You will no doubt come across the 3 methods of calculating GDP that is in the macro syllabus of most courses. Here are the main features of each.
National Income measures the value of output produced within the economy over a period of time. One of the key economic objectives of government is to increase the level, and rate of growth, of national income. Before we start to analyse why economic growth is so important, it is important to be able to define the key concepts.
GROSS DOMESTIC PRODUCT (GDP)
Under new definitions introduced in the late 1990s, Gross Domestic Product is also known as Gross Value Added. It is defined as the value of output produced within the domestic boundaries of the NZ over a given period of time, usually a year. It includes the output of foreign owned firms that are located in NZ, such as the majority of Trading Banks in the market – ASB, National, ANZ etc. It does not include output of NZ firms that are located abroad. There are three ways of calculating the value of GDP all of which should sum to the same amount since by identity:
NATIONAL OUTPUT = NATIONAL INCOME = NATIONAL EXPENDITURE
1. THE EXPENDITURE METHOD
This is the sum of the final expenditure on NZ produced goods and services measured at current market prices (not adjusted for inflation). The full equation for calculating GDP using this approach is:
GDP = Consumer expenditure (C) + Investment (I) + Government expenditure (G) + (Exports (X) – Imports (M))
GDP = C + I + G + (X-M)
2. THE INCOME METHOD
This is the sum of total incomes earned from the production of goods and services. By adding together the rewards to the factors of production (land, labour, capital and enterprise), we can see how the flow of income in the economy is distributed. The rewards to the factors of production can be loosely summarised in the following table:
Land – Rent
Labour – Wages and Salaries
Capital – Interest
Enterprise – Profit
Only those incomes generated through the production of a marketed output are included in the calculation of GDP by the income approach. Therefore we exclude from the accounts items such as transfer payments (e.g. government benefits for jobseekers allowance and pensions where no output is produced) and private transfers of money.
The income method tends to underestimate the true value of output in the economy, as incomes earned through the black economy are not recorded.
3. THE OUTPUT MEASURE OF GDP
This measures the value of output produced by each of the productive sectors in the economy (primary, secondary and tertiary) using the concept of value added.
Value added is the increase in the value of a product at each successive stage of the production process. For example, if the raw materials and components used to make a car cost $16,000 and the final selling price of the car is $20,000, then the value added from the production process is $4,000. We use this approach to avoid the problems of double-counting the value of intermediate inputs. GDP will, therefore, be equal to the sum of each individual producer’s value added.
Problems of accuracy:
Officially data on a nation’s GDP tends to understate the true growth of real national income per capita over time e.g. due to the expansion of the shadow economy and the value of unpaid work done by millions of volunteers and people caring for their family members. There may also be errors in calculating the cost of living
The scale of the informal “shadow economy” varies widely across countries at different stages of development. According to the IMF, in developing countries it may be as high as 40% of GDP; in transition countries of central and Eastern Europe it may be up to 30% of GDP and in the leading industrialised countries of the OECD, the shadow economy may be in the region of 15% of GDP.
It is believed that in 2009 Indians held more money is Swiss banks than people from all other countries combined.
- A 2010 study by the World Bank has suggested that India’s shadow economy is equivalent to 20% of GDP.
- Research indicates that 85% of jobs in India are typically cash orientated.
- Only 42,800 people declare income of over 10m rupees a year – only 2.5% of Indians pay income tax.
Mumbai has a huge stock of empty apartments held as investments, their owners unwilling to to sell for fear that the proceeds might enter the formal economy and be taxed.
Source: The Economist. March 23rd 2013
James Surowiecki in the New Yorker wrote a piece about the global real estate market in which he mentioned that recent statistics shows Vancouver as the most expensive real estate in North America. This is rather baffling when you consider that economically the city itself is not wealthy – the median income is US$70,000. There is no major industry in Vancouver like New York and London are to finance and San Francisco to technology. Furthermore it doesn’t have the cultural status of Milan or Paris. However single family houses now sell for US$1 million and smaller apartments are being bought for US$600,000.
