Measuring Economic Performance

Question 1

Define Macroeconomics

Answer 1

Macroeconomics is the study of an economy as a whole

Question 2

What are the 7 key objectives?

Answer 2

When judging the performance of an economy (or a government) we look at 7 key objectives:

• economic growth
• employment/unemployment
• inflation rate
• current account of the balance of payments (exports, imports)
• government deficit and surplus
• redistributed income/wealth (reduced inequality)
• the environment

Question 3

Describe the Circular flow of Income:

a) diagram
b) injections
c) leakages/withdrawals

Answer 3

a) Households provide firms with labour, Firms give wages/profits to households. Households provide firms with consumption, consuming services/goods from Firms.
b) Injections:
- Government Spending
- Exports
- Investment
c) Leakages/Withdrawals:
- Taxation
- Imports
- Savings

Question 4

Define Economic growth

Answer 4

Economic growth is a change in National Income (Y)

Question 5

Describe the most common measure of national income:

a) What is it and what are the ways of calculating it?
b) Definition
c) How do we use it?
d) What kind of payment is not included in GDP

Answer 5

a) Gross Domestic Product (GDP) is the most common measure of national income. There are 3 ways of calculating GDP: national output, national expenditure and national income. All 3 should be the same!
b) GDP = the total value of all goods and services produced in an economy over a period of time.
c) GDP figures are generally used to show comparison - either within a country over time or between different countries. We generally associate higher GDP with richer people/able to buy and consume more product and so higher standards of living
Although GDP is measured in money terms, we really use it as a measure of the quantity produced in an economy (which is why real GDP is important)
When looking at changes in (real) GDP we can use a simple year-on-year % change or we calculate an “index”, where we take a base year=100 and all other figures are relative to that. So if 2012 were the base year we would have (real GDP 2013/real GDP 2012)*100
d) Transfer payments are not included in GDP. A transfer payment is a payment without the production of a product. This includes pocket money, government benefits and sale of ‘second hand’ goods (including housing)

Question 6

What are the 2 other measures of national income?

Answer 6

• Gross National Income (GNI) = GDP + net interest payments and dividends from abroad
• Gross National Product (GNP) = output of all UK firms (not firms in UK!)

Question 7

What are the 3 types of GDP?

Answer 7

a) Nominal (or at current prices): actual GDP figures for each year
b) Real (or at constant prices): nominal GDP figures adjusted to account for a change in price level (inflation)
c) Per capita: this is (real) GDP per person

Question 8

How accurate are GDP figures? (4)

Answer 8

1. Statistical inaccuracies: there is a mass of data to be collected. Inevitably some things are missed or double-counted
2. Home produced services: if you work on your own house/land and consume the product yourself then the output will not appear in GDP. This is common in developing countries
3. Hidden economy: informal or black economy, include illegal activity and work done for cash to avoid tax. This is unknown to the government and difficult to count in GDP. Since 2014 EU and UK include an estimate in GDP, but it is unreliable.
4. Public sector: hard to measure the output of NHS since it is not sold. It is usually measured by its cost, but this could mean improved efficiency actually reduces GDP

Question 9

Problems comparing GDP over time: (6)

Answer 9

1. Changing prices: inflation affects it - use real GDP
2. Changes in population: larger population increases GDP - use real GDP per capita
3. Quality of products: quality may improve but price stay the same (computers) and so GDP stays the same
4. What types of goods are being produced: in war GDP may rise but the standards of living won’t
5. Externalities: higher GDP may be associated with more externalities (pollution)
6. Income distribution: GDP per capita only shows the average - it does not reflect how big the rich-poor gap is

Question 10

Problems comparing GDP of different countries: (3)

Answer 10

1. Different populations - use real GDP per capita
2. Different distribution of income
3. Different currencies - can’t use exchange rate as it varies daily. So instead we use PPP(Purchasing Power Parity) which calculates the actual buying power of a currency

Question 11

How is PPP calculated? (+2 evaluation points)

Answer 11

Purchasing Power Parity (PPP) is calculated using a made-up exchange rate, such as the Big Mac index, so it reflects exactly how many goods and services you can buy with a currency. To make it more accurate we use a typical basket of goods (1 litre of milk, 1kg of rice, a car etc) and look at how much the basket would be worth it each country and use this as the PPP exchange rate
BUT
- How do we select the products?
- Different countries spend different % of their incomes on each good so this would affect the PPP

*international basket of goods is different from the one used for CPI calculations, it is more general

