Contents
Imagine a country without any way to gauge its economic performance. How would policymakers know if the economy is growing, shrinking, or stagnant? How would businesses decide where to invest? The ability to measure economic activity is crucial for understanding a nation’s health and making informed decisions. This guide sheds light on the various methods economists use to quantify a country’s economic output, offering a clear picture beyond just the flow of money. Whether you’re new to economics or simply curious, this explanation will equip you with the essentials of economic activity measurement.
Why do we measure economic activity?
Economic activity is a nation’s lifeblood. It encompasses the production, distribution, and consumption of goods and services that fulfill our needs and wants. But how do we know if this engine of growth is running smoothly? This is where economic activity measurement comes in.
Measuring economic activity provides valuable insights for various stakeholders:
- Policymakers: By analyzing economic data, policymakers can assess the effectiveness of their economic policies, identify areas for improvement, and make informed decisions that promote growth, stability, and job creation.
- Businesses: Economic data helps businesses understand market trends, identify potential opportunities, and make informed investment decisions. They can assess consumer demand, analyze competitor activity, and gauge the overall economic climate to set strategic goals.
- Public: Understanding economic activity can empower individuals to make informed financial decisions, evaluate government policies, and stay informed about the overall health of the economy and its potential future prospects.
The three pillars of measurement
Economists rely on three main approaches to measuring a country’s economic activity: income, expenditure, and output. Interestingly, when applied correctly, all three approaches should arrive at the same overall number—a reflection of the country’s economic engine.
So, how do these seemingly different approaches converge on a single value? Economists utilize circular flow diagrams, also known as circular flows of income, to illustrate this concept. These diagrams depict the interconnectedness of economic actors – households, businesses, and the government – and how they interact through the flow of money, goods, and services.
Within these diagrams, economists categorize economic actors into three primary sectors:
- Households: These represent individuals and families that consume goods and services and also supply labor in the job market.
- Businesses: These are the entities that produce goods and services, utilizing labor and resources from households. Businesses then sell these outputs back to households and other sectors.
- Government: This sector plays a crucial role by providing public services, infrastructure, and regulations. The government collects taxes from households and businesses to finance its activities.
An additional sector, the external sector, can be included to account for international trade. This sector encompasses the same three actors (households, businesses, and government) from foreign countries, interacting with the domestic economy through exports and imports.
Circular flow model
Under a closed economy, economic activity does not involve the external sector. Thus, the circular flow diagram only depicts the relationship between the domestic, business, and government sectors in the country.
In contrast, the circular flow model includes the external sector under an open economy. Relations with the external sector involve exports and imports. Exports represent the sale of domestic goods and services to economic actors abroad, while imports represent foreign goods and services purchased by domestic economic actors.
Exports inject money into the domestic economy as money flows from external economic actors to the domestic economy. On the other hand, imports represent leakage because they attract money from the domestic economy to foreign countries.
Simple circular flow of income
The simplest model only uses the business and household sectors. The two interact in the product market and the factor market.
The household sector acts as a consumer in the goods and services market. However, in factor markets, it acts as a supplier or seller. Meanwhile, businesses play opposite roles in both markets, acting as suppliers in the goods and services market (product market) and buyers in the factor market.
In this simple model, economists show us how spending on output by households becomes income for businesses and vice versa. In the product market, households spend their money on goods and services, which in turn become income for the business. The business then uses the income to purchase factors of production, such as labor, in the factor market.
Thus, spending by households becomes income for businesses. And conversely, spending by businesses becomes income for households. This simple way of working explains how we will get an equal number when measuring economic activity using the output, expenditure, and income approach.
Understanding GDP and GNP to measure economic activity
Economists introduce gross domestic product (GDP) and gross national product (GNP) measures for economic activity. GDP represents the output produced in a country, regardless of who produces it. Meanwhile, GNP represents the output produced by citizens, regardless of where they produce it.
For example, Indonesia’s GDP only calculates output produced domestically, perhaps by Indonesians or foreigners. Meanwhile, Indonesia’s GNP only considers the output produced by Indonesians, regardless of where they produce it, whether domestically or abroad.
Since the output is equal to income, we can also say GDP and GNP as measures of the total income earned by the providers of factors of production. GDP represents the total income earned by Indonesians and foreigners who produce in Indonesia. Meanwhile, GNP represents the total income earned by Indonesians working in the country and abroad.
So, if your brother works abroad, his income is included when calculating GNI but not in GDP. Meanwhile, your income, because you are working domestically, is calculated in GDP but not GNP. Likewise, your foreign friends’ income is also calculated in GDP because they work and produce domestically.
Another measure related to GDP is green GDP. It is the GDP after adjusting for environmental costs, such as natural resource depletion and environmental degradation. It is used to measure continuity.
Calculating GDP with three approaches
As noted earlier, economists use three approaches to calculate GDP to measure economic activity: output, expenditure, and income.
Output approach. Economists calculate GDP by adding the value of all final goods and services produced in the economy in a year. The key word is final goods and services. Thus intermediates are excluded from the calculation under this approach.
The final value method can also be approached using a value-added method. It is calculated by subtracting the output value from the input value for products along the production chain, including considering intermediate goods.
Expenditure approach. GDP is equal to the total expenditures by the four sectors of the economy: household spending, business investment, government spending, and net exports. The last is the difference between exports and imports.
- GDP = Household spending + Business investment + Government spending + Net exports
Income approach. Economists add up the income received by the providers of the factors of production: land, capital, labor, and entrepreneurship. The income includes rent, interest, wages, and profits.
