Measurement of Economic Performance

Learning Objectives:

1. Aggregate Output
2. Unemployment
3. Inflation

Macroeconomists use three main variables to analyse the performance of an economy:

1. Aggregate Output – is the level of total production and its rate of growth

2. Unemployment – is the proportion of workers in the economy who do not have a job and
are looking for one.

3. Inflation – is the rate at which the average price of goods and services in the economy is
increasing over time

Aggregate Output

Aggregate output is the total output of goods and services in the entire economy. It is a measure
of total economic activity. Aggregate economic activity is measured using the National Income
and Product Accounts. The National Income and Product Accounts is an accounting system used
to measure aggregate economic activity. It defines concepts and constructs measures
corresponding to those concepts.

1.2 Gross Domestic Product

The measure of aggregate output in the national income and product accounts is gross domestic
product, or GDP. GDP can be looked at from two perspectives: the production side and the income
sides

Production side: from this perspective, GDP is defined in two ways:

1. GDP is the value of the final goods and services produced in the economy during a given
period. It counts only the production of final goods. A final good is a good destined for
final consumption. GDP does not count the production of intermediate goods. An
intermediate good is a good that is used in the production of another good.

2. GDP is the sum of value added in the economy during a given period. The term value
added means the value added by a firm. Value added by a firm is defined as the value of
the firm’s production minus the value of the intermediate goods used in production.

Income side: from this perspective, GDP is defined as:

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 3. GDP is the sum of incomes in the economy during a given period. This income is in the
form of labor income, capital income and indirect taxes.

The revenue left to a firm after it has paid for intermediate goods (value added) is distributed as:
i. Labor Income – revenues that go to pay workers (wages)
ii. Capital Income – revenues that go to the firm as profit income

Indirect taxes are revenues paid to the government in the form of sales tax.

Example: Consider an economy composed of two firms. Firm 1 produces steel, employing workers
and using machines to produce steel. It sells the steel for $100 to Firm 2, which produces cars.
Firm 1 pays its workers $80, leaving $20 in profit to the firm. Firm 2 buys the steel and uses it
together with workers and machines to produce steel. Revenues from car sales are $200. Of the
$200, $100 goes to pay for steel and $70 goes to workers in the firm leaving $30 in profit to the
firm. What is aggregate output using the three definitions of GDP?

Solution: First thing is to summarize the information given in the form of a table:

Firm 1 (Steel Co.) Firm 2 (Car Co.)

Revenues from sales $100 Revenues from sales $200

Expenses Expenses
1. Wages $70
2. Steel
1. Wages $80 purchases $100

Profits $20 Profits $30

 GDP as value of final goods produced: is $200. Therefore, aggregate output in this
economy as is just the value of cars. Steel is an intermediate good and is used up in the
production of cars.

 GDP as value added: The steel company does not use intermediate goods. Therefore it’s
value added is equal to the value of the steel it produces - $100. The car company uses
steel as an intermediate good. Thus the value added by the car company is equal to the
value of cars it produces minus the value of the steel it uses in production:
$200 - $100 = $100. Therefore total value added in the economy is $100 + $100 = $200.

 GDP as total incomes in the economy:

Firm 1 (Steel Company) Firm 2 (Car Company)

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 Value added - $100 Value Added - $100
Labor Income - $80 Labor Income - $70
Capital Income - $20 Capital Income - $30

Incomes for the economy as a whole:

Labor Income - $80 + $70 = $150

Capital Income - $20 + $30 = $50
Total Income = $200

Value added is equal to the sum of labor income and capital income.

Nominal and Real GDP

Nominal GDP is the sum of the quantities of final goods multiplied by their current prices. This
definition shows that nominal GDP increases over time for two reasons:

i. The production of most goods increases over time

ii. The prices of most goods also increases over time

To measure production and its change over time, we need to eliminate the effect of increasing
prices on the measure of GDP.

Real GDP is the sum of the quantities of final goods multiplied by their constant prices.

EXAMPLE: Consider an economy which produces a single final good specifically a particular car
model. The table below shows the quantities of cars produced and their respective prices for the
years 1999 to 2001. What is nominal and real GDP for years 1999, 2000 and 2001?