Question 12

Define Growth and Development

Answer 12

Growth is an increase in real GDP (per capita, $PPP)
Development is a wider concept, it measures “living standards”, “quality of life”. This is inevitably linked to “being richer” (increased real GDP per capita), but it is not the same

Question 13

What are the aspects that can be included when measuring development? (5)

Answer 13

Development is perhaps not measurable at all and is a subjective concept. There is no single measure of development, GDP is used to measure wealth, however this only gives us limited ideas of development. We need to consider other aspects such as:
1. A healthy life (measured by infant mortality rate, doctors per 10000, life expectancy etc)
2. Opportunities (measured by literacy rates, spending on education, measures of equality etc)
3. Infrastructure (measured by % of population with access to clean water, running water, electricity, telephone etc)
4. Safety (measured by homicide rates)
5. Poverty/income distribution (number of people living on less than $1.25/day, Gini coefficient etc)
and a variety of other factors

Question 14

What is the most common composite measure of development and how is it measured?

Answer 14

Composite measure - composed of a number of factors.
Human Development Index (HDI) is the most common one, used by UNDP. It is based on:
- Wealth - GNI per capita PPP
- Health - life expectancy
- Education - years of school enrolment - past and predicted
Each of the 3 areas is given a score out of 1, where 1 is the best country in the world. These scores are then averaged out to give an HDI value. Thus the highest HDI is 1

Question 15

Discuss advantages (5) and disadvantages (4) of HDI:

Answer 15

Advantages:

• Composite: not based on a single aspect of development, gives us more rounded views
• Reliable: the measures required are fairly reliable, easy and cheap to collect. Most countries collect this data
• It indicates GDP has been used to increase social welfare: “GDP rank - HDI rank” is a useful measure of social welfare (health and education)
• Government policies: use of education and health is a sign of successful government policies
• Future development: HDI is a sign of welfare in the future (a healthier, more skilled work force should mean more productive labour, so rising GNI and so more tax money to spend on health care and education)

Disadvantages:

• Poverty/Distribution of income - an indication of that would help HDI. The use of GNI per capita may not reflect median incomes or the rich-poor gap
• Other areas of development are not included (infrastructure, political freedoms etc)
• Problems with individual measures (is ‘years of education’ a good measure of quality? problems with GNI)
• It assumes 3 components are equally important, it is a simple average of the 3 values and there is a value judgement. We could argue that one is more important than others

Question 16

Define Inflation, Deflation and Disinflation

Answer 16

Inflation - a sustained rise in the general price level across an economy.
Deflation - a sustained fall in the general price level across an economy.
Disinflation - a fall in the rate of inflation.

Question 17

What is a measure of inflation and how is it calculated?

Answer 17

Consumer Price Index (CPI) is a measure of inflation. Prices of a representative range of goods and services (a basket of goods) need to be recorded on a regular basis. In the UK, the basket is calculated from the result of the Living Costs and Food Survey. Every year, a few thousand households are asked to record their expenditure for a month. From these figures it is possible to calculate how the average household spends its money. Prices are recorded in different areas of the country and in different types of retail outlets, by surveyors, monthly. These results are then averaged out to find the average price of goods and this figure is converted into index number form. Changes in the price of food are more important than changes in price of, say, tobacco because a larger proportion of total household income is spent on food than on tobacco. Therefore the figures have to be weighted before the final index can be calculated. The basket of goods has to be changed every year to reflect changes in consumer spending.

Question 18

What is PPI?

Answer 18

Producer Price Index (PPI) is a weighted index of prices measured at the wholesale, or producer level. It can serve as a leading indicator for CPI. PPI also presents the inflation picture from a different perspective than CPI. Tracking PPI allows one to determine the cause of changes in CPI.

Question 19

Define Cost-push inflation and Demand-pull inflation

Answer 19

Cost-push inflation - inflation caused by increases in the costs of production in the economy (‘imported inflation’ if you import FoPs and their prices rise)
Demand-pull inflation - inflation caused by excess demand in the economy

Question 20

What are the costs of high inflation? (6)

Answer 20

Inflation is generally considered to be a problem. The higher the rate of inflation the greater the economic cost

