Measuring Economic Performance

Measuring Economic Performance

In this lesson, you’re expected to learn about:
– key economic indicators
– the relevance of Gross Domestic Product (GDP) as a measure of performance
– the main components of GDP and how it is calculated

The performance of an economy is usually assessed in terms of the achievement of economic objectives.

These objectives can be long term, such as sustainable growth and development, or short term, such as the stabilization of the economy in response to sudden and unpredictable events, called economic shocks.

To know how well an economy is performing against these objectives economists employ a wide range of economic indicators.

Economic indicators measure macro-economic variables that directly or indirectly enable economists to judge whether economic performance has improved or deteriorated. Tracking these indicators is especially valuable to policy makers, both in terms of assessing whether to intervene and whether the intervention has worked or not.

Key Economic Indicators

• Levels of real national income, spending, and output.
These three key variables indicate whether an economy is growing, or in recession.
• Investment levels and the relationship between capital investment and national output.
• Levels of savings and savings ratios.
• Price levels and inflation.
• The purchasing power of a country’s currency.
• Debt levels with other countries.

Components of Macro Environment
Enlarged version:
Gross Domestic Product

The most important overall indicator of economic performance and output is GDP.

GDP measures the total value of all final production that occurs within a country over a period of time (normally a year). 

It is also a measure of annual spending on new domestic production and income earned from production.

GDP is probably the best measure of the overall condition of the economy because it includes the output of all sectors of the economy.

Relevance of GDP

GDP has become widely used as a reference point for the health of national and global economies.When GDP is growing, especially if inflation is not a problem, workers and businesses are generally better off than when it is not.

Real vs. Nominal GDP

Nominal GDP is reported using current prices while Real GDP reports output, holding prices constant.

Nominal GDP includes both prices and growth, while real GDP is pure growth.

As a result, nominal GDP is usually higher.

Measuring GDP

GDP measures the monetary value of final goods and services—that is, those that are bought by the final user—produced in a country in a given period of time (say a quarter or a year).It counts all of the output generated within the borders of a country. GDP is composed of goods and services produced for sale in the market and also includes some non-market production, such as defense or education services provided by the government.

Who Measures GDP?

GDP in a country is usually calculated by the national statistical agency, which compiles the information from a large number of sources.In making the calculations, however, most countries follow established international standards. The international standard for measuring GDP is contained in the System of National Accounts, 1993, compiled by the International Monetary Fund, the European Commission, the Organization for Economic Cooperation and Development, the United Nations, and the World Bank.

Who Measures GDP?

GDP in a country is usually calculated by the national statistical agency, which compiles the information from a large number of sources.In making the calculations, however, most countries follow established international standards. The international standard for measuring GDP is contained in the System of National Accounts, 1993, compiled by the International Monetary Fund, the European Commission, the Organization for Economic Cooperation and Development, the United Nations, and the World Bank.

For example, unpaid work (such as that performed at home or by volunteers) and black-market activities are not included because they are difficult to measure and value accurately.

Moreover, “gross” domestic product takes no account of the “wear and tear” on the machinery, buildings, and so on (the so-called capital stock) that are used in producing the output.

If this depletion of the capital stock, called depreciation, is subtracted from GDP we get net domestic product (NDP).

There are four major components of GDP:

1) Personal Consumption Expenditure
2) Gross Investment
3) Government Spending
4) Net Exports

In 2014, the GDP of the United States totaled $17.4 trillion, the largest GDP in the world. Below is a breakup of the components.

Source: Bureau of Economic Analysis
Enlarged version:

1) Personal Consumption Expenditure

Personal consumption expenditure is simply the act of purchasing goods and services. Households engage in this consumption.

Personal consumption can be broken down into:
• consumption of durable goods*
• consumption of non-durable goods**
• consumption of services

* Durable Goods: goods that do not quickly wear out, or more specifically, yield utility over time.
** Non-Durable Goods: goods that are immediately consumed in one use or ones that have a lifespan of fewer than 3 years.

Consumption expenditure by households is normally the largest component of a nation’s GDP.

Thus, consumers’ spending decisions are a major driver of the economy.

2) Gross Investment

Investment can mean a lot of things, but here, investment expenditure refers to purchases of physical plants and equipment, primarily by businesses.

Investment demand is very important for the economy because it is where jobs are created, but it fluctuates more noticeably than consumption as business investment is volatile.

3) Government Spending

Government spending is also important for an economy and can account for a large percentage of GDP.

