Measuring economic growth

Economic growth

Economic growth refers to increases in the total output of goods and services produced in an economy over a given period – usually one year but there are also quarterly and monthly estimates.

GDP

The metric commonly used to measure the quantity of goods and services is a country’s real Gross Domestic Product (GDP).

The idea of measuring ‘national income’ can be traced back to 17th Century English economists Sir William Petty (1623-1687)[i], who attempted the first assessment of national income, and to Charles Davenant (1656–1714)[ii], who suggested that England’s trade should be measured and recorded as on ongoing process. However, it was US economist, Simon Kuznets who developed the first ‘modern’ definition of GDP in a report to the US Congress in 1934 [iii].

GDP measures the market value of ‘final’ goods and services produced within a country, where gross means that any depreciation or capital consumption resulting from domestic (national) production is not considered – in other words gross figures are unadjusted for depreciation.

Nominal and real economic growth

The ‘nominal’ value of GDP is the sum of all goods and services produced within a country in terms of the monetary value of output.

This contrasts with ‘real’ GDP, which tracks the quantity (or volume) of output.

Volume, price and value

The value of GDP (or any other monetary aggregate) is found by multiplying the volume of output by the market price of that output. This is a straightforward concept in micro-economics - the value of a firm's output is its sales volume times its selling price. For a whole economy, national income accounting uses the same principles, but at a much larger scale. Taking a simple example, if a hypothetical economy produces 10m apples in a year, which sell at $1 each (assuming no tax), the value of nominal GDP is $10m. The volume is 10m, the price is $1, and the value is $10m.

Volume (apples) Price [$] Value [$]
Year 1 10 1 $10

Changes in GDP can, therefore, arise from three sources  – through an increase in output, through price, or through price and output. For example, if in the second year, 2 million more apples are produced (rising to 12m), but the price remains at $1, the nominal value of GDP will increase to $12 – a 20% increase. This is a real increase in GDP because it is the increase in volume that has led to the increase in the nominal value of GDP.

Volume Price [$] Value [$]
Year 1 10 1 $10
Year 2 (volume increase) 12 1 $12
Year 2 (price increase) 10 1.20 $12

However, what if the increase in nominal GDP had come about from an increase in ‘price’? If the price of apples had risen to $1.20, and 10m apples are still produced, the nominal value of GDP would also increase to $12.

However, the ‘real’ value of GDP has remained constant at 10m apples.

Inflation distorts values

From this simple example, we can see that price rises, and general inflation, can distort changes in GDP, so we need to strip out the effects of inflation from nominal values to get real values.

For example, if nominal GDP rises to $15m (an increase of 50%) following a rise in the price of apples to $1.25, and an increase in output, to 12m, real GDP has increased by only 20%. The remainder of the increase in nominal GDP comes from the price rise. Hence, if we take out the effects of the price rise, we can then arrive at the real change in GDP.

Adjusting the nominal value to create a real value is referred to as ‘deflating’ the nominal value.

  Volume Price Value
  [Real GDP] [Price level] [Nominal GDP]
Year 1 10 1 $10
Year 2 12 1.25 $15

Using an index

To achieve the adjustment of nominal GDP values, we can convert the various changes into an index. In the above example, the nominal GDP increases by 50%, giving us an index value of 150. The volume change is 20%, giving an index value of 120, and the price change is 25%, with an index value of 125.

  Volume Price Value
  [Real GDP] [Price level] [Nominal GDP]
Year 1 10 1 $10
Year 2 12 [Index=120] 1.25 [Index=125] $15 [Index=150]

However, we do not need to know the volume index separately. If we know two of the three indices, we can calculate the ‘missing’ index.

For example, if we know the price index (in this case, 125) and the nominal GDP index (in this case, 150), we can deflate (divide) the nominal GDP index by the price index, and multiply by 100, to arrive at the real (volume) index. Hence, 150/125 x 100 = 120 - real income has increased by 20%.

