There are leakages from and injections into the circular flow. Money is taken out of circulation when people buy imports, save or pay taxes. This means less spending, so firms sell fewer goods and services. Money is put into circulation when people run down their savings or borrow, when governments spend their taxes and when foreigners buy exports. These actions boost spending, so firms sell more goods and services.
All leakages and injections affect spending power and influence savings and investment decisions. These may be thought of as causing cyclical variations while productivity determines long-term growth. Life is never simple, of course, and productivity depends on investment, which in turn depends on many factors including the cycle itself.
Inflation and volumes
Higher demand can easily result in inflation. For example, if employers increase wages without raising output, and if the extra incomes are spent in full, prices will be pulled up (demand-pull inflation) but there will be no increase in real welfare.
The effects of inflation are wide and far-reaching. They are particularly relevant when analysing small parts of the economy in great detail, such as when projecting earnings and share prices for one company. For assessing the economy as a whole it is better to focus on the volume of output rather than its nominal money value, and to think in volume or inflation-adjusted constant price terms. These concepts are discussed in Chapter 2; Chapter 13 reviews inflation in detail.
Nominal GDP
Measures: Total economic activity in current prices.
Significance: Describes the total level of production. Use as a yardstick for measuring “economic achievement” or other indicators (such as the current-account balance as a percentage of GDP).
Presented as: Quarterly and annual totals – more rarely, monthly.
Focus on: Totals. Use factor cost when reviewing output or incomes, market prices if looking at expenditure patterns.
Yardstick: The world world total was $60.56 billion in 2008.
Released: Quarterly, 1–3 months in arrears; frequently revised.
Interpretation
Nominal GDP or GNI (GNP) is used to measure total economic activity. The choice between the two depends largely on national conventions (see page 29). Where GNI/GNP is higher than GDP it indicates net investment income from abroad.
Table 4.1 Nominal GDP, 2008
The annual total GDP ranges from under $1 billion in some small African countries to over $14,000 billion in America. For countries at similar stages of development, magnitude depends largely on population size. (See GDP per head below and Real GDP, page 47.)
4.2 Total GDP
Source: IMF
GDP per head
Measures: Output per person; GDP divided by population size.
Significance: Used as an indicator of overall economic welfare.
Presented as: Quarterly and annual totals.
Focus on: Nominal totals; changes in real terms.
Yardstick: The OECD average was $36,575 per head in 2008.
Released: Annually, sometimes quarterly; well in arrears; frequently revised.
What to look for
Output per head is a good guide to living standards. It implicitly allows for qualitative factors such as literacy or health although these are not covered directly.
In 2008, annual output per head was below $400 in some African states, and a mere $138 in Burundi, while the world average was around $8,300. The output per head of the rich industrial countries was nearly three times greater than the average. After adjusting for variations in purchasing power, the gap between the richest and poorest countries looks narrower. Even so, the richest countries’ output per head was nearly three times the world average (nearly $30,000). Zimbabwe’s was a mere $8.
If real GDP per head increases it indicates an improvement in overall economic well-being. Seeking to provide a better indicator of human development, the United Nations Development Programme, the UN’s global development network, has been publishing its Human Development Index since 1990. It is a composite index using data on life expectancy, adult literacy, education enrolment rates and GDP per head. The 2009 rankings for over 180 countries showed Norway and Australia at the top and Afghanistan and Niger at the bottom. Newly industrialising countries such as South Korea and Singapore have moved rapidly up the rankings.
Table 4.2 GDP per head, 2008
4.3 GDP per head
Source: IMF
Real GDP
Measures: Total economic activity in constant prices.
Significance: Most useful for tracking developments overtime.
Presented as: Quarterly and annual totals.
Focus on: Percentage changes, annual or over four quarters.
Yardstick: The Euro-area average was 1.3% a year growth during the period 1998–2008.
Released: Quarterly, 1–3 months in arrears; frequently revised.
What to look for
Real (constant price) GDP or GDP figures reveal changes in economic output after adjusting for inflation. These should be put in the context of the cycle (see Cyclical indicators, page 55). Strong economic growth following a recession may simply indicate that slack capacity is being put back into use (see Unemployment and Capacity use, pages 68 and 118). Strong growth when the economy is already buoyant may indicate the installation of new capacity which will add still more to future output (see Investment, Chapter 8). However, excess growth at the top of the cycle may bubble over into inflation and/or imports (see Chapter 13).
Developing countries have the capacity for faster GDP growth than more mature industrial economies. Real growth of around 3% per year is good for America and Europe. The newly industrialising countries of the Pacific rim, for instance, achieved much higher rates in 1999 and 2000. Before the Asian crisis of 1997, they even managed at least double that. China’s real GDP per head has averaged 9.1% between 1998 and 2008.