There are a few factors that come to mind when you have this imbalance:
1. The bank have been very lenient with loans – little or no down payment and very low interest rates to tempt buyers.
2. There is a housing bubble as price-to-income ratios are not in sync.
3. Vancover has found itself as a part of the global market in real estate.
It is this third point which has been by far the dominating factor with a flood of cash coming in from the emerging markets of China, Latin America, Russia, and the Middle East. This has led to a massive increase in demand for housing which in turn has been the catalyst to a luxury-construction boom. Foreign buyers account for over half the sales in the Vancouver real estate market in the first six months in 2013. However Australia has also been inundated with Chinese investors – it is estimated that US$44bn will be invested in real estate over the next seven years.
With the aftermath of the Global Financial Crisis in 2008 investors have been looking to markets that offer long-term protection against economic instability. Real estate appears to be this market where investors can park their money and feel secure that it will maintain or increase its purchasing power. Normally house prices are driven by fundamentals – i.e. local income levels – but in the global maker this is not apparent. Investors from overseas have a dilemma in that should they lose 10-20% of the value of an overseas property or potentially losing 100% of the value of a property in their own economy – Beijing being a prime example of this. In China the vacancy rate of sold residential homes in urban areas reached 22.4% in 2013, or 49 million homes, up from 20.6% in 2011, according to the Survey and Research Centre for China Household Finance
Although existing homeowners property’s go up in value from overseas investment there is the tendency of foreign buyers not actually living there most of the time. This has led to the concept by Andy Yan (an urban planner) of Zombie Neighbourhoods.
Below is an article from The Economist that focuses on stagnation in the euro-zone economy. I have put together a worksheet on the passage that you may find useful.
THIS week’s figures for the euro-zone economy were dispiriting by any measure. An already feeble and faltering recovery has stumbled. Output across the euro area was flat in the second quarter. That followed a poor start to the year when the single-currency club managed to grow by just 0.2% (0.8% at an annual rate).
There were some bright spots in the bulletin of misery. Both the Dutch and Portuguese economies, which had contracted in the first quarter, rebounded, growing by 0.5% and 0.6% respectively. Spanish growth picked up from 0.4% in the first quarter to 0.6% in the second. But these perky performances were overshadowed by the poor figures recorded in the three biggest economies. Italy, the third largest, had already reported a decline of 0.2%, pushing it into a triple-dip recession. France, the second biggest, continued to stagnate. But the real blow came from Germany, the powerhouse of the euro zone, where output slipped by 0.2%.
The setback may reflect some temporary factors, as workers took extra time off after public holidays. German output was also depressed by a fall in construction, some of which had been brought forward to the first quarter thanks to warm weather. This effect should also be temporary. However, the tensions between Europe and Russia over Ukraine and the resulting sanctions may adversely affect German growth in the coming months.
The new GDP figures are yet more evidence that the euro-zone economy is in a bad way, not least since it has come to rely so heavily upon Germany, which had grown by 0.7% in the first quarter. It is not only that growth is evaporating; inflation is also extraordinarily low. In July it was only 0.4%, far below the target of just below 2% set by the European Central Bank (ECB). Consistently low inflation has prompted fears that Europe will soon slide into deflation. Prices are already falling in Spain and three other euro-zone countries.
Deflation would be particularly grave for the euro area because both private and public debt is so high in many of the 18 countries that share the single currency. Even if inflation is positive but stays low it hurts debtors, as their incomes rise more slowly than they expected when they borrowed. If deflation were to set in, the effects would be worse still: when prices and wages fall, debts, which do not shrink, become harder to repay.
The poor GDP figures will intensify pressure on the ECB to do more. Already in June it lowered its main borrowing rate to just 0.15% and became the first big central bank to introduce negative interest rates, in effect charging banks for deposits they leave with it. That has helped bring short-term, wholesale interest rates close to zero and has also weakened the euro. Both these effects will help to bolster the economy and restore growth.
As well as these interest-rate cuts, the ECB announced that it would lend copiously to banks for as long as four years, as long as they pledged to improve their own lending performance to the private sector. The plan, which resembles the Bank of England’s “funding for lending” scheme, has some merit but may not boost lending as much as expected due to the feeble state of the banks. It will also take a long time to work its way through the economy.