150
125
x 100 = 120

In the following example, we can deduce the real GDP:

If the index for nominal GDP is 160, and the index of inflation is 112, real GDP has increased by?

160
112
x 100 = ?

Real GDP has increased by 160/112 x 100 = 142.9.

160
112
x 100 = 142.9

So, while nominal GDP rose by 60%, when inflation is considered, real GDP grew by only 42.9%.

Total and per capita national income

Total income (GDP) is the total value of income produced in a year. However, for comparative purposes it is more useful to convert the raw GDP figures to GDP per capita (or per head). This is found by dividing total GDP by the population. Hence, if we take the example of Japan, GDP in 2019 was $5,082 trillion (that is $5,082,000,000,000), and its population was 126.3 million (that is 126,300,000), making a GDP per capita of $5,082,000,000,000/126,300,000, which is $40,237!

GDP per capital forms the basis of international and historical comparisons of growth and growth rates.

Gross National Income (GNI)

Gross national income (GNI) is GDP plus income received from other countries (including interest payments and dividends earned), less these payments made to other countries.

GNI measures the value added by a country’s residents plus payments to employees and income from ‘property’ from non-residents (called ‘primary income’). Hence, while GDP measures the value of final goods and services produced within a country, GNI measures the value of final goods and services produced by a country's citizens, wherever they reside.

In developed countries the GDP and GNI are often very similar, with, perhaps just a percent or two difference. However, developing countries often receive significant financial flows from abroad in the form of investment flows, and foreign aid.

Prior to 1993, GNI was called Gross National Product (GNP)[1].

How is GDP measured?

From the simple circular flow of income, we can understand that the flow of economic output reflects three interconnected flows, all of which provide useful information to measure GDP. These flows refer to:

  1. The production of 'final' goods and services - which excludes any intermediate production, plus taxes, less subsidies [technically, called the 'output method'].
  2. The income received by individuals and companies when they produce a good or service. [the 'income method'].
  3. The net amount spent on purchasing these goods and services - net, meaning total 'final' spending less import spending. [The 'expenditure' method'].
Circular flow and its use in calculating GDP

The three methods produce similar, but not identical results. There are several reasons for this, but the variations are largely as a result of how the statistics are gathered, and the extent to which the income flow fails to record hidden transactions.

How useful are GDP statistics for international comparisons?

There are two separate questions to consider when assessing the use of the GNP metric.

  1. Firstly, does GDP give an accurate picture of economic output and activity?
  2. Secondly, is GDP a useful metric for assessing wider economic progress and wellbeing?

GDP statistics are widely used by governments, organisations including the World Bank, IMF, and OECD, and by private banks and investors.

However, when GDP statistics (or indeed any economic or financial statistic) are used for comparative purposes, they may not provide an accurate assessment of output and economic activity between countries or over time. This is largely as a result of the impact of price differences and because of the need to convert GDP statistics to a common currency.

Initially, each country will compile its statistics and report the value of its GDP in its local currency.  For example, Australia reports its GDP in Australian dollars (AUD), and Norway reports in Krona (NOK). In 2019, Norway’s GNP was 3,569 billion NOK, while in the same year, Australia’s GDP was worth approximately 1.4 trillion in Australia’s own currency (AUD). However, comparisons are impossible, so the value of GDP is, by convention, converted to US dollars, using the prevailing exchange rate (or an average rate over a period of time).

For example, at a market exchange rate of US$1 = A$1.30, Australia’s GDP in 2019 was US$1.08 trillion, and for Norway, with a rate of US$1 = 0.1137 (NOK), Norway’s GDP in US dollars was US$405 billion. Now, comparisons are possible, and the converted GDP, along with population figures, can provide a GDP per capita figure for both countries, which were $55,000 for Australia, and $75,400 for Norway (2019). [Source: World Bank].

However, for several reasons, simple conversions using the relevant market exchange rate may provide misleading results regarding the value of output.

