Measuring the Performance of the Economy

Measuring the performance of the economy

Macroeconomic objectives

How is the economy performing? What are our economic prospects? Are things going to improve and, if so, when? Why are certain economies doing so well while others are struggling?

In order to answer these questions, economists usually distinguish five macroeconomic objectives which can be used to judge the performance of the economy…

economic growth
full employment
price stability
balance of payments stability (or external stability)
equitable distribution of income

Measuring the level of economic activity: gross domestic product

The first step in measuring economic growth is to determine a country’s total production of goods and services in a specific period. The central concept in the national accounts is the gross domestic product (GDP).

Gross domestic product (GDP): the total value of all final goods and services produced within the boundaries of a country in a particular period (usually one year).

At first glance it seems to be a clear and simple concept, but how do the national accountants succeed in adding up all the different types of economic activity in the country during a particular period?

To explain this, we have to examine the various elements of the definition of GDP.

The first important element is value. The best way to determine value is to use the prices ofthe various goods and services to obtain the value of production. Once the production of each good or service is expressed in rand and cents, the total value of production can be determined by adding the different values together.

The second important element is the word final. One of the major problems that national accountantshave to deal with is the problem of double counting. If they are not careful they can easily overestimate or inflate the value of GDP by counting certain items more than once.

Consider the following simple example…

A farmer produces 1000 bags of wheat which he sells to a miller at R10 per bag, yielding a total of R10 000.
The miller processes the wheat into flour, which he then sells to a baker for R12 500.
After baking bread with the flour, the baker sells it to a shop for R18 000.
The shop subsequently sells the bread to final consumers for R21000.

What is the total value of these four transactions?

R61500? NO!Thetotal value of the farmer’s production cannot be added to the total value of the miller’s sales to the baker, since the value of the production of the wheatis included in the value of the flour sold by the miller. The same applies to the value of the bread.

To avoid the problem of double counting, national accountants start with the full value of the farmer’s production and then subsequently add only the value added by each of the other participants in the production process. Nowadays GDP is often also called gross value added (GVA).

But what has all this got to do with the adjective final in the definition of GDP? In our example the value of the shop’s sales to the final consumers also amounts to R21 000. The fact that this is exactly equal to the total value added is no accident.Double counting can also be avoided by counting only the value of those sales where a good orservice reaches its final destination. Such sales involve final goods and services which have to bedistinguished from intermediate goods and services. Any good or service that is purchased forreselling or processing is regarded as an intermediate good or service. Intermediate goods andservices do not form part of GDP.

Note, however, that it is the ultimate use of a product which determines whether it is a final or anintermediate product. If the flour in the above example is bought by consumers, it would be classifiedas a final good.

There is another way in which double counting can be avoided. That is by considering only theincomes earned during the various stages of the production process by the owners of the factors ofproduction.

In our example…

R10 000 is earned during the farming stage
R2 500 (R12 500 minusR10 000) during the milling stage
R5 500 (R18 000 minus R12 500) during the baking stage
andR3 000 (R21 000 minus R18 000) during the final selling stage.
This again yields a total of R21000(R10 000 + R2 500 + R5 500 + R3 000).

Note that the income earned during each stageof the production process is equal to the value added during that stage. This is also no accident.Income is earned by producing, that is, by adding value to goods and services. For the economy asa whole, income can be increased only if production increases (ie if more value is added).

The factthat value added, spending on final goods and income all yield the same answer means that there arethree different ways of calculating GDP.

The three methods of calculating GDP illustrated in the example are…

the production method (value added)
the expenditure method (final goods and services)
the income method (incomes of the factors of production)

Why do they yield the same answer? The value of final goods and services must necessarily be made up of the successive values added in the different stages of production. In addition, production and income may be viewed as two sides of the same coin.

Production is the source ofincome – the only way in which income can be generated in an economy is by producing (and selling) goods and services.
The income earned by the various factors of production (labour, capital, natural resources and entrepreneurship) consists of wages and salaries, interest, rent and profit.
Total value of production= combinedvalue of wagesand salaries, interest, rent and profit.

The three methods essentially measure the same thing, albeit at different points in the circular flow.

Further aspects of the definition of GDP

Two elements of GDP have now been explained: the meaning of value and the meaning of final goods and services.

Two further aspects need to be highlighted…

“within the boundaries of a country” - GDP is a geographic concept that includes all theproduction within the geographic area of a country. This is what is signified by the term domestic ingross domestic product. We shall return to this aspect when other measures of economic activity arediscussed.
The last important aspect to note is that only goods and services produced during a particular periodare included in GDP. GDP therefore concerns the production of new goods and services. GDP reflects only productionwhich occurred during the period in question. Also note that GDP is a flow which can be measuredonly over a period of time (usually one year).

Because production and income are two sides of the same coin. This means that incomecan be substituted for the product in GDP. Gross domestic product is therefore the same as gross domestic income.

