Theme 2 Revision Notes – The UK Economy, Performance and Policies
2.1 Measures of Economic Performance
2.1.1 Economic Growth
GDP and Economic Growth
Economic growth is defined as in increase in Real GDP (actual growth) or potential growth.
Gross Domestic Product is used to measure economic growth and can be measured in 3
ways:
- Output – Total value of all goods and services produced by an economy
- Income – Total income generated by producing goods and services
- Expenditure – Total value of purchases on goods and services
Level of GDP is a measure of the total amount of goods and services produced by an
economy, whereas the rate of change of GDP looks at change in output over time. GDP is
usually measured as a rate of change; percentage changed can be represented using index
numbers to make comparisons over time.
- Year 1 – Base year, index number = 100.
- Increase in GDP is expressed as a number above 100, percentage change. For example,
20% increase, new index 120. 9% decrease, new index 91.
Real Vs Nominal GDP:
- Nominal/money GDP is GDP at current prices; it is the market value of all goods and
services produced, not adjusted for inflation.
- Real GDP is GDP at constant prices; it is the market value of all goods and services
produced, adjusted for inflation.
- Therefore, nominal GDP is usually higher than real GDP due to inflation, a rise in average
prices over time.
The GDP deflator is a measure of the level of prices of all goods and services produced
domestically; it allows a conversion between nominal and real GDP.
- GDP Deflator: (Nominal/Real) x 100
- Expressed as in index number
Total GDP represents the overall GDP for a country, whereas GDP per capita is the total GDP
divided by the population of that country.
- GDP: Total value of all goods and services produced by an economy within a countries
geographical border
- GNP: Value of all goods and services produced by citizens of a country, irrespective of
location
- GNI: GDP + net primary income.
GDP at Purchasing Power Parity:
, - GDP is a measure of economic output, however each country reports data in its own
currency, Therefore, for international comparisons, a common currency of $USD is used.
- Purchasing Power Parity (PPP) is converting one currency into another to buy the same
amount of goods.
Limitations of GDP as a measure of standard of living:
- GDP is useful as you can draw comparisons against different countries and compare it on
a per capita level.
- However, GDP does not account for unpaid work such as volunteering, which can form
large proportions of an economy.
- GDP does also not consider environmental issues and sustainability, as well as wellbeing.
- GDP does not account for equality and the distribution of wealth as it calculates GDP per
capita by taking an average.
Easterlin Paradox: At a given time, richer people are on average happier than poorer people.
However, over time, as countries and people become richer, happiness doesn’t increase
proportionally.
2.1.2 Inflation
Inflation is the sustained rise in the average price of goods and services over time.
- Deflation is the fall of average price of goods and services over time.
- Disinflation is the reduction in the rate of inflation, however still positive inflation. The
average prices of goods are still rising, but not as much as previously.
One way of measuring inflation is the Consumer Price Index (CPI):
- Consumer Price Indices are calculated by collecting over 180,000 price quotations on
around 650 representative goods and services. This basket of representative goods and
services is reviewed and updated every month, and each goods or service is weight
proportionally to the amount of income spent on them. The prices are compared to the
same month of the previous year and is a measure of inflation.
Limitations of the CPI as a measure of inflation:
- Does not account for housing costs and mortgage interest payments
- In the short term, consumers substitute away from expensive items. CPI will assume
consumers buy these items until the next annual update.
- Does not consider quality and improvement in goods and services, which may explain
their rise in average prices.
RPI is a measure of inflation that includes mortgage interest payments, meaning it is heavily
influenced by house prices and interest rates.
CPI uses a geometric mean to aggregate prices, whereas RPI uses an arithmetic mean. CPI
includes the whole population whereas RPI excludes the top 4% income earners and
pensioners.
, Causes of Inflation
Demand pull inflation: Prices in a market are determined by supply and demand, and a shift
in either causes price level to change. Inflation can therefore be caused by an increase in
aggregate demand; therefore, any factor which increases AD can increase inflation
Cost push inflation: A decrease in aggregate supply can also push prices up; when businesses
find their cost of production has risen, they will put up prices to maintain profit margins;
therefore, any factor that decreases AS (increases cost of production) increases inflation.
Another potential cause of inflation is there being too much money in an economy; if people
have access to money they will want to spend it but if there is no increase in the amount of
goods and services supplied, price will rise and inflation occurs.
- The fisher equation: MV = PT, money supply x speed of money circulating in an economy
= price level x number of transactions. Ceteris paribus, an increase in money supply
leads to an increase in price level.
Effects of Inflation
For consumers:
If people’s incomes do not rise alongside inflation, they will have less to spend, causing a fall
in living standards.
Those who are in debt are able to pay off their debt at a cheaper value, but those who are
owed money lose out because they money they get back is of cheaper value.
Low and stable inflation is essential because it brings forwards consumer spending;
consumers would rather purchase a good/service sooner rather than wait as its value
increases.
For firms:
Deflation postpones purchases as people wait for prices to fall; fall in demand and
consumption, low business confidence and fall in investment, multiplier effect.
For governments:
If governments fail to adjust taxes in line with inflation, government revenue falls, increasing
budget deficit.
2.1.3 Employment and Unemployment
Unemployment represents a waste of a country’s resources and can therefore be used as a
measure of the performance of an economy.
One way of measuring unemployment is the Claimant Count. The Claimant Count is the raw
number of people who claim unemployment benefits. Another way of measuring
unemployment is the Labour Force Survey. This is a random household survey of around