Purchasing Power Parity (PPP)

Results may be misleading because a US dollar might buy different quantities of comparable goods and services in the countries being compared. If a single dollar buys more in Australia than in Norway, then the purchasing power of a dollar is higher in Australia.

Price differences

The solution is to adjust the market exchange rate to eliminate the effects of price differences in the countries compared. GDP (or other values) can then be adjusted to find a more realistic value – a process called adjusting for PPP.

Hypothetical example

Price differences in countries form the basis of adjusting the exchange rate. For example, if a bottle of Coca-Cola costs $1 in the US, and the same bottle costs $AS 1.4 in Australia, then the PPP for Coca-Cola between Australia and the United States is 1.4/1. So, for every dollar spent on a given quantity of Coca-Cola in the US, 1.4 Australian dollars would have to be spent in Australia. In Norway, the same bottle of Coca-Cola might cost the equivalent of $2.00, hence the PPP between Norway and the US is 2.0/1 - for every dollar spent on Coca-Cola in the US, the equivalent of $2.00 is needed in Norway.

The same process if used to construct PPPs for a wide range of products. [2]

How does using PPPs affect GDP listings?

When using exchange rates adjusted for PPPs, the IMF forecast for international GDPs for 2021 puts China in first position (from second, using market exchange rates) and raises India to third position (from sixth, using market exchange rates.) Russia's position also rises from eleventh to sixth.

Chart showing international league table of countries according to purchsing power parities in 2021

Exchanges rates reflect internationally traded goods

Of course, one problem with making comparisons is that current exchange rates reflect the international flows of traded goods. So, adjusting the exchange rate to consider price differences for Coca-Cola is relatively straightforward.

However, the value of output produced in a country is not just about internationally traded goods, but non-traded local goods, and especially services, such as lawyers, accountants, hairdressers, and cleaners.

The fact that local services are not internationally traded makes the use of current exchange rates much less useful for calculating GDP values and presents challenges for those create PPP adjustments.

General criticisms of using GDP to make comparisons

In addition to issues regarding international price differences, there are some weaknesses and criticism of making comparisons between countries and within one country over time. These include:

Hidden transactions are missing

The problem of hidden transactions can affect geographical and historical comparisons. Hidden transactions add value to an economy but are not included in raw GDP data. This is likely to mean that countries where transactions are hidden and unrecorded, including many developing countries, have a relatively higher GDP than indicated by unadjusted GDP data. Also, over-time, countries may better track transactions, and find ways to record economic activity. This means that some of historical increase in GDP could simply arise as a result of more effective data collection. Most economies make estimates of the size of their hidden economy, but these are, estimates, never-the-less.

Income distribution

GDP figures on their own make no reference to the distribution of income across a population. For example, GDP per capita is a simple (mean) average and gives no clue about how the average income is distributed. For example, while the average per capita GDP in India has increased considerably over the last 20 years, from around $440 in 2000 to just over $2000 in 1990 [3] which has clearly provided benefits in terms of reduced absolute poverty and raising of living standards for many, most metrics [4] of inequality suggest that over the same period inequality has risen.  See the Kuznets curve.

Quality variations

Over time products and services improve and develop, and while every effort is made to factor this into comparisons over time, including using identical weights and volumes, many products have improved considerably over time. This means that GDP figures between 2000, and 2020 are unlikely to reflect the fact that products have changed in quality.

Other factors

In addition to the above, GDP figures may mask how resources are used in the process of generating output. Two countries could have an identical GDP per capita figure, but the number of hours worked could be quite different. Also, working conditions can vary considerably, meaning that comparisons are distorted.

These issues are relevant to the first question - how useful is GDP as a narrow measure of economic growth?

Economic wellbeing

The second question regarding the value of GDP is whether it is an indicator of the wellbeing of a country's citizens, and indeed, whether an increase in economic growth always generates benefits.