The final element of GDP that needs explaining is the wordgross. The description of total outputas gross product means that no provision has been made for that part of a country’s capital equipment (buildings, roads, machinery, tools, etc) which is ‘used up’ in the production process.

Measurement at market prices, basic prices and factor cost (or income)

The three methods of calculating GDP will yield the same result only if the same set of prices is used in all the calculations. There are, however, three sets of prices that can be used to calculate GDP…

market prices
basic prices
factor cost (or factor income)

In practice…

market prices are used when calculating GDP according to the expenditure method
basic prices are used when the production (or value added) methodis applied
factor cost (or factor income) is used when the income method is used.

Different valuations of GDP will thus yield different results and you should therefore always check at which prices GDP is expressed.

The differences between market prices, basic prices and factor cost (or factor income) are due to various taxes and subsidies on goods and services. When there are indirect taxes (ie taxes on production and products) or subsidies (on production or products) the amount paid for a good or service differs from both the cost of production and the income earned by the relevant factors of production.

For example, the amount paid by a consumer for a packet of cigarettes is much higher than the combined income earned by the merchant, the manufacturer, the workers, the tobacco farmer and everyone else involved in the process of producing and selling the packet of cigarettes. The difference is the result of excise duty and value-added tax (VAT), which together constitute almost 50 per cent of the market price of a packet of cigarettes in South Africa.

Indirect taxes (i.e. taxes on production and products) thus have the effect of making the market prices of goods and services higher than their basic prices or factor cost.

Subsidies have just the opposite effect. They result in market prices being lower than basic prices or factor cost.

The national accountants distinguish between two types of tax and subsidy on production and products…

taxes/subsidies on products

other taxes/subsidies on production.

Taxes on productsrefer to taxes which are payable per unit of some good or service (eg value added tax, taxes and duties on imports and taxes on exports).

Other taxes on production refer to taxes on production that are not linked to specific goods or services (eg payroll taxes, recurring taxes on land, buildings or other structures and business and professional licenses).

Subsidies on products include directsubsidies payable per unit exported to encourage exports, and product-linked subsidies on products used domestically.

Other subsidies on production refer to subsidies that are not linked to specific goods or services (eg subsidies on employment or the payroll).

The following identities apply:

GDP at market prices - taxes on products + subsidies on products =GDP at basic prices

GDP at basic prices - other taxes on production + other subsidies on production =GDP at

factor cost (or factor income)

Likewise:

GDP at factor cost + other taxes on production - other subsidies on production =GDP at basic

prices

GDP at basic prices + taxes on products - subsidies on products =GDP at market prices

Measurement at current prices and at constant prices

Another important distinction that needs to be made is that between GDP at current prices(or nominal GDP) and GDP at constant prices (or real GDP).

For example, when they calculated the GDP for 2010, the national accountants had to use the prices paid for the various goods and services in 2010. We call this measurement at current prices or in nominal terms (see Box 2-1). However, we are not interested only in the size of GDP during a particular period. We also want to know what happened to GDP from one period to the next. We want to know, for example, how the 2010 GDP compared with the GDP for 2009. This is how we measure economic growth.

But in a world in which prices tend to increase from one period to the next (i.e. a world of inflation), it makes little sense to simply compare monetary values between different years. We have to allow for the fact that prices may have increased. For example, in 2010 the South African GDP at current market prices was 11,1% higher than in 2009. But this did not mean that the actual production of goods and services was 11,1% greater in 2010 than in 2009. The largest part of this increase simply reflected the fact that most prices were higher in 2010 than in 2009.

To solve this problem, national accountants convert GDP at current prices to GDP at constant prices (or real GDP). This is done by valuing all the goods and services produced each year in terms of the prices ruling in a certain year, called the base year. At the time of writing, 2005 was the base year used by Stats SA and the SARB. In other words, each year’s GDP was also expressed at 2005 prices. This is what we mean when we talk about GDP at constant prices or real GDP.

Once this adjustment had been made, the national accountants found that the South African GDP was 2,8% greater in 2010 than in 2009. The growth in GDP at constant prices (or real GDP) was therefore only 2,8%. The difference between this rate and the 11,1% growth in GDP at current prices (or nominal GDP) was the result of price increases (i.e. inflation).

Other measures of production, income and expenditure

While GDP is undoubtedly the most widely used barometer of total production in an economy in a particular year, the other measures also have specific uses.

Gross national income or gross national product

The D in GDP represents domestic. It indicates that we are dealing with what occurred within the boundaries of the country. It does not matter who produces the goods or who owns the factors of production.

But economists also want to know what happens to the income earned and the standard of living of all South African citizens or permanent residents in the country. To answer this question, all income earned by foreign-owned factors of production in South Africa has to be subtracted from GDP. In addition, all income earned by South African factors of production in the rest of the world also has to be taken into account.

To derive GNI from GDP the following must therefore be done:

Subtract from GDP

all profits, interest and other income from domestic investment which accrue to residents of other countries
allwages and salaries of foreign workers engaged in domestic production (eg the wages earned by residents of Lesotho, Mozambique and Malawi on the South African gold mines).

