2.1 Measures of Economic Performance

National income/GDP

The total value of goods/services produced by an economy over a period of time

GDP formula

National output (GDP) = national income = national expenditure

Price level

Represents the average/typical price of all goods and services in an economy

When the price level rises, an economy experiences inflation

When the price level falls, an economy experiences deflation

Index numbers

A model used to measure changes in price, quantity or value over a period of time, compared to a base year of 100

Index numbers only show the change in GDP, not the real value of GDP

Economic growth

The sustained increase in national income/value of output over a given period of time

Total GDP vs GDP per capita

GDP per capita is a better indicator of typical standard of living

Total GDP can still be useful to infer (e.g. the ability to fund defence/public services, or comparing GDP to national debt/trade deficits)

Real GDP

GDP adjusted for inflation

Real GDP formula

Real GDP = (GDP index / CPI (price index)) x 100

Nominal GDP

GDP not adjusted for inflation

Real GDP vs nominal GDP

Real GDP means to alter the raw GDP data to account for the actual purchasing power of consumers; even if a country is very rich, if prices are high, consumers will have less ability to actually purchase goods and services, compared to an equally rich country with lower prices, therefore the ‘real’ GDP of the country would be lower, as their purchasing power with that income is relatively lower

(e.g. if national income (GDP) grows by 5%, but the inflation rate is 6%, the economy had grown in nominal terms, however it has got poorer in real terms, because each person can afford less, despite their income rising

Relationship between GDP and inflation

If GDP growth < inflation, real GDP falls

If GDP growth > inflation, real GDP increases

if GDP growth = inflation, real GDP remains the same

Alternative measures of national income (GDP)

Gross national product (GNP)

Gross national income (GNI)

National happiness

Purchasing power parity (PPP)

Gross national product (GNP)

Measures the total value of goods and services produced by national citizens/assets, regardless of location, therefore it excludes the output of non-residents even if they produce domestically

Gross national income (GNI)

Measures the total value of income flows generated by national citizens/assets regardless of location, therefore it excludes income flows going to non-residents even if they produce domestically

National happiness

Measurement of happiness is done via the national well-being survey, which asks a sample of the population a range of questions to quantify average life satisfaction

Relationship between income and national happiness

At lower levels of income, citizens may not have access to basic necessities, therefore more income does increase happiness as they can drastically improve their quality of life via spending, however once one’s income reaches a certain level, further increases do not lead to more happiness, this is because once basic necessities are covered, the sources of additional happiness cannot be acquired simply through buying them

Purchasing power parity (PPP)

A technique used to adjust GDP figures to take into account the cost of living when making international comparisons

Purchasing power parity to adjust exchange rates

US total nominal GDP = $32 trillion, @PPP = $32 trillion

China total nominal GDP = $21 trillion, @PPP = $44 trillion

China’s PPP is higher than USA’s PPP because the average costs of goods and services is cheaper in China that it is in the US, therefore every dollar spent in China has more purchasing power then it does in the USA, meaning overall the Chinese economy can purchase more total goods and services each year

Advantages of GDP as a measure of standard of living

Indicates living standards reasonably well, as more GDP/national income means consumers and the government can afford more goods and services; both material and non-material living standards (health and education)

GDP is relatively simple to calculate so easy for countries to operate GDP data and compare their growth to their past performances or the performance of other countries

Disadvantages of GDP as a measure of standard of living

Non-adjusted GDP may not indicate true living standards

Fails to account for population differences, unlike GDP per capita

Fails to account for inflation, unlike real GDP

Fails to account for differences in international cost of living, unlike PPP

Only considers domestic output, countries may have significant foreign earnings that are not counted towards GDP, unlike GNI and GNP

Hidden/underground economy businesses engaging in tax evasion or illegal black markets will not declare transactions and therefore these will not be counted towards GDP, therefore most countries will under-report their true GDP

Ignores inequality, even if a country has a very high GDP, if the income is very unevenly distributed, it might be the case that a minority of the population have very high living standards but the majority may have low living standards

Higher income may not necessarily mean higher national happiness, arguably the true goal of economic activity is to make us happier, not necessarily just to be richer