It’s important to remember that a significant portion of government budgets are transfer payments—like unemployment benefits and Social Security payments to retirees—that are excluded from GDP because the government does not receive a new good or service in return.

The only part of government spending counted is government purchases of goods or services produced in the economy—for example, a new fighter jet purchased for the Air Force (federal), construction of a new highway (state), or building of a new school (local).

General Government Spending (% of GDP, 2015)
Source: OECD National Accounts Statistics

Enlarged version:

4) Net Exports

The net export component of GDP is equal to the value of exports minus imports.

The gap between exports and imports is called the trade balance. If a country’s exports are larger than its imports, then a country is said to have a trade surplus. If, however, imports exceed exports, the country is said to have a trade deficit .

Calculating GDP

GDP can be calculated by adding all of the expenditures on new domestic output. Households, businesses, governments, and other nations all spend money in the economy and each is represented in GDP by a different spending variable.

The formula to calculate GDP is:
Y = C + I + G + NE

where Y = Output
C = Personal Consumption Expenditure
I = Investment Expenditure
G = Government Spending
NE = Net Exports (Exports – Imports)

Approaches to GDP

So far we’ve looked at GDP as a sum of expenditures. However this is not the only way to measure the growth of the economy.

There are two other approaches that economists use:

– Income Approach
– Output or Production Approach

Let’s quickly recap the Expenditure Approach.

The expenditure approach adds up the value of purchases made by final users.For example, the consumption of food, televisions, and medical services by households; the investments in machinery by companies; and the purchases of goods and services by the government and foreigners.

1) Income Approach

The income approach sums the incomes generated by production. For example, the compensation employees receive and the operating surplus of companies.

Theoretically, GDP should remain the same whether you use the income approach or expenditure approach (since income = expenditure).

The ability to engage in consumption, investment, government spending, and net exports derives from the income earned, producing domestic output.

Income includes all of the rent, wages, interest, and profits earned by selling the factors of production.

2) Output or Production Approach

Another way of calculating the GDP is to add together all of the production activity in a country.

In this approach, the value-added at each stage of the production process is calculated.

Value-added is defined as total sales minus the value of intermediate inputs that go into the production process.

For example, flour would be an intermediate input and bread the final product.

Others way to measure the Economy

Gross domestic product, GDP, is one way of measuring the size of the economy—but it’s not the only way.

We can also measure the size of the economy by calculating gross national product, GNP, or net national product, NNP.

Net national product (NNP), is GNP minus depreciation.

Depreciation is the process by which capital ages over time and therefore loses its value.

Gross National Product (GNP)

An alternative concept, gross national product includes all the output of the residents of a country.

Specifically, GNP counts the investments made by a country’s residents and businesses, both within and outside the country.

In addition, it includes the value of all products manufactured by domestic businesses, regardless of where they are made.

On the other hand, GNP doesn’t count any income earned by foreign residents or businesses. Therefore, it doesn’t include investments made by overseas residents. It also excludes products manufactured in a country by overseas businesses.

Thus, GNP is a more accurate measure of a country’s income than its production.

For example, if a German-owned company has a factory in the United States, the output of this factory would be included in U.S. GDP, but not in GNP.

[Optional] Difference between GDP & GNP
Watch this 7-minute video to learn more:

What GDP Does Not Reveal

It is also important to understand what GDP cannot tell us. GDP is not a measure of the overall standard of living or well-being of a country. Although changes in the output of goods and services per person (GDP per capita) are often used as a measure of whether the average citizen in a country is better or worse off, it does not capture things that may be deemed important to general well-being.

Increased output may come at the cost of environmental damage or other external costs. Or it might involve the reduction of leisure time or the depletion of non-renewable natural resources. The quality of life may also depend on the distribution of GDP among the residents of a country, not just the overall level.

To try to account for such factors, the United Nations computes a Human Development Index (HDI), which ranks countries not only based on GDP per capita, but on other factors, such as life expectancy, literacy, and school enrollment.

Other attempts have been made to account for some of the shortcomings of GDP, such as the Genuine Progress Indicator and the Gross National Happiness Index, but these too have their critics.

Check out this link to see the HDI Value of your country:
[Optional] Five measures of growth that are better than GDP
Variation in Real GDP Growth (annual % change)
Enlarged version:
Source: IMF World Economic Outlook, October 2016
[Optional] Problems with GDP as an Economic Barometer
Watch this 8-minute video of Nobel-prize winning economist Joseph Stiglitz to learn more:
[Optional] Is GDP a satisfactory measure of growth?
Jim Rohn