• Growth and Unemployment: high inflation is typically unpredictable. Both consumers and firms find it hard to predict what will be the rate of inflation next month or next year. This unanticipated inflation ,ages it difficult to plan for the future. So both I and C go down, GDP falls and there is higher unemployment
• Competitiveness: if inflation rises faster in the UK than elsewhere and the value of pound stays the same, exports become less competitive and imports more competitive ↓(X-M) -> loss of jobs in domestic economy and lower growth
• Redistributional costs: anybody on fixed income will suffer, ie pensions on a fixed rate that are not adjusted for inflation. Also workers who are not able to negotiate a pay rise at least in line with inflation will suffer falls in their real incomes. Also, interest rates, if they are smaller than inflation, borrowers are better off and savers are worse off. If taxes are not changed, there is less tax revenue
• Psychological and Political costs: price increases are very unpopular even if people’s incomes go up by more than the rate of inflation
• Shoe-leather costs: when prices are going up customers ‘shop around’ ie spend more time shopping, which is a cost. It also leads to households and firms holding less cash. The higher the rate of inflation, the higher the opportunity cost of holding cash, since nominal interest rates are higher
• Menu costs: when prices are changing restaurants need to change menus, shops - labels, vending machines and parking meters, take account of price increases

Question 21

What is anticipated inflation and how does it help?

Answer 21

Anticipated inflation allows economic actors to plan for the future and adjust their decisions to take inflation into account. One way to do it is through indexation. This is when economic variables like wages or taxes are increased in line with inflation

Question 22

What are the costs of deflation? (2)

Answer 22

Over the past 50 years, the main problem that countries have faced is high rates of inflation. However there could also be problems with deflation. For example in Japan between 1995 and 2014, Japan experienced 9 years of falling prices. They were mainly caused by a lack of demand, but also caused demand to be depressed.

• Low consumer confidence: consumers are concerned about the future as they may buy a certain good for a cheaper price then. This leads to low business confidence and lower investment, as the real cost of borrowing is higher (even though the interest rates are very low)
• Effect on asset values: it encourages households to save rather than spend which leads to low or negative rates of economic growth

Question 23

What are the benefits of low inflation?

Answer 23

Many central banks set a target for inflation of around 2%. This is a very low rate of inflation, but is still a positive increase in prices.

• It avoids the problems associated with deflation and high inflation
• It gives policy makers room to adjust the economy if inflation goes above or below target
• At 2% the real value of borrowing falls gradually over time. This is seen as desirable because it makes it easier for those who borrow to finance C and I to repay their borrowing.
• It also doesn’t impact much on the incentive to save because it is argued that savers don’t take the real erosion of their savings into account. They suffer from money illusion, thinking that inflation is zero

Question 24

Define Labour force

Answer 24

Labour force (active population) - those in work or actively seeking work

Question 25

Define Unemployment, Unemployed, Under-employment and Hidden unemployment

Answer 25

Unemployment - occurs when individuals are without a job but are actively seeking work
Unemployed - the unemployed are those not in work but seeking work
Under-employment - those who would work more hours if available or are in jobs which are below their skill level
Hidden unemployment - when individuals are either those in the population who would take a job if offered, but are not in work and are not currently seeking work, or those who are underemployed

Question 26

How is LFS (or ILO) Unemployment calculated?

Answer 26

LFS (or ILO) Unemployment is calculated using Labour Force Survey (LFS) statistics. Each month 44,000 households with over 100,000 individuals are surveyed. The questionnaire used covers economic activity as well as household size and structure, accommodation details and basic demographic characteristics such as age, sex, marital status and ethnic origin. To be classified as unemployed, an individual has to be without a paid job, be available to start a job within a fortnight and has either looked for work at some time in the previous 4 weeks or been waiting to start a job already obtained.
This measure of unemployment is based on an international standard set by the International Labour Organisation (ILO). The U.K. is required by the EU to use it in order to be able to compare unemployment in different countries

Question 27

Why LFS may be inaccurate? (4+2)

Answer 27

Could be argued to underestimate unemployment:

• They do not include part-time workers who are actively seeking full-time work
• Those on government training and work schemes who would prefer to be in proper employment are not included. This particularly affects young workers
• There are some out of work who are not actively seeking work or receiving benefits for being unemployed but who would take a job if offered. This mainly applies to women bringing up families
• Some unemployed people moved from the unemployed registers onto sickness and disability benefits in the 1980s and 1990s. Governments are now attempting to get them off benefits and back to work. Currently they are not counted as unemployed

However it could be overestimating it:

• Some people find it impossible to get a job (disabled, ex-criminals, with no qualifications)
• Those working in the hidden economy may claim benefits and may declare on surveys that they are out of work and seeking work

Question 28

Explain the Types/Causes of unemployment: (5)

