Introduction

As discussed in our Introduction to Economics article, economics is the science of scarcity. Resources are scarce, and economics is the study of how best to use these resources to achieve productive efficiency (production at the minimum possible cost for the maximum possible output) and allocative efficiency (firms and consumers allocating their resources in a way that brings the most benefit to them).

In part 1 of the economics section, we discussed microeconomics, which looks at the individual parts of an economy. We will now move on to part 2 – macroeconomics.

Macroeconomics looks at an economy as a whole. Macroeconomics still deals with demand and supply, but with the whole demand and supply within an economy – an economy’s aggregate demand (“AD”) and aggregate supply (“AS”) – rather than the supply and demand for individual goods and services.

Macroeconomics also looks at matters connected to the interaction between AD and AS, such as gross domestic product (“GDP”), economic growth (GDP growth), inflation, the balance of payments, interest rates, and unemployment, among other things. We will be discussing these topics in this section.

The study of these topics enables economists to predict, make decisions, and give advice on the economy to ensure resources are being used to their fullest and are bringing the most benefit within an economy / country.

In this article, we consider general macroeconomic aims and GDP.

Macroeconomic aims

Governments want (or should want) to improve the lives of their citizens and benefit their country / economies generally.

To do this, there are various macroeconomic aims that governments may pursue, including:

1. Sustainable and stable GDP growth – GDP is a measure of wealth. The higher a country’s GDP, the better off the country and its citizens are perceived to be. However, there are some shortcomings with this measure, which we discuss below;
2. Low inflation – inflation is the general rise in prices of goods and services over time. If inflation is too high, it might outstrip any GDP / wealth growth, meaning citizens are worse off. For example, if a person gets a 2% salary increase but prices are 15% higher than the prior year, that person will be worse off (because they will not be able to purchase as many goods or services as last year, even with a higher salary);
3. Full employment – the full use of resources (including labour) to produce goods and services; and
4. Stability – avoiding fluctuations or shocks to the economy, and keeping production, employment, inflation and growth (amongst other things) stable.

Gross Domestic Product

GDP is the total output of an economy from the use of all its resources – usually measured on an annual or quarterly basis. This, broadly, indicates the wealth of an economy.

Since resources are scarce, a large part of macroeconomics involves the growth of GDP – maximising GDP through the efficient use of resources within an economy.

How is GDP determined?

GDP is determined through the interaction between AD and AS. This can be shown as an example in figure 1.

We use the short-run AS ("SRAS") curve in the below diagram, because economists disagree about the shape of the long-run AS curve ("LRAS")– we explain these concepts in further detail in the following articles.

Along the X axis, we measure the real (adjusted for inflation) output of an economy (GDP) and along with Y axis we measure the price levels within an economy.

Because GDP is determined by the interaction between AD and AS, the components of AD and AS (which affect the shape and movement of the AD and AS curves) have an impact on GDP.

We discuss this in more detail in the following two articles. For now, however, the shapes of the AD and AS curves in the diagram above are used for illustrative purposes only.

How is GDP calculated?

There are three ways to calculate GDP:

1. Product method - adding up the value of all the goods and services produced in each industry within an economy;
2. Income method - adding up the total incomes within an economy which are generated from the production of goods and services, for example wages, rent, interest, profit etc;
3. Expenditure method - adding up the total expenditure on products produced / supplied within an economy. This includes consumer spending, investment, government spending, and net exports (exports minus imports). We discuss this in further detail in our article on AD.

In the UK, GDP is calculated by the Office for National Statistics ("ONS") using all three methods from a variety of sources. In theory, the three methods should produce the same results. However, they are measured using different surveys and data sources, each of which may not be perfect and accordingly may produce different results. In order to produce a definitive GDP calculation / estimate, the ONS then undertakes a process of balancing and adjustment. Further details can be found here.

Inflation

For GDP to be a useful measure of comparing a country’s income from one year to the next, and also for the general wealth of a country’s citizens, it must take into account inflation.

Inflation is the general rise in prices of goods and services over time (this is discussed in more detail in other articles on this website). For example, if GDP grew by 5% one year but prices also rose by 5%, there would be no real growth in GDP – on average, citizens would be no better off.

The measure of GDP which takes into account inflation is called real GDP, and the measure of GDP which does not take into account inflation is called nominal GDP.

Use of GDP to measure standard of living

GDP Per Capita

Although GDP is useful in showing the annual wealth of a country / economy, it does not take into account its population. Accordingly, it might not be a good representation of the wealth of each citizen living within that country / economy.

To get a measure of the average wealth of each citizen, we can use the concept of GDP per capita. GDP per capita is the total GDP of a country / economy, divided by the total number of people in it. For example:

1. Country A - GDP: £100, Population: 10, GDP Per Capita: £10 (£100 / 10);
2. Country B - GDP: £150, Population 100, GDP Per Capita: £1.50 (£150/100).

As shown here, Country B has a greater overall GDP than Country A, but its citizens are (on average) less well off than those in Country A. However, there are shortcomings with using this a measure of the standard of living of citizens.

Shortcomings of GDP as a standard of living

The GDP per capita calculation gives an average wealth figure for each citizen within an country / economy.

However, there are several shortcomings when using it (and GDP in general) to measure standards of living and to compare the standards of living of citizens in one country / economy with another:

1. GDP is a measure of a country’s production / output. This is not the same as a measure of happiness. For example, GDP does not record the benefit of peoples’ leisure / free time; only time spent producing is recorded. However, free / leisure time may be an indication of a person’s welfare and happiness;
2. GDP per capita assumes that each person has the same amount of wealth and does not consider how this is distributed between citizens i.e. some may have more, and some may have less;
3. The prices of goods and services differ between countries. Accordingly, a measure of GDP / GDP per capita may not be an accurate measure of what citizens can acquire with their household incomes across countries. For example, prices in Pakistan are generally lower than in the UK, and you will be able to acquire more with £1,000 there than in the UK. To overcome this shortcoming in the measure of GDP, economists have cleverly come up with a common currency measure called the purchasing-power parity rate – which measures what a fixed amount of money can buy in various countries;
4. There are some items that aren’t measured in GDP figures, but which are still valuable and add to a person’s / household’s standard of living. For example, if a person pays for childcare, that is counted towards GDP. However, if a member of the household takes on such duties, this is not counted towards GDP, although it will have value and may have an impact on standard of living and wellbeing;
5. GDP growth may not be caused by an increase in production / consumption, but an increase in investment into an economy (which we will talk about when we discuss aggregate demand). Accordingly, in the short-term, GDP growth caused by investment might not result in a rise in living standards;
6. GDP does not record the negative externalities (side effects) from production – such as pollution – which may lower standard of living overall.

Household Disposable Income

Another useful measure in determining the real wealth of citizens within an economy is a household’s disposable income. This measures the income people have left to spend or save following deductions such as tax, national insurance etc.

Conclusion

You should now have a good understanding of what GDP is, how it is determined, how it is calculated, and how it can be used to measure the average wealth of citizens within an economy, plus the shortfalls of GDP as a measure of the standard of living.

In summary:

• GDP measures the total output of an economy, usually on an annual or quarterly basis;
• GDP is determined through the interaction of AD and AS. Accordingly, it is impacted by the components of AD and AS (this is discussed in further detail in the following two articles);
• There are three ways of calculating GDP: product method, income method, and expenditure method. All should theoretically give the same output however, in reality, this may differ due to the variety of data sources;
• GDP per capita measures the average GDP per individual within an economy, and can be used as an average measure of wealth. However, there are various shortcomings to this as a measure of the standard of living of a country’s / economy’s citizens.