Inflation

The persistent rise in the general price level over a period of time

Deflation

The persistent fall in the general price level over a period of time

Disinflation

The fall in the inflation rate over a period of time, where the price level is still rising but at a slower rate than previously

Ways to measure inflation

Consumer price index (CPI)

Retail price index (RPI)

Consumer price index

Retail price index

Difference between CPI and RPI

RPI includes housing costs (e.g. mortgages), whereas CPI does not, hence RPI usually generates a higher inflation rate

Causes of inflation

Demand pull inflation; when the price level rises due to an outward shift in aggregate demand

Cost push inflation; when the price level rises due to an inward shift in aggregate supply

An increase in the money supply

Fischer’s equation of exchange

Money supply x velocity of spending = price level x quantity of transactions

MV = PQ OR MV = PT

Assume V is constant because consumers will spend at a steady price rate over time; if the money supply increases, the price level would increase, assuming the quantity of transactions remains the same; the quantity of transactions remain the same when the money supply increases as money is not a factor of production, therefore it only leads to an increase in the price level of an economy

Evaluation for causes of inflation

Demand is not a significant cause of inflation when an economy has lots of spare capacity (Y₂ - Y₁)

Cost-push inflation may not be significant if the rising cost is a small percentage of a firms total costs (e.g. if wages rise in a capital-intensive economy, not much cost-push inflation would occur; if wages rise in a labour-intensive economy, a lot of cost-push inflation would occur)

The money supply may not be a significant cause of inflation if increases in M cause an increase in Q/T; Keynesians argue that money can be used to increase the capital stock of the economy, therefore Q/T increases when M increases, avoiding inflation

Effects/impacts/benefits of inflation - greater profit for firms

Inflation can be good for firms as they can sell goods/services for higher prices, acquiring more revenue, and hence more profit; inflation also encourages a faster rate of consumption, which may increase overall demand for goods/services (expectations of inflation↑ = C↑ = AD↑)

However, firms may not benefit if inflation of the input price (cost of production) rises faster than the output price (sale price); if input prices are rising faster than output prices, firms would be worse off (it is always likely that wages will rise as workers try to negotiate higher wages)

Effects/impacts/benefits of inflation - reduction in government debt

Inflation can benefit the government to some degree as it reduces the real value of their debt, with the government being a typically large borrower; as inflation reduces the value of money, debtors such as the government would pay back a lower value of money than they borrowed (the opportunity cost of the money they give back is less than what they initially received)

However, the reduction in the real value of debt can be counteracted by an increase in the value of the nominal debt (e.g. public sector workers will ask for higher wages, increasing government spending, and pension benefits, which are index linked, would automatically linked would rise, also increasing government spending)

Effects/impacts/costs of inflation - reduction in disposable income

Inflation is harmful for households as it reduces their real disposable income, which means lower purchasing power, less access to necessities/luxuries, lower standard of living

However, this depends upon whether workers are on a fixed wage/contract; inflation is much more damaging for those on fixed contracts as they must typically wait to negotiate higher wages

Effects/impacts/costs of inflation - reward for saving decreases

Inflation is harmful for savers (firms or high-income earners), as it reduces the real value of savings; their savings are worth less over time as prices rise, as they cannot afford to purchase as many goods/services with the money saved

However, the effects of inflation depend on the magnitude of inflation (e.g. 1% to 3% is actually desirable as it encourages extra consumption, but 10% inflation is detrimental)

Effects/impacts/costs of inflation - worsened trade balance

Inflation is damaging to the trade balance of an economy as high levels of inflation make exports less competitive/attractive leading to reduced export sales; imports also become more attractive as domestic consumers are more likely to purchase cheaper imports, therefore decreased exports and increased imports equal a greater trade deficit/current account deficit

However, if an economy is producing non-price competitive exports, their exports sales would not reduce given their high quality; cost-push inflation may be preferable as the fall in GDP means domestic consumers will not be able to afford imports

Effects/impacts/costs of inflation - economic growth

Inflation can be detrimental to economic growth as it discourages foreign direct investment; entrepreneurs may avoid investing during an inflationary period, therefore less investment into new capital constrains both AD and LRAS, reducing GDP, and thus economic growth

