GDP and Economic Growth

Lecture 8: GDP and Economic Growth

• Is GDP a good measure of living standard?

Objectives

• Define GDP and measurement of GDP.

• Distinguish between nominal GDP and real GDP.

• Describe the limitations of GDP as a measure of the standard of living.

• How to measure economic growth and explain how sustained growth transforms living standards.

• Sources of sustainable economic growth.

• To align and promote economic analysis with the UN Sustainable Development Goals.

Outline of Lecture

• Definition of GDP.

• The Circular Flow Model.

• Real GDP and Nominal GDP.

• Limitations of Real GDP.

• Meaning and measurement of economic growth.

• What makes potential GDP grow?

• Preconditions for labour productivity Growth.

• Is economic growth sustainable?

• Policies for Achieving Faster Growth.

Introduction to Macroeconomics

• Macroeconomics is concerned with:

  • How the national and international economy operates.

  • The overall performance of the economy.

• Macroeconomic indicators assist in decision making:

  • GDP and economic growth.

  • Unemployment rate.

  • Inflation rate (or price level).

  • A$

• Because indicators are interrelated, decision-making is not so straightforward.

Interactions Between Macroeconomic Variables

• GDP interacts with Balance of Payments, Money Supply, Interest Rate, Price, and A$.

GDP

• Measures the value of production.

GDP: Gross Domestic Product

• The market value of all the final goods and services produced within a country in a given time period.

• This definition has four parts:

  • Market value

  • Final goods and services

  • Produced within a country

  • In a given time period

The Circular Flow Model

• The final goods and services are purchased by the following groups:

  • Households

  • Firms

  • Government

  • The rest of the world

• The four groups correspond to the following expenditure groups:

The Circular Flow Model: Expenditure Groups

• Consumption expenditure (C): expenditure by households on consumption goods and services.

• Investment (I): the purchase of new capital goods (tools, instruments, machines, buildings, and other constructions) and additions to inventories.

• Government expenditure (G): expenditure by all levels of government on goods and services.

• Net exports (NX): the value of exports of goods and services minus the value of imports of goods and services.

  • Exports: items that firms in Australia produce and sell to the rest of the world.

  • Imports: items that households, firms, and governments in Australia buy from the rest of the world.

The Circular Flow Model: Flow of Money

• Households provide consumption expenditure, savings, and taxes.

• Firms provide export payments and import payments.

• Banks provide loans.

• The rest of the world interacts with households and firms.

• The government imposes taxes and provides government expenditure.

GDP: Approaches to measuring GDP

• Expenditure approach: GDP = C + I + G + (X – M)

  • Excludes expenses on used goods

  • Excludes transactions of financial assets such as bonds and stocks

• Income approach: GDP = \text{wage income} + \text{profits and rent} + \text{mixed incomes}

  • The section on 'The Income Approach' is not covered in EFB231.

• Production approach: Value adds each stage of production

Calculating Real GDP and Nominal GDP

• Real GDP: the value of the final goods and services produced in a given year expressed in the prices of the base year.

• Nominal GDP: the value of the final goods and services produced in a given year expressed in the prices of that same year.

Calculating Real GDP and Nominal GDP: Example

• Production and Price Statistics for Economy X

  • 2018:

    • Sunglasses: Quantity 1000, Price $20

    • Pizzas: Quantity 400, Price $10

    • Haircuts: Quantity 125, Price $8

    • GDP: $25,000

  • 2019:

    • Sunglasses: Quantity 1050, Price $22

    • Pizzas: Quantity 450, Price $12

    • Haircuts: Quantity 150, Price $10

    • GDP: $30,000

  • What is the % increase in nominal GDP from 2018 to 2019? 20%

  • Does it mean output in 2019 increased by 20%? (i.e. 5,000/25,000 x 100)

Calculating Real GDP and Nominal GDP: Real GDP Calculation

• To calculate real GDP, we need to use the prices of the base year.

• If we use 2018 as the base year, then the real GDP for 2019 is:
  1050 \times $20 + 450 \times $10 + 150 \times $8 = $26,700

• Hence, % increase is 6.8%.

• Economists use Real GDP to remove the inflationary effects when comparing GDP performance.

GDP Fetishism

• Joseph E. Stiglitz (Nobel laureate in economics).

• The big question concerns whether GDP provides a good measure of living standards.

• Focus on GDP creates conflicts: political leaders are told to maximize it, but citizens also demand that attention be paid to enhancing security, reducing air, water, and noise pollution, and so forth—all of which might lower GDP growth.

Limitations of Real GDP

• Goods and Services Omitted from GDP:

  • Household production

  • Underground economic activity

  • Leisure time

  • Environment quality

Final Word: GDP is Not a Measure of Human Well-Being

• Simon Kuznets is often credited with the invention of GDP (since he attempted to estimate the national income of the United States in 1932 to understand the full extent of the Great Depression).

• But in 1934, he cautioned against equating GDP growth with economic or social well­being.

• The purpose of measuring GDP is to answer questions such as “how fast is the economy growing” and “what is the pattern of spending on goods and services”.

• The modern definition of GDP was developed by John Maynard Keynes during the second world war.

Economic Growth

• United Nations Goal 8: Promote sustained, inclusive and sustainable economic growth, full and productive employment and decent work for all.

