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Block # 2:Measures of Economic Activity

Q # 1. Define Gross Domestic Product.

Ans. Gross Domestic Product

“Gross domestic product (GDP) refers to the market value of all final goods and services
produced in a country in a given period. GDP per capita is often considered an indicator of a country's
standard of living.”

GDP can be determined in three ways, all of which should, in principle, give the same result.
They are the product (or output) approach, the income approach, and the expenditure approach.

The gross domestic product (GDP) is one the primary indicators used to gauge the health of a
country's economy. It represents the total dollar value of all goods and services produced over a specific
time period - you can think of it as the size of the economy. Usually, GDP is expressed as a comparison
to the previous quarter or year. For example, if the year-to-year GDP is up 3%, this is thought to mean
that the economy has grown by 3% over the last year.

The most direct of the three is the product approach, which sums the outputs of every class of
enterprise to arrive at the total. The expenditure approach works on the principle that all of the product
must be bought by somebody, therefore the value of the total product must be equal to people's total
expenditures in buying things. The income approach works on the principle that the incomes of the
productive factors ("producers," colloquially) must be equal to the value of their product, and
determines GDP by finding the sum of all producers' incomes.

Example: the expenditure method:

GDP = private consumption + gross investment + government spending + (exports − imports)

"C" is equal to all private consumption, or consumer spending, in a nation's economy

"G" is the sum of government spending
"I" is the sum of all the country's businesses spending on capital
"X-I" Calculated as total exports minus total imports. (Exports - Imports)

Q # 2. Explain the difference between nominal GDP and real GDP.

Ans.

Nominal GDP

Nominal GDP is based on the prices of goods and services at the date they were produced,
according to HACC. Nominal GDP does not take into account inflation and therefore is not a good

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measure of actual growth within the economy, according to Mankiw. For example, if a country
experienced inflation, its nominal GDP would rise without any increase in productivity.

It can be misleading when inflation is not accounted for in the GDP figure because the GDP will
appear higher than it actually is. The same concept that applies to return on investment (ROI)
applies here. If you have a 10% ROI and inflation for the year has been 3%, your real rate of return
would be 7%. Similarly, if the nominal GDP figure has shot up 8% but inflation has been 4%, the real GDP
has only increased 4%.

Real GDP

An inflation-adjusted measure that reflects the value of all goods and services produced in a
given year, expressed in base-year prices. Often referred to as "constant-price", "inflation-corrected"
GDP or "constant dollar GDP".

According to Mankiw, real GDP is an adjustment of the nominal GDP to take into account
inflation. All official economic statistics given by government and non-government organizations are in
real GDP, as it is the best indicator of the overall productivity of the economy.

Nominal GDP is GDP evaluated at current market prices. Therefore, nominal GDP will include all
of the changes in market prices that have occurred during the current year due to inflation or deflation.
Inflation is defined as a rise in the overall price level, and deflation is defined as a fall in the overall price
level. In order to abstract from changes in the overall price level, another measure of GDP called real
GDP is often used. Real GDP is GDP evaluated at the market prices of some base year. For example, if
1990 were chosen as the base year, then real GDP for 1995 is calculated by taking the quantities of all
goods and services purchased in 1995 and multiplying them by their 1990 prices.

Real GDP = Nominal GDP / Price level

Q # 3. What does the unemployment rate measure? Briefly explain how it is calculated?

Ans. Unemployment rate

Unemployment (or joblessness), as defined by the International Labour Organization, occurs

when people are without jobs and they have actively looked for work within the past four weeks. The
unemployment rate is a measure of the prevalence of unemployment and it is calculated as a
percentage by dividing the number of unemployed individuals by all individuals currently in the labour
force.

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Percentage of employable people actively seeking work, out of the total number of employable
people; determined in a monthly survey by the Bureau of Labor Statistics. An unemployment rate of
about 4% - 6% is considered "healthy".

The unemployment rate measures the percentage of employable people in a country's workforce who
are over the age of 16 and who have either lost their jobs or have unsuccessfully sought jobs in the last
month and are still actively seeking work.

The formula for unemployment rate is:

Number of unemployed
Unemployment Rate =
Total Labour Force

Labour Force = Number Employed + Number Unemployed

It is important to distinguish between the percentage of people who are unemployed and those
who are simply not working. Some people may be in school full-time, working in the home, disabled, or
retired. These people are not considered part of the labor force and are therefore not included in the
unemployment rate. Only those people actively looking for a job or waiting to return to a job are
considered unemployed.

Q # 4. What is the GDP deflator and how is it calculated?

Ans. GDP Deflator

In economics, the GDP deflator (implicit price deflator for GDP) is a measure of the level of
prices of all new, domestically produced, final goods and services in an economy. GDP stands for gross
domestic product, the total value of all final goods and services produced within that economy during a
specified period.