However

General evaluations for inflation

Employment

When a labourer who is willing and able to work has a job

Unemployment

When a labourer who is willing and able to work does not have a job

Underemployment

When a labourer has a job but is not being used to its maximum capacity efficiency

(e.g. over-qualified workers, zero-hour contracts, part-time jobs or self-employed workers)

Inactive worker

When a labourer is unwilling and/or unable to work

(e.g. pensioners, students or workers with long-term health issues)

Labour force

Constitutes the employed and unemployed workers in an economy (excludes inactive workers)

Ways to measure unemployment

The claimant count

The labour force survey

The claimant count

The government counts the number of citizens claiming unemployment benefits, they then divide this by the total size of the labour force to generate an unemployment rate

Limitations of the claimant count

Not all unemployed workers are eligible for benefits (e.g. household or family income may be too high, or households may have sources of non-labour income; the claimant count underestimates underemployment)

Not all unemployed workers claim benefits (e.g. due to social stigma)

Fails to take into account the underground economy (e.g. certain people working illegally may claim benefits even if working)

The labour force survey

A quarterly survey of approximately 30,000 households which asks three key questions to determine if someone is unemployed:

• are you out of a job?

• are you able to start a job in the next two weeks?

• have you been looking for a job in the last four weeks?

Yes to all three questions indicates unemployment

These three questions are the same questions asked by the International Labour Organisation (ILO), allowing for easy international comparison

The number of unemployed respondents can then be taken as a percentage of the total size of the labour force to generate an unemployment rate

Limitations of the labour force survey

Only takes a sample rather than the whole population; although measures are taken to make it as representative as possible)

Fails to take into account the underground economy (e.g. certain people will say they do not have a job on the labour force survey)

Causes/types of unemployment

Frictional unemployment

Seasonal unemployment

Classical unemployment

Cyclical unemployment

Structural unemployment

Frictional unemployment

Occurs when workers are between jobs; there will always be some frictional unemployment in an economy (full employment is impossible), which is often referred to as natural unemployment

It is often considered to not be damaging as it is temporary in nature and often voluntary

Season unemployment

Occurs when the demand for certain workers or professions falls at a certain time of the year (e.g. ice cream sellers during the winter or private tutors during the summer)

It is often considered not too problematic as it is temporary in nature; seasons also always cycle and workers will typically have other work during the off-season; not many countries are reliant on seasonal industries (however countries specialising in tourism/agriculture may suffer a lot more from seasonal unemployment)

Classical unemployment

Occurs when wages are artificially forced above the free market equilibrium (e.g. through minimum prices legislations or trade unions); if wages are forced upward, firms will demand less workers, and replace them with capital, leading to underemployment

It is often considered as very significant by classical economists as it prevents the economy reaching full employment as workers cannot legally accept lower wages when employed; however, Keynesians view this as less significant as paying workers more makes them more motivated/productive, meaning they are more desirable for firms not less desirable, the Keynesian Efficient Wage Theory (KEWT)

Cyclical unemployment

Occurs due to a general lack of demand for labour during the recession/trough phase of the trade cycle; as aggregate demand falls, the derived demand for labour in various industries fall with it, leading to unemployment until the aggregate demand in the economy recovers

It is often considered not too be damaging as it is temporary meaning the economy will eventually recover, but on the other hand the cycle may take a long time

Structural unemployment

Occurs when the pattern of labour demand changes, such that certain skills become obsolete/unnecessary given the current structure if the economy, occurring for two main reasons:

• technological change (e.g. cars make cart drivers obsolete, AI may do similar in a modern context)

• a change in international production (e.g. steel and coal industry left the UK in the 70s/80s

It is often considered a very damaging form of unemployment unless workers retrain (which may be practically difficult and/or expensive); it is much more likely to lead to skill decay (hysteresis) and long-term unemployment

Effects/impacts/benefits of unemployment on the whole economy - deflationary

Unemployment↑ = Y↓ = C↓ = AD↓ = Pl↓

Effects/impacts/benefits of unemployment on the whole economy - migration

Population↑ (due to greater inward migration) = C↑ = AD↑ = demand for labour↑ = employment↑; migrants are willing and able to work in areas that UK workers are unwilling and unable to work in (e.g. lorry drivers, care workers or fruit pickers); moreover migrants provide a greater supply of labour in the economy for firms to choose from, enabling more overall supply and therefore more output and overall jobs in the the long-term (e.g. through LRAS shifts and long-run increase in GDP)