Add to GDP

all profits, interest and other income from investments abroad which accrue to permanent residents
all wages and salaries earned by permanent residents outside South Africa

GNI=GDP + primary income receipts – primary income payments or (since payments are larger)

GNI= GDP – net primary income payments to the rest of the world where net primary income payments = primary income payments – primary income receipts)

Expenditure on GDP

As we learnt previously, there are three approaches to calculating GDP…

the production approach (which measures the value added by all thepartĪcipants in the economy)
the income approach (which measures the income received by the different factors of production)
expenditure approach (which measures the spending on final goods and services by the different partĪcipants).

With the expenditure approach, the national accountants add together the spending of the four major sectors of the economy: households, firms, government and the foreign sector. Thus, the elements of total spending are…

consumption expenditure by households (C)
investment spending (or capital formation) by firms (I)
government spending (G)
expenditure on exports (X) minus expenditure on imports (M)

GDP = C + I + G + (X – M)

In the South African economy, final consumption expenditure by households is the largest single element of total expenditure.

Gross domestic expenditure (GDE)

Expenditure on GDP is always equal to GDP at market prices. It indicates the total value of spending on goods and services produced in the country. However, it does not indicate the total value of spending within the borders of the country.

Part of the expenditure on South African GDP occurs in the rest of the world, while part of the spending in the country is on goods and services produced in the rest of the world.

The three central domestic expenditure items (C, I and G) do not distinguish between goods and services manufactured locally and those manufactured in the rest of the world (such as French wine, Italian shoes, Japanese CD players and German machinery). These three items constitute gross domestic expenditure (GDE). Economists are particularly interested in GDE, which indicates the total value of spending within the borders of the country. It includes imports but excludes exports, since spending on exports occurs in the rest of the world.

GDE = C + I + G

GDE includes imports (M) and excludes exports (X),

GDP = C + I + G + (X – Z)

GDP includes exports (X) and excludes imports (Z).

If GDP GDE then exports imports during that period.

If the value of production in the domestic economy exceeded the value of spending within the country it follows that the value of exports was greater than the value of imports.

Conversely, if GDE > GDP, it follows that M > X.

Summary

Gross domestic expenditure (GDE) consists of expenditure on final goods and services by households (C), firms (I) and government (G) during a particular period.
GDE includes spending on imported goods and services (M) and excludes exports (X).
GDE is expressed at market prices.
GDE = C + I + G (C, I and G include imported goods and services)

From GDE to gross domestic product (GDP) at market prices,

imports have to be subtracted from GDE and exportsadded.
GDP at market prices = GDE + X – Z
= C + I + G + X – Z

From GDP at market prices to gross national income (GNI) at market prices…

net primary income payments to the rest of the world have to be subtracted from GDP
GNI at market prices = GDP at market prices – net primary income payments

This information is also summarised in table form on the next page for your convenience. You need to know it well as it is a very popular matric examination question.

The three methods of calculating GDP (You must know this table!)

Gross Domestic Product
Income Approach / Gross Domestic Product
Production Approach / Gross Domestic Product
Expenditure Approach
+
+ / Compensation to employees
Net operating surplus
Consumption of fixed capital(provision for depreciation) / +
+ / Primary sector
Agriculture, forestry and fishing
Mining and quarrying
Secondary sector
Manufacturing
Electricity, gas and water
Construction
Tertiary sector
Wholesale and retail trade, catering and accommodation
Transport, storage and communication
Financial intermediation insurance, real estate and business services
Community, social and personal services
Central government services / C
+
G
+
I
+ / Consumption expenditure by households
Expenditure by government
Gross fixed capital formation and changes in inventories
(Gross fixed formation capital
- Changes in inventories)
Residual item(errors &omissions)
= / Gross domestic expenditure (GDE)
X
-
Z / Exports of goods and non-factor services
Imports of goods and non-factor services
= / Gross value added at factor cost
+
- / Taxes on production
Subsidies onproduction
= / Gross value added at basic prices / = / Gross value added atbasic prices
+
- / Taxes on products
Subsidies on products / +
- / Taxes on products
Subsidies on products
= / Gross domestic product (GDP) at market prices / = / Gross domestic product (GDP) at market prices / = / Expenditure on gross domestic product (GDP) at market prices
+ / Primary income from therest of the world / + / Primary income from therest of the world / + / Primary income from therest of the world
- / Primary income to the restof the world / - / Primary income to the restof the world / - / Primary income to the restof the world
= / Gross national product (GNP) at market prices / = / Gross national product (GNP) at market prices / = / Gross national product (GNP) at market prices
- / Consumption of fixedcapital / - / Consumption of fixedcapital / - / Consumption of fixedcapital
= / Net national product (NNP) at market prices / = / Net national product (NNP) at market prices / = / Net national product (NNP) at market prices

Amplification of elements contained in the table: