are even occasions when the economy stops growing and actually shrinks for a period. growing and actually shrinks for a period.

A rapidly growing economy is one in which people A rapidly growing economy is one in which people enjoy rapidly rising living standards and in which enjoy rapidly rising living standards and in which good jobs are easy to find.good jobs are easy to find.

In a slow-growing or shrinking economy, living In a slow-growing or shrinking economy, living standards decline and unemployment becomes a standards decline and unemployment becomes a serious problem.serious problem.

1.3 Unemployment Rate1.3 Unemployment Rate

Unemployment rate is the ratio of the Unemployment rate is the ratio of the unemployed to working age unemployed to working age (adult) population(adult) population

The The unemployment rate unemployment rate is the key and the is the key and the most watched indicator. At times when the most watched indicator. At times when the unemployment rate isunemployment rate is

high, a person may take a long time to find a high, a person may take a long time to find a job.job.

Governments macroeconomic policyGovernments macroeconomic policy

Governments have set the following as goals of Governments have set the following as goals of macroeconomic policy:macroeconomic policy:

• • sustained income growthsustained income growth• • low unemploymentlow unemployment• • mild fluctuationsmild fluctuations• • price stabilityprice stability• • exchange rate stabilityexchange rate stability• • balance of trade surplus.balance of trade surplus.

2 Measuring Economic Performance:2 Measuring Economic Performance:Output and IncomeOutput and Income

2.1 GDP versus GNP2.1 GDP versus GNP GDPGDP is total income earned domestically: all is total income earned domestically: all

economic activity that takes place within the economic activity that takes place within the country. country.

It includes income earned domestically by It includes income earned domestically by foreigners, but it excludes income earned by foreigners, but it excludes income earned by domestic residents on foreign ground. domestic residents on foreign ground.

Since some income is received from Since some income is received from individuals owning capital equipment in other individuals owning capital equipment in other countries, GDP is not a perfect measure of countries, GDP is not a perfect measure of total domestic income.total domestic income.

Thus, statisticians also compute an Thus, statisticians also compute an alternative measure of aggregate economic alternative measure of aggregate economic activity, the activity, the gross national product gross national product (GNP). (GNP).

GNPGNP is total income earned by nationals. It is total income earned by nationals. It includes the income that nationals earn includes the income that nationals earn abroad.abroad.

But it does not include the income earned But it does not include the income earned within a country by foreigners. within a country by foreigners.

The difference between GDP and GNP is, The difference between GDP and GNP is, therefore, known as “net investment therefore, known as “net investment income from non-residents.”income from non-residents.”

Most countries pay more attention to GDP than to Most countries pay more attention to GDP than to GNP for measuring aggregate economic activity. GNP for measuring aggregate economic activity.

For the purpose of stabilizing employment, we are For the purpose of stabilizing employment, we are interested in a broad measure of job-creating interested in a broad measure of job-creating activity within the nation. We use the GDP.activity within the nation. We use the GDP.

For evaluating trends in the standard of living of For evaluating trends in the standard of living of many nations, including the Organization for many nations, including the Organization for Economic Cooperation and Development Economic Cooperation and Development (OECD) of nations, GNP is more appropriate.(OECD) of nations, GNP is more appropriate.

Methods (Ways) of measuring GDPMethods (Ways) of measuring GDP

There are three different ways measuring GDP. There are three different ways measuring GDP. They are: They are:

The production method/approach: ie the The production method/approach: ie the production of each industry, agriculture, mining, production of each industry, agriculture, mining, manufacturing, services and so on.manufacturing, services and so on.

The income method/approach: ie the income The income method/approach: ie the income that production generates in the form of wages, that production generates in the form of wages, salaries, profits, rent, interest and so on.salaries, profits, rent, interest and so on.

The expenditure method/approach: ie the The expenditure method/approach: ie the expenditure on the goods and services expenditure on the goods and services produced spending by households, firms, produced spending by households, firms, governments, in the form of consumption governments, in the form of consumption (C), Investment (I) and Government (C), Investment (I) and Government expenditure (G)expenditure (G)

2.3 Income, Expenditure, and the Circular Flow2.3 Income, Expenditure, and the Circular Flow

Figure 2-1 illustrates all the economic Figure 2-1 illustrates all the economic transactions that occur between households transactions that occur between households and firms in this economy.and firms in this economy.

