GDP and the Business Cycle Economic Health Memo - Term Paper Example

The business cycle, predictive statistics and government policy are obviously all intertwined. GDP and the business cycle are closely tied together. But how much? Is GDP actually good at predicting the future of the market? And what do the commensurate fiscal policies do to the economy? GDP is different from GNP. GDP is the domestic product: It is all the things and services that were produced domestically, no matter who owned them, even if it was foreign buyers. GNP, meanwhile, is the amount held by the nation, including the value of its overseas investment.

GDP is about the borders of the nation, GNP about the national ownership. But both are used to predict the business cycle. GDP is designed to help firms manage uncertainty (Roubini). By getting a feeling for how the whole economy is doing, business managers can decide whether or not to pursue risky policies or batten the hatches and wait for things to get better. In general, markets go through boom-bust cycles about every twenty years (Mead, 1992). Knowing how GDP is doing now helps to predict if we're in a boom or a bust, which is important to the business cycle.

However, GDP's value as an economic indicator, and therefore a predictor of the business cycle, is coming under attack now. Roubini, for example, points out that, “The best advice I can give you is to realize that there is an unavoidable amount of uncertainty in the economy. This is even more true of firms and their financial statements. So what do we do? My choice is to get out of this game altogether, but not everyone has this option---a firm, for example, has to forge ahead the best it can.

The first thing you should know is that there's a lot of uncertainty out there, and no amount of commercial forecasting is going to change that”. Roubini is saying that GDP isn't ever for certain: It can be determined one year then the same year can be revised a whole percentage point later! It's hard to predict things like wars or terrorist attacks. In fact, GDP is very easy to “game” (Ritholtz, 2010). “[Y]ou simply under-report inflation, and GDP appears to be better than it is”. Since inflation depends on counting the value of a good last year, and doing so across many goods to make sure that it's not just one or two goods that grew in price for other reasons, there's a lot of subjectivity and uncertainty in making it.

GDP is also not as helpful as it could be because it positively counts negative externalities (Ritholtz, 2010). That means that pollution, which is a bad thing, is counted as a good thing because it makes people spend money to go to the doctor or buy new houses to move. “If you buy a car, the GDP goes up. If you cut a tree, the GDP goes up. But if you preserve the tree, the GDP does not grow. Now you have to decide whether you need the tree or the GDP” (Sharma, 2010). Thus, it is hard to use the GDP to predict the business cycle, and economists are looking for a better indicator of economic health.

Fiscal policies are guided by economic facts and by measures like the GDP: As we've seen already, the GDP's inadequacies can cause lawmakers concerned only with increasing the GDP to increase externalities such as injured workers, ecological damage and health costs as a byproduct, and not reap the consequences or even be aware of them. But what about fiscal policy and unemployment? The jury is out as to whether reducing or increasing taxes, reducing or increasing spending, etc. is better for production and employment.

A major Heritage Foundation study finds that “a large and growing government is not conducive to better economic performance. Indeed, reducing the size of government would lead to higher incomes and improve America's competitiveness” (Mitchell, 2005). Mitchell cites a Rahn curve, which says that there's a curve in tax revenue between 0 and 100%. The theory is simple: If you tax 100% of income, no one produces anything; but if you tax 0%, the government