Principles of Macroeconomics - Example

PRINCIPLES OF ECONOMICS By of the of the School Introduction Gross Domestic Product (GDP) refers to the widest quantitative measure of the total economic activity of a nation. More specifically, GDP denotes the total monetary value of all products and services manufactured within geographic borders of a nation over a particular period of time. It is defined by OECD (Maddison, 2003: p.1) as "an aggregate measure of production equal to the sum of the gross values added of all resident institutional units engaged in production (plus any taxes, and minus any subsidies, on products not included in the value of their outputs) ." The estimates of GDP are usually used to measure the economic or monetary performance of an entire nation or region; however, it can also be used to measure the relative or comparative contribution of an industry sector (Edward et al 2010:197). GDP is often used to gauge the standard of living of a country. However, the critics of GDP as an economic measure maintain that the statistic ignores the underground economy, those transactions that, for any given reason, are not reported to the government. Some, on the other hand, maintain that GDP is not intended to assess material well-being. They say that it serves as a measure of productivity of the nation, which is not related. GDP can be expressed in either nominal or real terms. Real GDP reflects the value of all services and products manufactured within a nation during a given period, using a constant producer and consumer price indices to eliminate the effects of escalating price levels (inflation). Nominal GDP, on the other hand, reflects the total value of produced goods and services during a given period, but it uses their prices at the time of production. Periods of growth in real GDP are considered to enhance the welfare of individuals because economic growth permits a rise in average incomes, thereby supporting a superior level of consumption (Mankiw, 2012: 213). In contrast, periods of negative growth in real GDP are linked with lower consumption, lower incomes and thus a lower standard of living. The most well-known use of GDP estimate is the determination of the growth of the economy from one year to another (and recently from one-quarter to another). The growth pattern of GDP is kept to reveal the failure or success of an economic policy and to uncover whether an economy is in recession. Determining GDP There are three different ways (approaches) that can be used in determining the GDP. All the three methods are believed to yield the same result. Such approaches include the income approach, the expenditure approach, output (or production or value approach) approach. Among the three methods, production approach is the most direct as it sums the outputs of each category of enterprise to attain the total (Hall & Lieberman, 2010: 552). The income approach assumes that all the incomes of the productive factors should be equivalent to the value of their product. It arrives at the GDP by summing up all the incomes of the producers. The expenditure approach assumes that all the products must be purchased by somebody; hence the value of the total products should be equivalent to the total expenditures of people in buying things (Mankiw, 2012: 214). Description how Gross Domestic Product (GDP) is calculated The equation used in the computation of GDP is as follows: GDP = Consumption (C) + Government Expenditures (G) + investment (I)+ (Exports – Imports) (NX) GDP= C + G + I + NX The following are the components used to compute the GDP: Consumer spending (consumption) refers to the sum of household expenditures and it includes expenditures on services, nondurable goods, for instance, clothing and food, and finally durable goods, for instance, items that are expected to last more than three years. Government expenditures refer to the total expenditures by all government bodies on services and goods. Government expenditures include naval ships, roads, schools and salaries to employees (recurrent expenditures and capital expenditures). Investment spending refers to the total expenditures on business inventories, capital equipment and structures ((both residential, plant and equipment, and nonresidential). Finally, the net export is the difference between expenditures on local goods by foreigners (exports) and expenditures on foreign goods by local residents (imports) (Mankiw, 2012: 213). Example of GDP calculation Transfer payment $540 Interest income $1500 Depreciation $360 Wages $670 Gross private investment $1240 Business profits $2000 Indirect business taxes $740 Rental income $750 Net exports (X-M) $180 Net foreign factor income $120 Government purchase $1560 Household consumption $3040 Expenditure approach GDP = C + G + I + (X - M) GDP = $3040 + $1560 + $1240 + $180 GDP = $6020 Income approach GDP = NI + Indirect Business Taxes + Depreciation NI = W + R + i + PR Where, W= wages, R= rental income, i= interest income and PR= business profit Therefore: NI = $670 + $75 + $1500 + $2000 NI = $4920 Hence, GDP = NI + Indirect Business Taxes + Depreciation GDP = $4920 + $740 + $360 GDP = $6020 It is evident that the two methods give the same results. The economy of the country is said to be in recession in case the GDP declines for two or more consecutive quarters. However, if a country’s GDP is growing too quickly, the fears of inflation arise. The economy is then stimulated by the Federal Reserve by raising rates of interest (Hall & Lieberman, 2010: 555). Discussion how good a measure GDP is of a country’s economic well-being In the recent years, the idea of having growth in GDP as the main target of the country’s economic policy has been strongly criticized. Many economists have argued that GDP is not able to adequately reflect the nation’s true health and should, therefore, be replaced by more comprehensive measures (Edward et al. 2010:211). The GDP is able to measure the economic performance of a country since it is determined by the total market value of all final services and goods. It has been in used since 1934. The exclusive use of this measure has put the US at or close to the top for decades. Today, many experts argue that GDP measures are far too narrow to assess the nations and its people’s overall health. Many criticisms have been leveled against the use of GDP as a target of policy (Maddison, 2003: p.120). Firstly, GDP analysis does not include free time or leisure. The additional day of leisure reduces the GDP number. Using GDP as a measure of happiness