The ECB’s critics say that this is not enough and urge the central bank to introduce quantitative easing—creating money to buy financial assets. The ECB is likely to hold off; it seems to consider QE as a weapon of last resort. For his part Mario Draghi, the central bank’s president, urges countries like Italy and France to get on with structural reforms that would improve their underlying growth potential. Patience on all sides is wearing thin.
Read the article from The Economist and answer the questions below:
a) What happened to the GDP figures for the euro-zone economy in the second quarter for 2014? (2)
b) What have been the surprises in the contributions of the six countries mentioned in the articles? (3)
c) Although the GDP figures are dispiriting there is the indication that this is a temporary problem. Explain (2)
d) Comment on the level of inflation in the euro-zone and the target set by the European Central Bank (ECB). (4)
e) Why is deflation particularly grave for the euro area? (4)
f) Explain negative interest rates. Why has this policy been implemented by the ECB? (4)
g) What have the ECB’s critics suggested they should do and explain how this policy works. (4)
Listening to “From Our Own Correspondent” on the BBC World Service I came across an interesting piece by Kate Adie on Global Trade. With the downturn in global trade the international transport industry has been very much affected. Those that have been associated with the distribution of goods get an early indication of the slowdown in global growth. The obvious indicators are: idle cranes, queues of merchant ships dwindle etc. But what about the speed of cargo ships and the length of ladders to climb aboard?
When the world economy was “steaming” ahead the captain of a merchant ship said that they cruised at 20 knots but when the economic crisis of 2008 arrived we slowed to 16 knots. A harbour pilot summed up the state of world trade by the length of the ladders that he climbs on the sides of ships.
A long climb up the ladder signifies that the ship is high in the water and exports are correspondingly low.
A short climb up the ladder signifies that the ship is low in the water and exports are correspondingly high.
The seafarers say that they take air to China before they load up with goods for the US.
The recent ‘Special Report’ in The Economist outlined the benefits of Poland’s membership of the EU to the agricultural sector. Agriculture is the biggest beneficiary and ironically farmers were some of the most committed opponents of EU entry. They suggested that only 600,000 of the country’s 2m farms would survive entry. But their mood changed when Polish agriculture received 40 billion in 2007-13 and another 42.4 billion from 2014 – 2020. From the EU funds farmers’ incomes have tripled since entry, with half of the money coming from direct cash payments, regardless of need. But the agricultural subsidies are a mixed blessing as it encourages inefficiency in the sector as half the farms that receive assistance are just subsistence plots, and 92% of them are less than 20 hectares. But Polish agriculture accounts for only 3.4% of GDP but 12.4% of employment. However the rural population makes up about 39% of the total so therefore farmers are an important political constituency. The graph below shows the impact of the price support system.
Here is a great infographic about the iPhone that I got from colleague David Parr. It shows the impact the iPhone has had on the global supply chain, jobs and the world in general. Some statistics from it are as follows:
1. To assemble 1 iPhone = 600 workers
2. 500,000 iPhones produced in 1 day (at peak)
3. 307,250 jobs have been created by Apple
4. 44% are sold in North, Central and South America. 9% are sold in Japan alone.
5. There are 330 manufacturing locations in China.
The graph from National Australia Bank below shows the components of Australian GDP March Quarter 2014. This is particularly useful when doing GDP Expenditure approach in Unit 5 of the A2 Cambridge course where you can breakdown the equation C+I+G+(X-M).
C = Private Consumption
I = Business Investment
G = Government Demand
(X-M) = Net Exports
Consumption is still the largest contributor to Australia’s GDP. Over the next couple of years GDP is expected to grow around 3% but key to meeting that target is a solid consumer sector. Household consumption growth in recent quarters has been solid, contributing 0.3 percentage points to growth in Q1 – only exports have contributed more to growth over the past year. However sustaining solid consumption growth in years ahead requires the labour market to improve and consumer confidence levels to recover from their recent lows.