2.4 Value Added and Intermediate Goods2.4 Value Added and Intermediate Goods

Several difficulties arise when output is measured. Let us Several difficulties arise when output is measured. Let us explore two of them. Suppose a farmer produces $5 worth of explore two of them. Suppose a farmer produces $5 worth of wheat, which he sells to a baker. The baker exerts $20 worth wheat, which he sells to a baker. The baker exerts $20 worth of effort to turn the wheat into bread, which she sells for $25.of effort to turn the wheat into bread, which she sells for $25.

At the end of the day, what has been produced? The answer is At the end of the day, what has been produced? The answer is just $25 worth of bread. But if we ask the farmer and the baker just $25 worth of bread. But if we ask the farmer and the baker to report their output for the day, the farmer says, ‘I produced to report their output for the day, the farmer says, ‘I produced $5 worth of wheat,’ and the baker says, ‘I produced $25 worth $5 worth of wheat,’ and the baker says, ‘I produced $25 worth of bread."of bread."

A statistician who naively adds these numbers might A statistician who naively adds these numbers might think that there has been $30 of output in the economy. think that there has been $30 of output in the economy.

The statistician is led astray by counting the wheat, The statistician is led astray by counting the wheat, which is not a which is not a final final good but rather an good but rather an intermediate intermediate good that disappears after it is used to produce thegood that disappears after it is used to produce the

bread. bread. There are two ways to avoid this measurement pitfall:There are two ways to avoid this measurement pitfall: 1. Ask the farmer and the baker to report the value of 1. Ask the farmer and the baker to report the value of

their sales of their sales of final final goods to consumers. The baker goods to consumers. The baker reports $25 and the farmer reports $0, because his reports $25 and the farmer reports $0, because his wheat is not a final good.wheat is not a final good.

2. Ask the farmer and the baker to report the 2. Ask the farmer and the baker to report the contribution contribution of each made to the total.of each made to the total.

The farmer reports $5 worth of wheat, and the The farmer reports $5 worth of wheat, and the baker reports $20 worth of effort, for a total value baker reports $20 worth of effort, for a total value of $25 worth of output.of $25 worth of output.

We call the baker's contribution to output her We call the baker's contribution to output her value value addedadded, which the baker calculates by, which the baker calculates by

subtracting her costs, $5, from her revenue, $25. subtracting her costs, $5, from her revenue, $25. The baker's value added is thus $20. The farmer's The baker's value added is thus $20. The farmer's

value added is $5: in our example, the farmer had value added is $5: in our example, the farmer had no costs. no costs.

When businesses report their output to the When businesses report their output to the government, they subtract their costs, so they are government, they subtract their costs, so they are reporting value added. reporting value added.

The government then sums the value added by all The government then sums the value added by all businesses to arrive at GDP.businesses to arrive at GDP.

3 Several Measures of Income3 Several Measures of Income

To obtain GNP from GDP, we subtract the net To obtain GNP from GDP, we subtract the net income of foreigners who own factors of income of foreigners who own factors of production employed in Ghana:production employed in Ghana:

GNP = GDP - Net Income of Foreigners.GNP = GDP - Net Income of Foreigners.

To obtain net national product (NNP), we To obtain net national product (NNP), we subtract the depreciation of capital,subtract the depreciation of capital,

i.e., the amount of the economy's stock of i.e., the amount of the economy's stock of plants, equipment, and residential structures plants, equipment, and residential structures that wear out during the year:that wear out during the year:

NNP = GNP - Depreciation.NNP = GNP - Depreciation. In the national accounts, depreciation is In the national accounts, depreciation is

called the called the capital consumption allowancescapital consumption allowances

The next adjustment in the national accounts is The next adjustment in the national accounts is for indirect business taxes, such as salesfor indirect business taxes, such as sales

taxes and subsidies. taxes and subsidies. These taxes place a wedge between the price that These taxes place a wedge between the price that

consumers pay for a good and the price that firms consumers pay for a good and the price that firms receive. Because firms never receive this tax receive. Because firms never receive this tax wedge, it is not part of their income.wedge, it is not part of their income.

Once we subtract indirect business taxes from Once we subtract indirect business taxes from NNP, we obtain a measure called NNP, we obtain a measure called national national income at factor costincome at factor cost::

National Income at factor cost = National Income at factor cost = NNP - Indirect Business Taxes.NNP - Indirect Business Taxes.