Quantity of Price Nominal Real GDP

Year Cars of cars GDP (in 2000 dollars)
1999 10 $20,000 $200,000 $240,000
2000 12 $24,000 $288,000 $288,000

2001 13 $26,000 $338,000 $312,000

The problem of constructing GDP in practice is that there is more than one final good. Real GDP
must be defined as a weighted average of the output of all final goods. The weights used to
construct real GDP reflect relative prices that change over time. This measure of real GDP is called
Real GDP in Chained (2000) Dollars.

In this case 2000 is used because it is the year when by construction real GDP is equal to nominal
GDP. If one good costs twice as much per unit as the other, then that good should count for
twice as much as the other in the construction of real GDP.

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Real GDP is the best measure of the output of an economy. Its evolution shows how output has
increased over time. The difference between nominal GDP and real GDP comes from the increase
in prices over the period.

Other Names for Nominal and Real GDP

1. Nominal GDP is also called Dollar GDP or GDP in current Dollars

2. Real GDP is also called GDP in terms of goods, GDP in Constant dollars, GDP adjusted
for inflation or GDP in 2000 dollars if the year in which real GDP is set equal to nominal
GDP is 2000.

Notations

1. Yt will refer real GDP in year t.

2. $Yt. nominal GDP in year t.

GDP: Level versus Growth Rate

The level of real GDP is a number that gives the economic size of a country. A country with twice
the real GDP of another country is economically twice as big as the other country.

The level of real GDP per capita defined as the ratio of real GDP to the population of the country
gives the average standard of living of the country.

To assess the performance of the economy from year to year economist focus on the rate of
growth of real GDP called GDP growth.

Expansions: are periods of positive GDP growth

Recessions: are periods of negative GDP growth

GDP growth in year t, is given by: (Yt  Yt 1 )

Yt 1

GDP is the most important macroeconomic variable because it is a measure of aggregate

economic activity. The other two variables that tell us about other important aspects of how the
economy is performing are the unemployment rate and the inflation rate.

The Unemployment Rate

Employment is the number of people who have a job. Unemployment is the number of people
who do not have a job but are looking for one.

The Labor force is the sum of employment and unemployment: L = N + U

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The unemployment rate is the ratio of the number of people who are unemployed to the number
of people in the labor force. The formula for the unemployment rate (u) is given by:

U
u
L

Example: in the year 2000, wonderland had 135.2 million employed individuals while 5.7 million
individuals were unemployed. What was the unemployment rate for the year 2000?

Solution: size of the labor force is 140.9 million. Then using the formula for the unemployment
rate, we get:

5.7
u2000   4.0%
135.2  5.7

It is harder to determine whether somebody is unemployed. To be classified as unemployed, a

person must meet two criteria:

i. A person must not have a job

ii. A person must be looking for a job – this second condition is harder to assess.

The Labor Force Participation Rate

When unemployment is high some of the unemployed give up looking for a job and therefore are
no longer counted as unemployed. These people are known as discouraged workers. When the
economy slows down, there is an increase in the unemployment rate and an increase in the
number of people who drop out of the labor force.

A higher unemployment rate is associated with a lower participation rate. The labor force
participation rate is the ratio of the labor force to the total population of working age. The formula
for the Participation rate is given by:

labor force
=
population of working age

Why Study Unemployment

There two reasons why we study unemployment:

1. Unemployment affects the welfare of the unemployed. It is associated with financial and
psychological suffering. How much the unemployed suffer depends on the nature of
unemployment. There is much suffering if there is a stagnant unemployment pool of
people remaining unemployed for long periods of time. There is less suffering if each
month many people become unemployed and many of the unemployed find jobs. Some
groups such as the young, ethnic minorities and the unskilled suffer disproportionately

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 from unemployment remaining chronically unemployed and being more vulnerable to
becoming unemployed when the unemployment rate increases.

2. Unemployment provides a signal that the economy may not be using some of its resources
efficiently. If many workers who want to work do not find jobs, then the economy is not
efficiently utilizing its human resources. Low unemployment can also be a problem
because the economy may be over utilizing its human resources and run into labor
shortages.

