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FOE: Session 6

Economic Growth

Gross Domestic Product

Gross National Product

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Economic Growth:

An increase in the capacity of an economy to produce goods and services, compared fromone period of time to another. Economic growth can be measured in nominal terms and in realterms.  Nominal growth is defined as economic growth including inflation, while real growth is

nominal growth minus inflation. Economic growth is usually brought about bytechnological innovation and positive external forces. 

Difference between Economic Development and Economic Growth

Economic Development Economic Growth

Single dimensional i.e. increase in output alone.Multi dimensional i.e. more output and changes

in technical and institutional arrangements.

Quantitative Changes-Change national and per

capita income.

Qualitative Change-Change in composition and

distribution of national and per capita income

and change in functional capacities.

Spontaneous in character. Regulated and controlled in character.

Continuous Change. Discontinuous Change.

Growth is possible without development.Growth to some extent is essential for

development.

Determinant of economic growth may be

economic development.

Economic development is the determinant of 

economic growth.

Solution of the problem of developed countries.Solution of the problem of under developed

countries.

 

Measuring Economic Growth

Calculating GDP

The basic formula for calculating the GDP is:

Y = C + I + E + G

where

Y = GDP

C = Consumer Spending

I = Investment made by industry

E = Excess of Exports over Imports

G = Government Spending

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There are three ways to calculate either nominal or real GDP, each yielding identical results:

1. The final goods approach - which relies on data from the production of final goods andservices

2. The value-added approach - which relies on data from the productionof intermediate goods and services

3. The income approach - this looks at incomes of workers and employers.

The final goods approach. First we should distinguish between a final good and an intermediategood. Intermediate goods are used in the production of final goods. Suppose you suddenly havethe urge to race to the nearest auto dealer and buy a new convertible. You will see glisteningunder the lights a final good. Probably the first thing you will do is kick the tires of the car. Thiswill be followed by sitting in the fresh driver's seat and giving the horn a few toots. The tires, theseat, the horn, the steel of which the car body is made are intermediate goods used in the production of the automobile that you drive off into the setting sun.

The goods we buy are a collection of intermediate goods, assembled in a unique way to producethe final good. The final goods approach to calculating GDP only counts the price thatconsumers pay for the good. It does not include the price the manufacturer paid for intermediategoods, as that would be double counting. The values of the intermediate goods are included inthe price of the final good.

The final goods calculation of GDP adds up the monetary value of all goods and services produced during a given time period (either a year or a quarter). Rather than tracking the value of goods and services produced, the price paid by end users goes into the GDP calculation. Endusers of goods and services fall into one of four categories:

1. Consumption (C)

The consumption of goods and services falls under one of the following categories:

a) Durable goods - The consumption of durable goods is considered similar to a consumer investment. Durable goods are purchased with the intention of keeping them for asustained duration of time. Examples of durable consumer purchases include washingmachines, refrigerators, automobiles, and toaster ovens.

b) Nondurable goods - In contrast to durable goods, nondurable items have a shorter life

span. An example of a nondurable consumer purchase is groceries. The life span of thetypical food is short, especially compared with the refrigerator (durable item) in which perishable foods are kept. Other examples of purchases that are considered nondurablesinclude newspapers, magazines, clothing, and hats (which are always flying off with thewind).

c) Services - Since the 1960s the fastest growing component of consumer purchases has been the area of services. Services include medical treatment, lawyers, and dry cleaners.

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2. Investment (I)

Businesses and corporations undertake investment activity that involves the purchase of goodswhich themselves assist in the production process. The categories of investment are:

a) Business Investment - This includes the actual purchases of goods used in the production process. Business investment includes the construction of new offices andfactories, and the purchase of machinery, computers, and any other equipment used toassist labor in the production of goods and services.

Business investment counts as gross investment, which includes purchases of machineryto replace worn-out equipment. If a firm replaces one machine with another that does notincrease output, then nothing is added to the nation's economy. To correct for this, netinvestment can be used, which subtracts out depreciation of existing capital from thegross (total) business investment made by firms.

 b) Residential Construction - This part of overall investment tracks the actual constructionof housing, not the sale of homes. A new home that is built during a given year is counted

in that year's GDP, while the purchase of a previously owned house has already beencounted in the GDP of the year it was constructed. In this way, only those residences thatadd to the overall housing stock count towards GDP.

c) Changes in inventories - Firms invest in inventories, which are produced goods held instorage in anticipation of later sales. Firms also stockpile raw materials and intermediategoods used in the production process. Goods held in inventories are counted for the year  produced, not the year sold.