3.1 Potential GDP3.1 Potential GDP

Potential GDPPotential GDP, , indicates what the economy could indicates what the economy could produce if labour and machines were fully used up. produce if labour and machines were fully used up.

Although it is true that actual GDP usually falls short Although it is true that actual GDP usually falls short of its potential, sometimes it could exceed it. of its potential, sometimes it could exceed it.

This happens when the rate of utilization of the This happens when the rate of utilization of the labour force and that of other factors of production labour force and that of other factors of production exceeds their normal rates.exceeds their normal rates.

Strong upward fluctuations are called Strong upward fluctuations are called booms booms and and downwards ones are called downwards ones are called recessions recessions . .

Severe downturns are referred to Severe downturns are referred to as depressionsas depressions. . The last depression, called the Great Depression The last depression, called the Great Depression because of its length and depth, began in 1929. The because of its length and depth, began in 1929. The economy did not fully recover from it until four economy did not fully recover from it until four years later. years later.

There is no technical definition of a boom, but There is no technical definition of a boom, but there is one of a recession; a recession is said to there is one of a recession; a recession is said to have occurred when GDP falls for at least two have occurred when GDP falls for at least two consecutive quarters.consecutive quarters.

The economy's fluctuations are sometimes The economy's fluctuations are sometimes called called business cycles business cycles but the term ‘cycle’ but the term ‘cycle’ suggests a kind of regularity that cannot be suggests a kind of regularity that cannot be found between one downturn and the next.found between one downturn and the next.

Economists call the bottom of a recession a Economists call the bottom of a recession a trough and the top of a boom a peaktrough and the top of a boom a peak

4 Real versus Nominal GDP4 Real versus Nominal GDP

To keep the comparisons of different years To keep the comparisons of different years straight, economists adjust GDP for changes in straight, economists adjust GDP for changes in the average level of prices. the average level of prices.

Unadjusted GDP is known as Unadjusted GDP is known as nominal nominal GDP GDP ($Yt).($Yt).

The term The term real real GDP (Yt) is used for inflation-GDP (Yt) is used for inflation-adjusted GDP figures, which are true year-to-adjusted GDP figures, which are true year-to-year measurements of what the economy year measurements of what the economy actually produces. actually produces.

To calculate real GDP, economists take the To calculate real GDP, economists take the nominal value of GDP the money value of nominal value of GDP the money value of all the goods and services produced in the all the goods and services produced in the economy and divide it by a measure of the economy and divide it by a measure of the price level.price level.

Thus, real GDP is defined by the equation:Thus, real GDP is defined by the equation:

Real GDP = Nominal GDP/ Price levelReal GDP = Nominal GDP/ Price level

If, for instance, nominal GDP has risen 5% If, for instance, nominal GDP has risen 5% in the past year but prices have also in the past year but prices have also increased by 5%, then real GDP is increased by 5%, then real GDP is unchanged. unchanged.

If nominal GDP has risen 5% in the past If nominal GDP has risen 5% in the past year but prices have increased by 6%, real year but prices have increased by 6%, real GDP has actually decreased.GDP has actually decreased.

Real GDP in year t (Yt) is the sum of the quantities Real GDP in year t (Yt) is the sum of the quantities of goods and services produced in year t times the of goods and services produced in year t times the prices of the same goods and services in prices of the same goods and services in some some particular yearparticular year. This ‘particular year’ is called the . This ‘particular year’ is called the base year. base year.

To calculate Yt we must first choose a base year, To calculate Yt we must first choose a base year, say, 1997. say, 1997.

Then real GDP in any year is the value of that Then real GDP in any year is the value of that year's final goods and services measured at year's final goods and services measured at 1997prices. 1997prices.

Real GDP is also called GDP in terms of goods, Real GDP is also called GDP in terms of goods, GDP in constant dollars or price, GDP adjusted for GDP in constant dollars or price, GDP adjusted for inflation and, in the case of our example, GDP in inflation and, in the case of our example, GDP in 1997 dollars.1997 dollars.

Economists focus on real GDP since it Economists focus on real GDP since it eliminates the effects of changing prices eliminates the effects of changing prices on the measure of output. on the measure of output.