4.4 GDP growth
Sources: IMF; OECD
The inflation/output trade-off
The change in real GDP plus the change in the deflator (see page 39) approximately equals the change in nominal GDP. For example, if real output rises by 3% and inflation is 5%, nominal output has risen by about 8%. Some economists argue that aggregate demand determines nominal GDP and that there is a trade-off between real output and inflation: each can rise by any amount so long as the total equals the change in nominal output. Higher inflation therefore means lower growth in output.
World cycles
For the industrialised world, 1960, 1968, 1973 and 1979 were peak years for economic activity. There was another peak around the start of the 1990s, but it was unusual in that it was staggered across countries (see Cyclical indicators, page 55). The financial crisis of 2008 saw the first truly global recession since the 1930s, but with many large developing countries, such as China and India, bouncing back into growth rapidly, developed European countries such as Britain and Spain were slower to climb out of recession. Table 4.3 shows examples of economic growth rates within each cycle, which provide useful yardsticks for judging future growth rates.
Table 4.3 Four world cycles Average annual % change in real GDP
Industrial economies
The 1960s were a period of rapid expansion, due at least in part to technological advances and freedom from external shocks. The 1973 and 1979 oil price rises caused temporary setbacks. Japan was perhaps more badly hit by the first; Europe and America suffered more from the second. Growth was rapid again in the mid–late 1980s and 1990s. The financial crisis of 2008 impacted all industrial economies, particularly those heavily exposed to financial markets and property bubbles such as the United States, United Kingdom, Ireland and Spain.
Developing countries
The oil producers enjoyed rapid growth rates in the 1970s and suffered the greatest setbacks in the 1980s. Broadly similar patterns were recorded by many Latin American and African countries, with the slowdown in the 1980s reflecting the debt crisis, a lack of inward inves
tment and shortages of foreign exchange. East European countries also had feeble growth in the 1980s, reflecting the shortcomings of their planned economies. Export-orientated economies such as China, India and Brazil continued to grow rapidly once the financial crisis abated.
GDP: output
Measures: GDP according to sector (agriculture, mining, manufacturing and service industries).
Significance: Provides analysis of total output at a high level of detail.
Presented as: Quarterly and annual totals.
Focus on: Real growth rates.
Yardstick: Overall real growth in the GDP total.
Released: Quarterly, 1–3 months in arrears; frequently revised.
What to look for
Compare the percentage change in each sector with the overall percentage change in GDP. A sector which is growing faster than the average is making a very positive contribution to growth. A sector which is growing less rapidly than the average is clawing it down.
A change in a dominant sector has a larger effect on total activity than a change in a smaller sector. For example, in the industrial economies a 1% rise in services boosts GDP by more than a similar increase in agriculture. Indeed, the mature industrialised countries have been undergoing a shift from manufacturing to services. In the OECD countries, services’ share of output rose from 45% in 1960 to 72% in 2007.
Table 4.4 Dominant sectors Output as % of GDP, 2007
In general developing countries depend more on agriculture or, if they are at a later stage of development, manufacturing. Chapter 9 reviews individual indicators of output.
GDP: expenditure
Measures: GDP according to category of spending (consumption, investment and net exports).
Significance: Provides detailed analysis of total spending.
Presented as: Quarterly and annual totals.
Focus on: Real growth rates.
Yardstick: Overall real growth in the GDP total.
Released: Quarterly, 1–3 months in arrears; frequently revised.
What to look for
As with the GDP output breakdown, compare the percentage change in each category of spending with the overall percentage growth in GDP in the same period.
Personal consumption
Growth in this category often leads a general recovery from recession, encouraging manufacturers to invest more. However, if consumption grows faster than the productive capacity of an economy, imports are sucked in and inflation rises. Personal consumption typically accounts for 60% of GDP in industrial countries, so a change in consumption has a big effect on total output.
Government spending
This reflects, to some extent, politics rather than market forces. Its share in GDP is higher in countries where the state provides many services. A short-term increase in government spending can provide a stabilising boost to the economy, but in general it diverts resources from productive growth.
Investment
This is a key component, contributing to current growth and laying down the foundation for future expansion. Look for spending on machinery (which produces more output) rather than, say, dwellings.
Changes in stocks
These can be erratic. They decline when demand is growing more rapidly than production (a good sign at the beginning of a recovery, potentially inflationary at the end) or when manufacturers and distributors are squeezed and are trying to cut the cost of holding stocks. Inventories tend to rise when demand slows.
Exports and imports
Exports contribute to overall GDP growth; higher imports reduce the increase in output relative to the growth in demand. A sudden increase in import penetration (imports divided by GDP) suggests that consumer demand is growing faster than the domestic economy can cope with (overheating). A longer-term increase in imports relative to exports may imply a decline in the competitiveness of domestic producers. Imports that are substantially larger than exports may point to exchange-rate problems.