Although inventories are a relatively small portion of the overall investment sector,inventories are a critical component of changes in GDP over the business cycle. If theeconomy is slowing down, possibly entering a recession, the bearer of the bad news willoften be an undesired accumulation of inventories. As consumers reduce their purchases,sales of goods and services slow, inventories build up, and firms slash production (layingoff employees) to reduce unwanted (and costly) inventories.

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Inventories can be considered a part of a group of leading indicators of business cycles. Byleading indicator, we mean that changes in a variable such as business inventories can lead tochanges in the future condition of the economy. To explain the linkage between changes in thelevel of business inventories in many economic sectors and economic growth, let us consider twocases: an undesired accumulation of inventory, and an undesired decrease in business

inventories. We will look at the economy as a whole.

• The economic impact of an undesired accumulation or increase in business

inventories. Businesses plan ahead and forecast future sales. Based on their expectations,they stockpile inventories of goods expected to sell in the near future. The reason issimple. Businesses want the goods available to meet customer demands or else they willlose the sale, and most likely lose it to a competitor. If there is a slowdown inconsumption in many economic sectors, then many businesses will not sell as manygoods as they had planned to. As a result, businesses will not sell off their inventories of goods as they had planned and inventories will accumulate.

When inventories accumulate due to a decrease in consumption, businesses respond byreducing orders of goods from producers. In turn, as producers face a cutback in demandfor their goods, they will decrease output. When inventories are accumulating in manysectors of the economy, reductions in the production of goods becomes widespread, andas firms reduce their output, many workers are laid off. As payrolls are reduced, thenumber of unemployed swells and the unemployment rate rises. With the reduction inoutput, GDP growth falls and if the drop in production is sharp enough, the economygoes into a recession.

•The opposite occurs with an undesired or unanticipated decrease in inventories. If thedemand for goods is greater than businesses had forecast, inventories will be rapidlydepleted. As firms restock their inventories and adjust for a higher level of sales, theyincrease their production. Increases in output require firms to employ more workers. If this is occurring throughout the economy, the unemployment rate will fall as moreindividuals find jobs and economic output will increase. This leads to a jump in economicgrowth as measured by GDP.

The surge in demand for goods and services as well as the responding hike in production

and employment comes at a possible cost. As more jobs are created, incomes rise, further contributing to an increase in the demand for goods and services. The potential result is arise in the inflation rate due to demand-pull effects. Demand-pull inflation results from price pressures caused by rising demand for a good. In addition, cost-push pressures mayalso lead to greater inflation. As firms increase their output and demand for labor, wagesmay rise, especially if the economy was already near or at full-employment. Higher wages increase production costs that may be passed on to the consumer in the form of higher prices for goods.

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The important point made here is that although inventories are a relatively minor component of GDP, rapid changes from their desired levels can have important economic consequences. Wheninventories accumulate beyond desired levels, an economic slowdown may be on the horizon as producers reduce their output. Or if inventories are rapidly being depleted, then economic growthand possibly inflation may soon rise as wage and price pressures build. Economic analysts

monitor the divergence of inventories from desired levels as a leading indicator of potentialchanges in future economic growth rates.

3. Government spending (G) includes purchases by central, state, and local governments.

The government sector tracks what the government actually spends money on. Government purchases of goods and services include stealth bombers, government-funded research, spaceshuttles, salaries, and toasters. Many of these items are seldom sold in markets; as a result, theyare valued at the price the government pays for them. The calculation of government spendingfor GDP purposes excludes several tremendous categories of actual spending: transfer payments,which redistribute income primarily to individuals who are potential consumers, and interest

 payments on the debt.

4. Net Exports:

Some of the goods produced domestically are sold abroad to foreign consumers in the form of exports. However, a portion of the goods consumed in our country are made by foreign producers and imported. The difference between exports and imports is known as Net Exports.

Net Exports = Value of exports - Value of imports

If Net Exports are positive, the country runs a trade surplus where exports > imports.

If Net Exports are negative, the country runs a trade deficit where exports < imports.

Using GDP as an Economic Indicator

Despite the use of GDP as the foremost indicator of economic prosperity, the measure does havea number of noticeable faults.

• GDP only counts the market value of economic activity. This excludes nonmarket

activities such as:

1. housework by housewives and husbands.

2. the underground economy - a good deal of economic activity takes place outside themarket. Examples range from illegal drug dealing to house painting. In somecountries underground activity may account for as much as 25% of measured GDP.Including an estimate of underground activity would lead to a significantly higher level of GDP for many countries.