or wellbeing does not make sense because it is just a mere measure of the total value o0f output. A very industrious country is likely to have a high GDP value, but nearly its entire people could be sick and overworked, translating to a poor measure of well-being (Mankiw, 2012: 213). It does not create a good work-life balance. For instance, the US maybe having a very high GDP because the average worker there may be the most hardworking employee in the Western nations, according to the UN International Labor Organization because they currently work for far more hours than a generation ago, however such hard work produces a negative net increase in their standard of living (Oulton, 2012: 25). According to Dr. Ed Diener and Dr. Martin Seligman and Dr. Sonja Lyubomirsky, world experts on the issue of happiness, beyond the fundamental level of needs to support life, such as water, housing, adequate food and clothing, the level of happiness can be increased by things like meaningful close relationship; living in the present; accepting responsibility of one’s life; an optimistic, positive frame of mind; practicing an altruistic life, with compassion, gratitude and forgiveness; and engaging in meaningful work. It is not just GDP that contributes to happiness because people may not be happy even if they have a high GDP (Oulton, 2012: 19). In 1968, Robert Kennedy made the following comment regarding GDP “Our gross national product…counts air pollution and cigarette advertising and ambulances…It counts the destruction of our redwoods…Yet it does not allow for the health of our children the quality of their education or the strength of our marriages; neither our wisdom nor our learning; neither our compassion nor our devotion to our country which makes life worthwhile.” A country’s exclusive reliance on economic measurement has aligned them around managing the financial assets or resources that do not create value. Among all developed nations, the US has the greatest gap between the rich and the poor, the worst child well-being and the lowest level of trust among people (Maddison, 2003: p.91). The second argument against the use of GDP as a measure of well-being is its treatment of defensive expenditures. This category includes expenditures on military, security, police, lawsuits, services for drug addiction, construction of dams to protect human settlements from flooding and clean-up costs after an oil spill, for instance in the gulf of Mexico. Such expenditures contribute positively to the GDP of a country but clearly they do not contribute to the well-being (Edward et al. 2010:199). The services and goods included in the GDP tend to lower our well-being. Just because they are being purchased by a nation does not imply that they improve the well-being of such nation. It is, therefore, clear that GDP is not a good measure because it overestimates what it is supposed to approximate; that is social welfare. For instance, The US has the greatest gap between the rich and the poor, the worst child well-being and the lowest level of trust among people despite having more than a quarter of its federal budget spent on the military (Hall & Lieberman, 2010: 552). The total cost of the Afghanistan Iraq wars is currently creeping up to $10 trillion. Therefore, the growth of GDP is not a good indicator of enhancing the quality of life because it ignores the bigger picture. The quality of life in US depends on several different variables, and GDP is just a small portion of them (Mankiw, 2012: 215). Thirdly, GDP fails to account for the underground economy. It relies on official data and hence fails to take into account the amount of the underground economy that may be significant in some nations, for instance, the cash generated from drug trafficking in Mexico. GDP figures, therefore, underestimates the nation’s true living standards due to the existence and the expansion of the black economy. Economic activities that take place there normally go unrecorded by the country’s Inland Revenue and Customs & exercise. Such activities are not included in the GDP statistics although they may possess immense influence on the welfare particularly of the poorest parts of the society (Oulton, 2012: 15). Finally, GDP is often computed at market values or prices. It, therefore, ignores externalities specifically (but not only) environmental ones. Therefore, increasing national output is normally accompanied by a rise in environmental pollution and other negative externalities. Such conditions often have negative effect or impact on the economic welfare (Edward et al. 2010:197). In addition, the output figures give a little information about the quality of services and goods produced. The GDP fails to take into account the dimension of interrelation and the economic system’s dependence on its surrounding (Maddison, 2003: p.19). The application of GDP to measure wealth does not reflect the idea of economics being incorporated into a system of the closed biosphere. An increase in GDP causes an unbalanced constellation of the general factors that are responsible for wealth thus having a negative influence on the whole wealth concerning culture and environment. Therefore, the pursuit of rise in income does not make people individually or collectively better off. GDP emphasizes economic output and fails to consider economic well-being (Mankiw, 2012: 213). It does not measure the development of a nation or the well-being of the citizens, For instance, the rapid growth in GDP may increase income disparity. It is an imperfect measure in certain cases, for example, it ignores profits earned in a country by foreign corporations that are paid back to overseas investors (Hall & Lieberman, 2010: 552). This may overstate the actual economic output of the country. For example, in 2012, Ireland had GNP of $164.6 billion and GDP of $210.3 billion. The difference of $45.7 billion, 21.7 percent of GDP, is largely due to repatriation of profit by foreign companies that are based in Ireland. References Edward Wolff, E, A Zacharias and T Masterson (2012) ‘Trends in American Living Standards and Inequality’, Review of Income and Wealth 58(2): 197-232. Hall, R. E., & Lieberman, M. (2010). Economics: principles & applications. Mason, OH, South-Western Cengage Learning. 552 Maddison, A (2003) The World Economy: Historical Statistics, OECD. Mankiw, N. G. (2012). Principles of macroeconomics. Mason, OH, South-Western Cengage Learning. 213 Oulton, N (2012a) ‘Hooray for GDP!’, Centre for Economic Performance Occasional Paper No. 30. Read More