GDP deflator. Using the statistics on real GDP and nominal GDP, one can calculate an implicit
index of the price level for the year. This index is called the GDP deflator and is given by the formula

It is often useful to consider implicit price deflators for certain subcategories of GDP, such as
computer hardware. In this case, it is useful to think of the price deflator as the ratio of the current-year
price of a good to its price in some base year. The price in the base year is normalized to 100. For
example, for computer hardware, we could define a "unit" to be a computer with a specific level of
processing power, memory, hard drive space and so on. A price deflator of 200 means that the current-
year price of this computing power is twice its base-year price - price inflation. A price deflator of 50

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means that the current-year price is half the base year price - price deflation. This can lead to a situation
where official statistics reflect a drop in prices, even though they have stayed the same. Consider the
example of the computer. From year to year, assume that the price of a new computer stays the same,
but the computing power doubles. This would result in a price deflator of 50, though the consumer
would have to spend the same amount of money on both systems.

Q # 5. What is Consumer Price Index (CPI) and how it is calculated?

Ans. Consumer Price Index (CPI)

A consumer price index (CPI) measures changes in the price level of consumer goods
and services purchased by households. The CPI is defined by the United States Bureau of Labor Statistics
as "a measure of the average change over time in the prices paid by urban consumers for a market
basket of consumer goods and services."

The CPI is a statistical estimate constructed using the prices of a sample of representative items
whose prices are collected periodically. Sub-indexes and sub-sub-indexes are computed for different
categories and sub-categories of goods and services, being combined to produce the overall index with
weights reflecting their shares in the total of the consumer expenditures covered by the index. It is one
of several price indices calculated by most national statistical agencies. The annual percentage change in
a CPI is used as a measure of inflation. A CPI can be used to index (i.e., adjust for the effect of inflation)
the real value of wages, salaries, pensions, for regulating prices and for deflating monetary magnitudes
to show changes in real values. In most countries, the CPI is, along with the population census and the
USA National Income and Product Accounts, one of the most closely watched national economic
statistics.

The formula for Consumer price index(CPI) would be,

CP , I =Value of ¿ basket ∈current prices ¿ basket at base year prices ¿ ×100

Value of ¿

Alternatively, the CPI can be performed as,

The "updated cost" (i.e. the price of an item at a given year, e.g.: the price of bread in 2004) is
divided by the initial year (the price of bread in 2011), then multiplied by one hundred.

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Q # 6. Why should we be concerned about an increase in the unemployment rate? Briefly explain.

Ans. Unemployment rate

Unemployment (or joblessness), as defined by the International Labour Organization,
occurs when people are without jobs and they have actively looked for work within the past four weeks.
The unemployment rate is a measure of the prevalence of unemployment and it is calculated as a
percentage by dividing the number of unemployed individuals by all individuals currently in the labour
force.

The unemployment rate measures the percentage of employable people in a country's

workforce who are over the age of 16 and who have either lost their jobs or have unsuccessfully sought
jobs in the last month and are still actively seeking work.

The formula for unemployment rate is:

Number of unemployed
Unemployment Rate =
Total Labour Force

Low unemployment rate is good for the individual and the wider community. Those who work
feel better about themselves and can afford to spend more. With low unemployment rates, those who
work can demand higher wages and feel more secure in their jobs. The economy benefits from
increased activity and governments receive more tax dollars, which can then be spent on schools or
hospitals. Low unemployment also tends to have a positive effect on social divisions in the society.

Beyond the loss of income, losing a job also comes with other major losses, some of which may
be even more difficult to face:

 Loss of your professional  Loss of purposeful activity

identity  Loss of your work-based social
 Loss of self-esteem and self- network
confidence  Loss of your sense of security
 Loss of your daily routine

Q # 7. Increase in the rate of inflation can have a number of negative effects. Briefly explain two (2) of
them.

Ans. Inflation

The overall general upward price movement of goods and services in an economy, usually as
measured by the Consumer Price Index. As inflation rises, every dollar will buy a smaller percentage of a
good. For example, if the inflation rate is 2%, then a $1 pack of gum will cost $1.02 in a year.

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In economics, inflation is a rise in the general level of prices of goods and services in an economy
over a period of time.[1] When the general price level rises, each unit of currency buys fewer goods and
services. Consequently, inflation also reflects an erosion in the purchasing power of money – a loss of
real value in the internal medium of exchange and unit of account in the economy. A chief measure of
price inflation is the inflation rate, the annualized percentage change in a general price index (normally
the Consumer Price Index) over time.

Negative effects of Inflation

i. General
An increase in the general level of prices implies a decrease in the purchasing power of the
currency. That is, when the general level of prices rises, each monetary unit buys fewer goods and
services.[29] The effect of inflation is not distributed evenly in the economy, and as a consequence there
are hidden costs to some and benefits to others from this decrease in the purchasing power of money.
For example, with inflation, lenders or depositors who are paid a fixed rate of interest on loans or
deposits will lose purchasing power from their interest earnings, while their borrowers benefit.
Individuals or institutions with cash assets will experience a decline in the purchasing power of their
holdings.

ii. Hoarding

People buy durable and/or non-perishable commodities and other goods as stores of wealth, to
avoid the losses expected from the declining purchasing power of money, creating shortages of the
hoarded goods.

iii. Allocative efficiency

A change in the supply or demand for a good will normally cause its relative price to change,
signaling to buyers and sellers that they should re-allocate resources in response to the new market
conditions. But when prices are constantly changing due to inflation, price changes due to genuine
relative price signals are difficult to distinguish from price changes due to general inflation, so agents are
slow to respond to them. The result is a loss of allocative efficiency.

Edited by: Lect. Imran Monus