Answer 28

1. Frictional unemployment - short term unemployment, caused by workers who lose their jobs and wait to get new ones. It is not a problem in the free market economy. The higher the level of benefits or redundancy pay, the longer they can afford to stay unemployed. Also the better the job information available through newspapers, job centres etc the shorter the time workers will spend looking for jobs
2. Seasonal unemployment - occurs in markets where the demand for labour varies each year. There is little that can be done to prevent this pattern occurring in such industries (tourism, construction)
3. Structural unemployment - a serious problem, occurs when the demand for labour is less than its supply in an individual labour market in the economy. There are 3 types of it:
   - regional unemployment - occurs because of lack of mobility of FoPs
   - sectoral unemployment - occurs when the skills of workers are no longer needed in the economy
   - technological unemployment - when workers are put out of work by new technology
   These can only be solved by retraining or increasing geographical mobility
4. Cyclical (Demand-deficient) unemployment - occurs when the economy is not in boom. There is insufficient AD in the economy
5. Real wage (classical) unemployment - exists when real wage rates are stuck at a level above that needed to reduce unemployment any further. For example a NMW. Even though unemployed workers would work for a wage lower than NMW, it is illegal. Also it can be caused by welfare benefits being too high

Question 29

What are the costs of unemployment? (6)

Answer 29

• Costs to the unemployed and their dependants: less income, more stress, stigma of being unemployed. For long-term unemployed harder to get a job, reduced human capital, employers want work experience
• Costs to local communities: more violence, crime, vandalism (youth), shops go out of business
• Costs to the government: paying more benefits, less tax revenue, more money spent to provide help, training schemes
• Costs to the consumers: in areas of high unemployment there is a smaller range of shops available
• Costs to firms: a decrease in demand, reduced pool of skilled workers

Question 30

Define The Balance of Payments

Answer 30

The Balance of Payments shows all money flows into and out of a country, ie for the UK it is a measure of all pounds bought and sold. The BoP is always 0 (pounds bought = pounds sold). We are interested in why people are buying/selling pounds so we divide the BoP into different parts

The Balance of Payments:

1. Current Account
2. Capital & Financial Accounts (Savings & Investment)

Question 31

What are the 3 parts of the Current Account?

Answer 31

There are 3 parts of the Current Account:

1. Trade in goods balance (or ‘visible balance’) = Export of goods - Import of goods (by value)
2. Trade in services balance (or ‘invisible balance’) = Export of services - Import of services (by value)
3. Income & Transfer Payments = Income from interests/dividends on overseas assets, UK contribution to EU/UN etc

Question 32

Explain Current Account Surplus/Deficit and what it is determined by: (5)

Answer 32

CA surplus is when the CA is positive, a deficit is when it is negative. The level of Net Exports (NX) (X-M) is determined by:

• Exchange rate (value of 1 currency in terms of another): if a currency gets stronger it means a foreigner will have to pay more in their currency to buy the exported product, so demand falls and so does the value of exports. The reverse it true for imports (↑P€ -> more $ per € ->↓Pm); SPICED = WPIDEC
• Level of ‘protectionism’: trade barriers, such as tariffs, which discourage imports (but other countries will retaliate and so exports fall as well). Tariff - a tax on imported goods. Quota - a physical limit on the quantity of a good imported
• Relative economic growth: if your country has economic growth then people get rich so imports rise. If the RoW has economic growth exports rise. So if growth is faster than elsewhere Net X worsens (↓(X-M). This depends on the ‘marginal propensity to import’ - how much of any extra income is spent on imports
• Relative levels of inflation: if UK has inflation, prices rise, foreigners buy less, exports fall. If RoW has inflation, imports fall - So impact on Net X depends on relative UK inflation
• Non-Price Factors: price is not the only factor to consider when we X or M

Question 33

Is a Current Account Deficit bad?
Yes - 4
No - 2

Answer 33

YES:

• Negative Net X is a net withdrawal from the circular flow (↓AD) and so makes people worse off/lower GDP
• Needs to be financed by a surplus in the Capital & Financial Account (attracting Foreign Direct Investment, foreign savings, gov selling foreign currency)
• It is likely to cause devaluation (or depreciation) of your currency, then import prices rise and cause ‘imported inflation’ (especially if your imports are inelastic)
• CA deficit is a symptom of problems in an economy - low productivity. This makes domestic products more expensive then imports so ↑M

NO:
- It depends on the cause of the deficit. If it is caused by high economic growth, this is hardly bad. Other causes may be SR only
- If you allow your currency to change in value (float) then a deficit should be self-correcting
↓X ->↓D€ ->↓P€ ->↓Px ->↑X (value)
↑M->↑S€ ->↓P€ ->↑Pm ->↓M (value)