This was the question posed by English economist, E J Mishan, who in 1965 produced a strong critique of the assumption that economic growth only brought about benefits. In his ground breaking The Costs of Economic Growth [6] [published in 1967] he argued that growth is likely to lead to widespread negative externalities, which would reduce the value of any growth. Mishan became one of the first 'environmental economists' and his work and ideas have had a significant impact on the development of welfare economics, including the use of cost-benefit analysis.

Environmental degradation

Since the work of Mishan, economists have widened the debate, both in terms of raising questions about the benefit of economic growth, but also the extent to which GDP should be regarded as an indicator of wellbeing.

GDP figures clearly do not include any reference to the impact of environmental degradation on the welfare of a country's citizens. As countries get richer, and GDP grows, production and consumption externalities are likely to increase. The world's biggest polluters are not only the developed 'rich' economies, but also the rapidly emerging countries including China, India and Brazil. [5}

This means that other measures, such as that of Tobin and Nordhaus's Measure of Economics Welfare (MEW), widen the definition of wellbeing to move away from the narrow use of unadjusted GDP figures and to include degradation of the environment. This was further developed in the Index of Sustainable Economic Welfare (ISEW).

Public spending may not add to wellbeing

Public spending, which is included in the national income accounts that help generate GDP figures, may not add to the wellbeing of citizens. The case of the Great Pyramids in Ancient Egypt is often cited of as an example of colossal spending and the use of scarce resources that benefitted a small number of Pharaohs and their administrators and had little impact on the wellbeing of the majority of Egyptian citizens.

Of course, many of the projects of the Pharaohs did benefit citizens more widely, including using gangs of slaves to dredge the Nile to ensure a continued water supply. The point here is that government spending it not, on its own, necessarily going to increase wellbeing - even taking into account the wider multiplier effects of spending.

Other ways to track economic wellbeing

The Genuine Progress Indicator - GPI

The Genuine Progress Indicator (GPI) is one of several attempts to develop a comprehensive index of the overall economic progress an economy is making and includes social and environmental categories.

The Genuine Progress Indicator - GNI

There are different versions of this, and a several countries have adapted the concept to develop their own GPI. Of course, with so many versions using the GPI for comparative purposes is made difficult.

There is also the broader criticism that as economists have looked for ever wider and more comprehensive indices, and moved away from narrow GDP indicators, some categories included are increasingly hard to value.

Conclusion

The great benefit of GDP is that it is relatively simple to measure, employs common national accounting standards, is easy to understand, and is frequently measured and published. In contrast, more comprehensive indices are complex to create, have no agreed standards, are less easy to understand, and cannot be produced on a regular basis.

When the analysis is extended to consider economic development, the Human Development Index (HDI) has been the the widely accepted metric since it was launched by the United Nations Development Programme in 1990.


Economic development

Measuring development

Development
Externalities

What activities create externalities?

Externalities
Supply-side policy

Can supply-side policy promote development?

Supply-side policy

[i] William Petty - https://en.wikipedia.org/wiki/William_Petty

[ii] Charles Davenant - https://en.wikipedia.org/wiki/Charles_Davenant

[iii] Simon Kuznets - contribution to GDP covered in: - https://en.wikipedia.org/wiki/Gross_domestic_product

[1] World Bank - https://datahelpdesk.worldbank.org/knowledgebase/articles/Economic growth, viewed March 16, 2020.

[2] OECD - https://www.oecd.org/fr/sdd/purchasingpowerparities-frequentlyaskedquestionsfaqs.html

[3] World Bank - https://data.worldbank.org/indicator/NY.GDP.PCAP.CD?locations=IN

[4] Oxfam - https://www.oxfamindia.org/sites/default/files/himanshu_inequality_Inequality_report_2018.pdf

[5] Our World in Data - https://ourworldindata.org/contributed-most-global-co2

[6] Mishan, Ezra J., The Costs of Economic Growth, Staples Press, 1967. viewed June 8 2021, https://www.amazon.co.uk/dp/028661619X/