The Inflation Rate

Inflation is a sustained rise in the general level of prices (price level). The inflation rate is the rate
at which the price level increases. Deflation is a sustained decline in the price level. It corresponds
to negative inflation. The price level can be defined in terms of two measures: the GDP deflator
and the Consumer Price Index

The GDP Deflator

The GDP Deflator – Increases in nominal GDP can from an increase in real GDP or from an
increase in prices. If nominal GDP increases faster than real GDP, the difference comes from an
increase in prices.

The GDP deflator in year t (Pt) is defined as the ratio of nominal GDP to Real GDP in year t:

nominal GDPt $Yt

Pt  
real GDPt Yt

In the year in which real GDP is equal to nominal GDP by construction, the price level is equal to
1. The GDP deflator is called an Index number. Its level is chosen arbitrary e.g. it is equal to 1 in
2000 and has no economic interpretation. But its rate of change Pt – Pt-1/Pt-1 gives the rate at
which the general level of prices increases over time (inflation rate.)

The GDP deflator implies a simple relation between nominal GDP, Real GDP, and the GDP deflator.
Using the equation of the GDP deflator we can get an expression for nominal GDP:

$Yt  Pt Yt

Nominal GDP is equal to the GDP deflator multiplied by real GDP. In terms of the rate of change,
the rate of growth of nominal GDP is equal to the rate of inflation plus the rate of growth of real
GDP:

The Consumer Price Index

The GDP deflator gives the average price of final goods produced in the economy. The Consumer
Price Index gives the average price of goods consumers consume. Consumers care about the
average price of consumption. The two prices may not be the same because the set of goods

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produced in the economy is not the same as the set of goods purchased by consumers. This is
because of the following reasons:

1. Some of the goods in GDP are sold to firms , the government or foreigners
2. Some of the goods bought by consumers are not produced domestically but are imported
from abroad.

To measure the average price of consumption (cost of living), we look at the Consumer Price
Index (CPI). The CPI gives the cost of a specific list of goods and services over time. This list is
based on a detailed study of consumer spending and attempts to represent the consumption
basket of a typical urban consumer.

The CPI just like the GDP deflator is also an index. It is set equal to 1 in the period chosen as the
base period and so its level has no particular significance. For example, if the base period is 1982
to 1984, then the average for the period 1982 to 1984 is equal to 100. If in 2011 the CPI was
201.6, it means that it cost roughly twice as much in dollars to purchase the same consumption
basket than it did in the period 1982 to 1984.

The rate of inflation may differ depending on whether the GDP deflator or the CPI is used to
measure it. However, the following are worth noting:

1. The CPI and the GDP deflator move together most of the time but in some years they
may differ.

2. There are exceptions to the first point. For example, the CPI may be significantly larger
than the GDP deflator. The GDP deflator is the price of goods produced in the economy.
The CPI is the price of goods consumed in the economy. This means that if the price of
imports increases relative to the price of domestic goods, the CPI increases faster than
the GDP deflator.

Why Study Inflation

Pure inflation is a faster but proportional increase in all prices and wages. If pure inflation existed,
inflation would only be a minor inconvenience as relative prices would be unaffected. For example,
in an economy with 10%, prices would increase by 10% per year. But wages would also increase
by 10% so that real wages would be unaffected by inflation.

The real wage is the wage measured in terms of goods. The nominal wage is the wage measured
in monetary terms.

Even in the case of pure inflation, inflation would not be entirely irrelevant because people would
have to keep track of the increase in prices and wages when making decisions. We study inflation
because pure inflation does not exist. Inflation is a problem because of the following reasons:

1. During periods of high inflation not all prices and wages rise by the same amount. As a
result inflation affects income distribution. For example, retirees lose in relation to other
groups because in many countries retirees receive payments that do not keep up with the

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 inflation. If retirement pensions do not keep up with inflation, retirees are pushed to
poverty.

2. Inflation leads to other distortions. For example, variations in relative prices lead to
uncertainty making it harder for firms to make decisions about the future. For example,
investment decisions. Some prices which are fixed by regulation or by law lag behind
leading to changes in relative prices.