Economic Growth Explained

• Economic growth is a sustained expansion of production possibilities measured as the increase in real GDP over a given period.

• Economic growth rate is the annual percentage change of real GDP.

• For example, if real GDP in the current year is $8.4 trillion and in the previous year was $8.0 trillion, then

\text{Growth of real GDP} = \frac{\text{Real GDP in current year} - \text{Real GDP in previous year}}{\text{Real GDP in previous year}} \times 100

\text{Growth of real GDP} = \frac{$8.4 \text{ trillion} – $8.0 \text{ trillion}}{$8.0 \text{ trillion}} \times 100 = 5 \text{ per cent}

Economic Growth in Australia

• Gross domestic product, chain volume measures, seasonally adjusted.

• Quarterly change Dec 2024: 0.6%.

How Potential GDP Grows

• Production Function

• A relationship that shows the maximum quantity of real GDP that can be produced as the quantity of labour employed changes and all other influences on production remain the same.

Labour Market and Real GDP

• Full Employment and Potential GDP

  • When the labour market is in equilibrium, the economy is at full employment.

  • When the economy is at full employment, real GDP equals potential GDP.

What Makes Potential GDP Grow?

• Growth of Supply of Labour

  • When the supply of labour grows, the supply of labour curve shifts rightward.

• Q1: Do you think an increase in supply of labour improves the standard of living?

  • A. Yes B. No

• Growth of Labour Productivity

  • Labour productivity is the quantity of real GDP produced by one hour of labour.

  • An increase in labour productivity shifts PF from PF0 to PF1.

  • This increases the demand for labour, the real wage rate rises, and aggregate hours increase.

• \text{Labour productivity} = \frac{\text{Real GDP}}{\text{Aggregate hours}}

Is Economic Growth Sustainable?

• Preconditions for labour Productivity Growth

• Three Growth Theories

• Policies to Achieve Faster Growth

Preconditions for Labour Productivity Growth

• The growth of labour productivity depends on:

  • Physical capital growth

  • Human capital growth

  • Technological advances

• Physical capital growth

  • increase in the stock of capital per worker

• Human capital growth

  • accumulated skill and knowledge

• Technological advances

  • new technologies increase output

Is Economic Growth Sustainable? Three Theories

• Classical growth theory

• Neoclassical growth theory

• New growth theory

Is Economic Growth Sustainable? Classical Growth Theory

• The view that the growth of real GDP per person is temporary and that when it rises above the subsistence level, a population explosion eventually brings it back to the subsistence level.

• (Adam Smith, Thomas Robert Malthus, and David Ricardo)

Is Economic Growth Sustainable? Neoclassical Growth Theory

• (Robert Solow)

• Of population growth

  • Population explosion eventually ended and grew slowly thereafter because of:

    • The opportunity cost of a woman’s time (women’s wages were increasing then) and their job opportunities expanded. This reduced the birth rate.

    • Technological advances improved healthcare and reduced the death rate.

• Of technological change and diminishing returns

  • Because technological change induces saving and investment that make capital per hour of labour grow.

  • Technological change influences growth but not the other way round.

  • Growth ends if technological change stops because of diminishing marginal returns to both labour and capital.

Is Economic Growth Sustainable? New Growth Theory

• The theory that our unlimited wants will lead us to ever greater productivity and perpetual economic growth.

• Choices and Innovation

• Perpetual Motion

Choices and Innovation

• Emphasises three facts about market economies:

  • Human capital grows because of choices (e.g. further studies; and for those who decide to further studies while working).

  • Discoveries result from choices (e.g. evolution of mobile phones).

  • Discoveries bring profit, and competition destroys profit (e.g. evolution of web browsers).

Policies for Achieving Faster Growth

• Governments can play a role through the following policies:

  • Stimulate saving

  • Stimulate research and development

  • Improve the quality of education

  • Provide international aid to developing nations

  • Encourage international trade

Policies for Achieving Faster Growth - Saving

• Stimulate saving

  • Saving finances investment, which brings capital accumulation.

  • For example: Superannuation

Policies - Research and Development

• Stimulate research and development

  • Most technological advancements come from private research by firms and individual inventors.

  • Government can encourage the development of new technologies through research grants, tax breaks and the patent system.

Policies - Quality of Education

• Improve the quality of education

  • By funding basic education and ensuring high standards in skills such as language, mathematics and science; governments can contribute enormously to a nation’s growth potential.

  • The potential that new ideas can be generated to produce new goods and services is an external benefit to others.

Policies - International Aid

• Provide international aid to developing nations

  • If rich countries give financial aid to developing countries, investment and growth will increase in the recipient countries.

  • But this does not routinely happen.

  • A large amount of data-driven research studies found that the effects of aid on growth turned up a zero or even negative effect.

  • Aid often gets diverted and spent on consumption.

Policies - International Trade

• Encourage international trade

  • Trade is, in some ways, a type of technology.

  • A country that eliminates trade restrictions will experience the same kind of economic growth that would occur after a major technological advancement. (e.g. China since the open­door policy in 1978)

Review of Today’s Lecture

• Define GDP and measurement of GDP.

• Distinguish between nominal GDP and real GDP.

• Describe the limitations of GDP as a measure of the standard of living.

• How to measure economic growth and explain how sustained growth transforms living standards.

• Sources of sustainable economic growth.