Calculating GNP
GNP equals GDP after adjusting for net factor payments (also known as net factor income). GNP with gross national income (GNI) is the equivalent. Like the GDP calculation, GNP and GNI are different names even though they both measure the same. GNP uses the output approach, while GNI uses the income approach.
The formula for GNP/GNI is:
- GNP = GDP + Net factor payments = GDP + Factor payments from abroad – Factor payments abroad
Factor payments abroad refer to the income earned by foreigners and foreign companies domestically, while factor payments from abroad refer to the income earned by citizens or domestic companies in other countries.
Nominal vs. real GDP
When reading GDP figures, we may encounter the terms nominal and real GDP. Other terms we might encounter are GDP at current prices and GDP at constant prices. So, what’s the difference between them?
Nominal GDP is another name for GDP at current prices. Real GDP is another name for constant price GDP.
As the name suggests, nominal GDP is calculated using current prices. For example, let’s say we are calculating nominal GDP in 2020. We use prices for that year to calculate the final value of goods and services. Likewise, when we calculated nominal GDP in 2021, we used prices in 2021.
- Nominal GDP 2020 = Final output quantity in 2020 x Prices in 2020
- Nominal GDP 2021 = Quantity of final output in 2021 x Price in 2021
- Real GDP 2020 = Quantity of final output in 2020 x Prices in 2020
- Real GDP 2021 = Quantity of final output in 2021 x Prices in 2020
In contrast, real GDP uses constant prices. Let’s say 2020 is the base year for calculations. So, when calculating real GDP in 2021, we used prices in 2020. And real GDP in 2020 uses prices in 2020. Then, in 2022, we will continue to use prices in 2022 when calculating the final value of goods and services.
When to use nominal and real values?
Changes in nominal GDP from year to year occur due to two factors:
- Price changes
- Output quantity change
Meanwhile, changes in real GDP represent changes in output because prices do not change, i.e., they are the same as prices in the base year. For this reason, real GDP is widely used to measure economic growth, which shows us the growth in economic activity as measured by the output produced.
Meanwhile, nominal GDP is used to measure economic size. For example, how big is the United States economy in 2021? We can answer this by looking at nominal GDP. This approach makes more sense than real GDP because we use prices in 2021. On the other hand, using real GDP is probably unrealistic because it uses prices in the base year, which were probably prices ten years ago and have changed significantly compared to 2021.
Apart from being an economic size, for example, we can also use nominal figures to measure how much household spending or business investment contributes to the economy in a given year.
Long story short, real GDP is useful for time series comparisons. Meanwhile, nominal GDP is useful for comparison at a certain point in time (cross-section).
GDP per capita
Per capita means per head. GDP per capita means nominal GDP divided by the total population. It shows the output produced by each person. As mentioned above, nominal GDP per capita is more appropriate for cross-section comparisons. Meanwhile, real GDP per capita is more appropriate for time series comparisons.
For instance, economists usually focus on changes in real GDP per capita from year to year when evaluating trends in a country’s standard of living. Its increase over time significantly impacts improving the standard of living. Higher real GDP per capita indicates the country is more productive because it produces more output. That ultimately drives an increase in income and positively impacts several aspects, such as better health and education.
Limitations of GDP
Gross Domestic Product (GDP) is a powerful tool for measuring economic activity, but it’s important to recognize its limitations. While it provides a valuable snapshot of a country’s output, GDP doesn’t capture the whole picture. Here are some key aspects it doesn’t fully account for:
- Income inequality: GDP doesn’t tell us how wealth is distributed within a country. A rising GDP could simply mean the rich are getting richer while the standard of living for the average citizen remains stagnant.
- Environmental impact: Economic activity often comes at an environmental cost. Pollution, resource depletion, and climate change aren’t reflected in GDP calculations, so a high GDP could mask significant environmental degradation.
- Non-market activities: GDP only considers production that is exchanged in a market. Unpaid work like childcare, volunteer efforts, and household chores contribute significantly to well-being but are not included in GDP.
- Quality of life: GDP doesn’t measure factors that directly affect quality of life, such as access to healthcare, education, leisure time, or social well-being. A high GDP doesn’t necessarily equate to a happy or healthy population.
Understanding these limitations is crucial when interpreting GDP data. While it’s a valuable indicator, it should be used alongside other metrics to get a more comprehensive picture of a country’s economic and social well-being.
Beyond GDP: other economic indicators
While Gross Domestic Product (GDP) is a widely used measure of economic activity, it doesn’t tell the whole story. To gain a more comprehensive understanding of a country’s economic health, economists consider several other key indicators:
- Unemployment rate: This measures the percentage of the labor force actively seeking employment but unable to find it. A low unemployment rate suggests a strong economy with businesses actively hiring.
- Inflation rate: This tracks the rise in prices of goods and services over time. A controlled level of inflation can indicate a healthy economy, but high inflation erodes purchasing power and hinders growth.
- Poverty rate: This measures the percentage of the population living below a certain income threshold. Understanding poverty levels helps policymakers develop targeted programs to address inequality and improve living standards.
- Gini coefficient: This measures income inequality within a country. A higher Gini coefficient indicates greater inequality, while a lower value suggests a more even distribution of wealth.
- Human Development Index (HDI): This composite index goes beyond just economic output. It considers factors like life expectancy, education levels, and standard of living to provide a more comprehensive picture of human well-being and development.
By analyzing these economic indicators alongside GDP, we gain a deeper understanding of a country’s strengths and weaknesses. This allows policymakers and businesses to make more informed decisions, ultimately leading to more sustainable and equitable economic growth.