Productivity
Measures: Output for one unit of labour or capital.
Significance: Indicator of efficiency and potential total economic output.
Presented as: Index numbers.
Focus on: Trend, especially relative to other countries.
Yardstick: OECD average growth in real GDP per hour worked was 1.4% a year during 2004–08.
Released: Sometimes monthly, often two months in arrears; frequently revised.
Overview
Productivity measures the amount of output that is produced with given amounts of factor inputs (mainly land, labour and capital). Land is basically fixed and capital is very difficult to measure, so attention tends to focus on labour productivity. This can be defined in various ways. The most common are as follows.
Output per worker = total output divided by total employment.
Output per man hour = total output divided by hours worked.
Labour productivity reflects capital investment and offers a guide to capital productivity. A company using high-tech machinery will probably produce more per person than a company using 19th-century steam technology. Other factors which affect labour productivity include social attitudes, work ethics, unionisation and, perhaps most important, training. These are not measured directly by economic statistics.
The arithmetic of growth
Economic growth reflects growth of the labour force plus growth of labour productivity.
Labour productivity in turn depends on new investment (which raises the capital:labour ratio, which is known as factor substitution in economic jargon) and technological progress (which increases output for a given capital:labour ratio).
Interpretation
Productivity figures can be calculated in money terms, but they are generally produced as index numbers. As a result, analysts often look at changes over time and disregard the important question of the base from which the index numbers are calculated. If this was a period of high or low productivity, changes will be distorted.
Nevertheless, trends are important. If output per person increases by 5%, an identical increase in wage rates may leave profitability unchanged. Indeed, since total labour costs (including, for example, the cost of providing recreational facilities for workers) may increase less rapidly than wages, profitability may actually improve. (See Wages and Unit labour costs, pages 214 and 217.)
Cycles
Productivity is highly cyclical since employment and capital are less flexible than demand and output. When production falls after a peak in economic activity, employment declines less rapidly and output per head plummets.
Table 4.5 Productivity Average annual % change in real GDP per worker
When demand for goods and services increases after a recession, slack capacity is called into use and productivity rises rapidly.
Comparisons
When comparing absolute levels of productivity (rather than trends) remember that productivity also depends on technology and costs. Companies in Asia have a lower dollar value of output per person, but can still be more profitable than European or American companies because labour costs are cheaper in Asia.
Exchange-rate changes are also important for international comparisons of competitiveness (see page 166).
Cyclical or leading indicators
Measures: The economic cycle.
Significance: Useful tool for short-term predictions of economic activity.
Presented as: Index numbers.
Focus on: Trends.
Yardstick: Look for turning points.
Released: Monthly, at least one month in arrears; frequently revised.
Overview
In developed economies at least, GDP progresses erratically around its long-term growth trend. There are periods when growth spurts ahead, followed by periods of recession. This variation is known as the economic, business or trade cycle. It repeats every five years or so, although no two cycles are ever of the same magnitude or duration.
The cycle has four phases:
expansion, peak, recession and trough.
Expansion
When demand first increases, for whatever reason, it gathers momentum automatically. The first sign is often a rundown in inventories. Output then rises faster than demand while these are rebuilt (see Stocks or inventories, page 107). Companies take on unemployed workers, who spend their new income on postponed purchases of consumer goods. This creates more demand and so companies employ more people, and so the process continues (the multiplier). Before long producers come up against capacity constraints. If they are confident that demand will remain buoyant (expectations), they invest more in new plant and machinery, which generates even more demand (the accelerator).
Peak
The upward momentum cannot continue indefinitely. Eventually output hits a ceiling owing to bottlenecks and supply constraints. Demand for investment funds may push up interest rates to the point where new investment is not profitable, or at full employment there may be no more workers to take on. Consumer demand may be steady, but the fall in investment demand pulls back the level of total output.
Recession
With investment demand falling, producers of capital goods start to cut back on labour. Higher unemployment reduces consumer demand. The inventories, multiplier, expectations and accelerator principles work in reverse and so the economic contraction gathers momentum.
Not much of a party
How the most recent recessions in rich countries compare
GDP growth of 0.1% in the three months to December 2009 means that Britain, where output fell for six successive quarters, is now officially out of its longest post-war recession. This leaves Spain, whose fourth-quarter GDP figures are not yet published, as the only big, rich country where growth may still not have resumed. Britain’s slump was not nearly as deep as Japan’s, where GDP contracted by 8.6% from peak to trough. Canada’s recession was the least severe of any country in the G7: output fell by a relatively modest 3.3% between its peak and the bottom of the cycle.
Guide to Economic Indicators Page 5