However, it depends on the skill of the worker, if they come over for work illegally, the extent by which they compete with domestic workers, whether remittances (a form of transfer, nothing given in exchange) are sent back to their home country or the extent by which remittances occur

Effects/impacts/costs of unemployment - lower standard of living

Households/consumers will face lower standard of living as they lose their main form of income and may need to rely on benefits (the standard allowance for people younger than 25 is roughly £340 per month), therefore material standard of living (ability to afford necessities/luxuries) and non-material standard of living (health/education services) will both decrease

However, if households/consumers have savings or other sources of income/wealth, their living standards may not decrease by a significant amount; depends on the type of unemployment, frictional is not so bad whereas structural is particularly bad as its permanence may lead to skill decay (hysteresis)

Effects/impacts/costs of unemployment - higher taxation

Households who remain employed may have to pay higher taxes in the future to support the increased welfare spending by the government; firms may also face declining demand, revenue and profits as when unemployment↑ = Y↓ = purchasing power↓ = demand↓ = total revenue↓ = profits↓

However, prices of goods/services may fall as consumption decreases due to a loss of income for unemployed people, therefore real Y↑; moreover firms may also face declining costs as there are more people looking for work and competing for jobs (i.e. greater supply of labour) allowing firms to offer lower wages and thus reduce costs, increasing profits; it also depends on whether YeD is inferior or normal/luxury, if inferior total revenue does not decrease as much and vice versa

Effects/impacts/costs of unemployment - fiscal deficit

Unemployment creates a fiscal deficit for the government as unemployed workers no longer pay income tax and government spending on benefits increases; as a fiscal deficit occurs where G>T, as G↑ and T↓ due to unemployment, a fiscal deficit is created

However, it depends upon the type of unemployment, if cyclical, the budget deficit during a recession can be paid for with the budget surplus during a recovery or boom (i.e. Keynesian demand-management - when the government smoothens out the fluctuations in the trade cycle graph; if they reduce taxes and increase spending during a recession, aggregate demand would increase, if they increase taxes and decrease spending during a boom, aggregate demand would decrease, smoothening out the curve); it also depends on the income levels of the unemployed workers, if largely lower income earners are losing their job the impact on tax revenue will be limited, it may also be the case that higher income earners also pay little tax, and therefore mass unemployment of the middle class is particularly damaging, who are threatened by AI

Effects/impacts/benefits of unemployment on the whole economy - environment

Unemployment↑ = Y↓ = production↓ = pollution↓

Effects/impacts/costs of unemployment on the whole economy - worsened government finances

Unemployment↑ = Y↓ = income tax↓ = tax revenue↓ = fiscal deficit↓

Effects/impacts/costs of unemployment on the whole economy - youth unemployment

Youth unemployment may increase in the long-term as they are not building essential work skills

Effects/impacts/benefits of unemployment on the whole economy - migration

Inward migration may increase employment; population↑ = C↑ = AD↑ = demand for labour↑ = employment↑; migrants have skills/are willing to work in areas that UK workers do not have/are not willing (e.g. lorry drivers, care workers or fruit pickers); migrants provide a greater supply of labour in the economy for firms to choose from, enabling more overall supply and therefore more output and overall jobs in the long-run (e.g. through LRAS shifts and GDP increasing in the long-run)

However, it depends on the skills of the migrant; if they come over for legally or illegally; the extent to which the migrants compete with domestic workers; whether remittances (a form of transfer, nothing given in exchange) are sent back to their home country/ the extent by which remittances occur

General evaluations for the effects/impacts/benefits/costs of unemployment on the whole economy

Effects of unemployment depend on the type of unemployment

Effects of unemployment depend on how severe the unemployment rate is (e.g. UK unemployment increased from 4.9% to 5% in early 2026, this is a small increase, and still near full employment)

Effects of unemployment depend on demographics of unemployed workers (e.g. in the UK there is a growing problem of NEET workers (not in employment, education and training), almost one million in the UK)