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• Production and consumption that creates negative externalities is counted

equally. An example of a negative externality is air or water pollution. When a good issold, its value adds to GDP, but if it is a polluting good there is no account for thenegative impact on our environment. A country that has rapid GDP growth mayaccomplish the feat by sacrificing the environment, leading to GDP as a misleading

measure of economic well-being.

• GDP does not account for the value of unused natural resources such as minerals

and forests. If these assets were valued in their natural state and included in GDP, rapidexploitation would actually reduce or slow the rate of GDP growth.

• GDP counts all business investment, including purchases of machinery that simply

replace worn-out capital and add nothing to overall productive capacity. To correctfor this Net National Product (NNP) is used, which is defined as GDP minusdepreciation.

• There is no account for the value of knowledge or human capital. To date, there is no

contribution to a nation's output from having a well-educated population, although thereare tangible external benefits to education. If a nation can contribute to GDP by not only producing goods and services but also by providing better education for its population,then greater emphasis will be placed on education than is presently.

• Although often used for international comparisons, GDP is a poor measure of 

international economic well-being. Economics often uses GDP per capita, which iscalculated by taking real GDP divided by population. The use of GDP per capita leads towide discrepancies. India, for example, has a GDP per capita below $400, an unrealisticcomparison to many Western nations that are in the neighbourhood of $20,000.

A better measure of international economic health is the purchasing power parity index (PPP),which gives an indicator of what people can afford in their own country given market andcultural differences. Another alternative to using GDP for international comparisons is theSystem of National Accounts (SNA), which is the result of a joint effort by the United Nations,the International Monetary Fund, the World Bank, the OECD and others. Another considerationis the attempt by the World Bank to include natural resource endowments and development as asource of national wealth. This information can be accessed by choosing thenext option below.

In order to better estimate the relative consumer purchasing power between nations, theInternational Monetary Foundation (IMF) revised its estimates of the comparative size of economies in the spring of 1993. Traditional benchmarks of GDP per capita convert each

country's GDP into dollars using market exchange rates. The resulting figures indicate what theaverage resident in India or China can purchase compared to the typical inhabitant of the UnitedStates. This provided an international comparison of purchasing power but ignored differences inhome markets regarding the cost of goods and market structure (the presence of barter and other non-traditional markets).

Comparing GDP per capita in dollars causes the real output of many developing countries to beunderestimated, as markets are not as well defined as in developed countries. Furthermore,

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changes in exchange rates could help or hinder a country's GDP per capita. Countries with anappreciating currency were given a boost to GDP per capita, the opposite occurring for countrieswith deflating currencies. To help correct these distortions, the IMF now uses purchasing power  parities (PPP). The PPP takes account of what money can buy in each country's home market,accounting for international differences in prices. It is especially useful in capturing differences

in the prices of non-internationally traded goods such as housing, domestic transport, and energy,items that make up a large percentage of consumer expenditures.

In theory, if the prices of traded goods were equal everywhere then wages in each country woulddepend on the productivity of its traded-goods industries. We would expect that countries withlow productivity would have low wages, while countries that are abundant in capital andworkforce skills would have greater productivity and higher wages. The same reasoning appliesfor producers of non-traded goods in high vs. low worker-productivity countries. Low productivity and low wages result in a minimal GDP per capita in comparison to the more productive countries. Yet for the majority of developing countries, the prices of many services,housing, energy, and other consumer goods will be cheaper in these developing countries,

 partially offsetting the wage disparity with developed economies.

Gross National Product:

GDP is just one way of measuring the total output of an economy. Gross National Product, or GNP, is another method. GDP, is the sum value of all goods and services produced within acountry. GNP narrows this definition a bit: it is the sum value of all goods and services produced

 by permanent residents of a country regardless of their location. The important distinction between GDP and GNP rests on differences in counting production by foreigners in a countryand by nationals outside of a country. For the GDP of a particular country, production byforeigners within that country is counted and production by nationals outside of that country isnot counted. For GNP, production by foreigners within a particular country is not counted and production by nationals outside of that country is counted. Thus, while GDP is the value of goods and services produced within a country, GNP is the value of goods and services produced by citizens of a country.

The distinction between GDP and GNP is theoretically important, but not often practicallyconsequential. Since the majority of production within a country is by nationals within that

country, GDP and GNP are usually very close together. In general, macroeconomists rely onGDP as the measure of a country's total output.