4.6 - Measurement of Economic Growth
The meaning of economic growth and development
Economic growth refers to the expansion of an economy's total production over time. It is a fundamental measure of macroeconomic performance, showing how much more goods and services are being produced compared to previous periods.
Economic growth
Economic growth occurs when there is an increase in the overall output of an economy. The economic growth rate measures this as the yearly percentage change in that output.
Economic growth vs economic development
Economic growth and economic development are related but distinct concepts. While growth focuses on output increases, development emphasises broader improvements in societal welfare.
Key differences:
- Economic growth - An increase in the total output of goods and services in an economy, typically measured over a year.
- Economic development - The broader process of enhancing people's economic well-being and overall quality of life.
Historically, economic growth was often seen as synonymous with economic development, based on the "trickle-down" theory. This idea proposed that benefits from growth would eventually spread to all parts of society. However, in practice, growth does not always lead to widespread improvements. For example, if wealth concentrates among a few, living standards for the majority may not rise. Conversely, economic development can advance without significant growth, such as through fairer income distribution or efforts to cut environmental harm like pollution.
How economic growth relates to living standards
Economic growth can influence living standards, but it is not the only factor. For growth to truly benefit people, it must outpace other demographic changes.
GDP per capita and living standards
Living standards improve when economic output rises faster than the population, leading to more resources available per person. This is captured by GDP per capita, which is gross domestic product (GDP) divided by the population size.
Key considerations:
- If output grows but population increases at a similar or faster rate, GDP per capita may stay the same or fall, meaning no real gain in individual well-being.
- Even without growth, living standards can rise through measures like redistributing income more equally or implementing policies that reduce negative externalities, such as cleaner air.
The difference between nominal and real GDP
Gross domestic product (GDP) measures the total value of goods and services produced in an economy. However, not all GDP figures provide an accurate picture of true growth, as price changes can distort the data.
Nominal GDP
Nominal GDP, also known as GDP at current prices, values output using the prices from the year it was produced. It does not account for inflation or deflation, which can make it misleading.
Limitations of nominal GDP:
- For instance, if an economy produces the same amount of goods but prices rise, nominal GDP increases even though actual output has not changed.
- This measure includes the effects of price fluctuations, so it may overstate growth during inflationary periods.
Real GDP
Real GDP adjusts nominal GDP for changes in price levels, providing a clearer view of actual output changes. It is calculated using constant prices from a chosen base year, eliminating the impact of inflation.
Benefits of real GDP:
- Real GDP reflects genuine increases in production, making it a better indicator of economic growth.
- The economic growth rate is typically expressed as the percentage change in real GDP over a year.
Government analysts start with nominal GDP and then apply adjustments based on price indices to derive real GDP.
Calculating real GDP using the GDP deflator
To convert nominal GDP to real GDP, economists use a price index called the GDP deflator. This adjustment ensures the figures represent true output changes rather than price variations.
Formula for real GDP
Where:
- Real GDP = GDP adjusted for price changes
- Nominal GDP = GDP at current prices
- Price index in base year = Typically set at 100 for the reference year
- Price index in current year = Reflects price levels in the year being measured
The GDP deflator
The GDP deflator is the specific price index used for this conversion. It tracks price changes in all goods and services produced within the country, including capital goods and exports, but excludes imports. It helps distinguish between growth driven by higher production and that caused by rising prices.
Worked example - Calculating real GDP
An economy has a nominal GDP of £720 billion in the current year. The price index for the current year is 115, and the base year price index is 100. Calculate the real GDP.
Step 1: Identify the values
- Nominal GDP = £720 billion
- Price index in base year = 100
- Price index in current year = 115
Step 2: Apply the real GDP formula