For example, if real GDP in 2001For example, if real GDP in 2001

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

5 Price Indexes and Inflation5 Price Indexes and Inflation

In macroeconomics, the price level is the In macroeconomics, the price level is the average level of prices measured by a average level of prices measured by a price price indexindex. .

Two main price indexes that are used are the Two main price indexes that are used are the Consumer Price Index and the GDP DeflatorConsumer Price Index and the GDP Deflator

5.2 The Consumer Price Index (CPI)5.2 The Consumer Price Index (CPI)

The CPI is a measure of the price level that considers The CPI is a measure of the price level that considers the price of a list of specific goods and services the price of a list of specific goods and services purchased by a typical household at current prices.purchased by a typical household at current prices.

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

purchases and calculates this year's CPI bypurchases and calculates this year's CPI by expressing the cost of the basket in the current year as expressing the cost of the basket in the current year as

a percentage of the cost of that same basket in the a percentage of the cost of that same basket in the base year. base year.

The CPI is the weighted average of price The CPI is the weighted average of price movements of several thousands goods and movements of several thousands goods and services grouped into several hundred services grouped into several hundred categories. categories.

More precisely:More precisely:

Where the value of the basket represents total Where the value of the basket represents total expenditure on (or the cost of) the basket in any expenditure on (or the cost of) the basket in any period, month or year. The base year is an period, month or year. The base year is an arbitrary year employed by the nation’s arbitrary year employed by the nation’s statisticians.statisticians.

Suppose the CPI in 2001 equals 107.6. This Suppose the CPI in 2001 equals 107.6. This suggests that the average price of goods and suggests that the average price of goods and services in 2001 is 7.6% higher than the average services in 2001 is 7.6% higher than the average price of the same basket of goods and services in price of the same basket of goods and services in the base period (i.e., 1997).the base period (i.e., 1997).

5.3 Implicit GDP Deflator5.3 Implicit GDP Deflator

Economists generally tend to prefer measures of the Economists generally tend to prefer measures of the inflation rate that are broader than the CPI.inflation rate that are broader than the CPI.

The GDP deflator is an average of the prices of all The GDP deflator is an average of the prices of all goods in the economy, weighted by the quantities of goods in the economy, weighted by the quantities of those goods that are actually purchased. those goods that are actually purchased.

It is equal to nominal GDP (expressed in dollars) as a It is equal to nominal GDP (expressed in dollars) as a percentage of real GDP (expressed in the dollars of percentage of real GDP (expressed in the dollars of the base year):the base year):

5.4 Inflation Rate5.4 Inflation Rate

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

5.4 Inflation Rate5.4 Inflation Rate

The percent change in the price level is called The percent change in the price level is called the the inflation rateinflation rate. .

If the price level rises from $20 per good to If the price level rises from $20 per good to $22 per good over a period of time, the $22 per good over a period of time, the inflation rate for the period is 10 percent. inflation rate for the period is 10 percent.

If the price level falls from $20 per good to If the price level falls from $20 per good to $18 per good, the inflation rate is -10 percent; $18 per good, the inflation rate is -10 percent; that is, there is a 10 percent deflation.that is, there is a 10 percent deflation.

6 Unemployment Statistics6 Unemployment Statistics

Unemployment rate is the ratio of the number Unemployment rate is the ratio of the number of unemployed (those seeking employment) to of unemployed (those seeking employment) to the total the total labour forcelabour force

6.1 Problems with Unemployment Statistics6.1 Problems with Unemployment Statistics

Economists believe that the statistics agencies’ Economists believe that the statistics agencies’ unemployment surveys provide too high an estimate unemployment surveys provide too high an estimate of the true unemployment rate. of the true unemployment rate.

Discouraged workersDiscouraged workers are those who do not have jobs are those who do not have jobs may have in fact abandoned hope of finding one. may have in fact abandoned hope of finding one.

Statistics will not count them as unemployed, thus Statistics will not count them as unemployed, thus will provide an underestimate of the number that will provide an underestimate of the number that would choose to work if a job were available.would choose to work if a job were available.

Employment rateEmployment rate is the ratio of employment to is the ratio of employment to working age working age (adult) population(adult) population::

Labour force participation rateLabour force participation rate is the fraction is the fraction of the working age population that is of the working age population that is employed or seeking employment.employed or seeking employment.

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