Notes · EconomicsUK · A-Levels

The measurement of macroeconomic performance

This chapter introduces macroeconomics by setting out the objectives of government economic policy and how the key indicators of performance are measured. It covers real and nominal GDP and the use of index numbers, the measurement of inflation using the CPI and RPI, and the measurement of unemployment and the balance of payments - together with the limitations of each measure as a guide to living standards.

4 sections~17 min reading time4 competenciesLevel Foundation 1 · Standard 3

T·0999 / 14

Exam profile

AO1 · Define the policy objectives, GDP, inflation, unemployment and the balance of payments and their measuresAO2 · Calculate and interpret index numbers, real values, growth rates and per-capita figures from dataAO3 · Analyse what the indicators reveal about performance and living standardsAO4 · Evaluate the limitations of GDP and of the inflation and unemployment measures

Operators:defineexplainanalysecalculateevaluateassess

basic level

AS-Level requires the policy objectives and the meaning and measurement of GDP, inflation, unemployment and the balance of payments.

higher level

The full A-Level expects confident use of index numbers and real values and evaluation of the measures' limitations.

Depth

Text

Contents · 4 sections

The measurement of macroeconomic performance

The objectives of macroeconomic policy#

FoundationAQA 7136 4.2.1DfE GCE Economics - objectives of government policy

Macroeconomics studies the economy as a whole, rather than individual markets, and governments pursue a set of macroeconomic objectives that provide the framework for the whole of the rest of the course. The four principal objectives are: strong and sustainable economic growth (a rising real output over time); low unemployment (a high level of employment, often described as 'full employment'); low and stable inflation (in the UK a target of 2% on the CPI measure); and a satisfactory position on the balance of payments (avoiding a large, persistent current-account deficit).

Alongside these four, governments increasingly pursue further objectives: balanced government finances (avoiding an unsustainable budget deficit and rising national debt); a fairer distribution of income and wealth (greater equity); and protection of the environment (sustainable growth that does not deplete natural capital or cause unacceptable pollution). The relative priority given to these objectives is partly a normative matter and varies between governments and over time - for example, priorities shift towards employment and growth in a recession and towards controlling inflation in a boom.

A crucial theme is that these objectives can conflict, so that pursuing one may harm another - a set of trade-offs explored fully in the economic-performance chapter. Faster growth and lower unemployment may, through higher aggregate demand, raise inflation and worsen the current account (as imports rise); reducing inflation may require slowing the economy and raising unemployment; reducing a budget deficit through austerity may slow growth. Because of these trade-offs, macroeconomic policy is a balancing act, and the measurement of each objective is the first step towards managing it.

Measuring performance accurately therefore matters greatly: policy is set and judged against the indicators, so their strengths and limitations shape decisions. The rest of this chapter examines how output (GDP), inflation, unemployment and the balance of payments are measured, and how far each is a reliable guide to what we ultimately care about - living standards and economic wellbeing - which no single number captures perfectly.

Worked example

Spotting a policy conflict

A government uses expansionary policy to cut unemployment. Explain, with reference to the objectives, one conflict this might create.

Identify the effect on the target objective
Expansionary policy raises aggregate demand, which raises output and cuts cyclical unemployment - the intended effect.
Trace the effect on another objective
Higher aggregate demand, especially near full capacity, tends to raise the price level, so inflation may rise above the 2% target - a conflict with the low-inflation objective.
Note a second conflict
Higher domestic demand also pulls in more imports, worsening the current account of the balance of payments - a second objective potentially harmed.

Result: Cutting unemployment through higher demand can raise inflation and worsen the current account - a classic conflict between macroeconomic objectives.

Typical mistakes

Stating the inflation target as 'zero inflation' - the UK target is 2% on the CPI, not zero.
Treating the objectives as always compatible - many pull against each other.

Active revision

Identify the four main macroeconomic objectives and explain one way in which the pursuit of faster economic growth might conflict with another objective.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

Measuring output: real and nominal GDP and index numbers#

StandardAQA 7136 4.2.1DfE GCE Economics - measures of economic performance

Nominal and real GDP over time

Fig. 1Nominal GDP (current prices) rises faster than real GDP (constant prices) when there is inflation; the gap between them reflects rising prices, not extra output. Values are illustrative.

Gross domestic product (GDP) is the total value of all goods and services produced within a country's borders in a given period. Because output, income and expenditure in the economy are three ways of measuring the same flow (one person's spending is another's income, paid out to produce output), GDP can be measured by the output, income or expenditure method, and the three should in principle give the same total. National income is closely related; the specification uses GDP as the headline measure of the size of the economy and of economic growth (the percentage change in real GDP).

The vital distinction is between nominal and real GDP. Nominal (money) GDP measures output at current prices, so it rises both when more is produced and when prices rise. Real GDP measures output at constant (base-year) prices, stripping out the effect of inflation, so it reflects only changes in the quantity of goods and services produced. Because we care about output, not price rises, real GDP is the correct measure of economic growth and of changes in material living standards. Confusing the two - crediting an economy with 'growth' that is merely inflation - is a serious error. GDP per capita (GDP divided by population) is a better guide to average living standards than total GDP, because it accounts for population size.

Index numbers are the tool that makes real values and comparisons possible, and the quantitative-skills strand requires fluency with them. An index number expresses a value as a percentage of a base-year value, which is set to 100: index = (value in year / value in base year) x 100. So if output is 100 in the base year and the index reads 108 three years later, output has risen 8% since the base year. The same device underlies the price indices used to measure inflation, and converting nominal to real values uses a price index: real value = (nominal value / price index) x 100.

GDP is the standard measure of economic performance, but it is an imperfect guide to living standards and wellbeing, and evaluation of its limitations is heavily rewarded. It omits non-marketed output (household and voluntary work), it takes no account of the hidden (informal) economy, and it says nothing about the distribution of income - a rising average can hide growing inequality. It counts 'bads' as well as 'goods' (spending to clean up pollution adds to GDP), ignores the depletion of natural capital and the environmental costs of growth, and does not measure leisure, health, or the quality of life. This is why economists supplement GDP with wider measures of wellbeing (such as the Human Development Index or subjective wellbeing surveys), and why comparisons over time and between countries must adjust for prices, population and purchasing power.

\text{Index number} = \frac{\text{value in the year}}{\text{value in the base year}} \times 100

Index number

Expresses a value relative to a base year set to 100. An index of 108 means the value is 8% above the base year.

\text{Real value} = \frac{\text{nominal value}}{\text{price index}} \times 100

Converting nominal to real

Deflating a nominal value by the price index removes the effect of inflation, giving the value at base-year prices - the basis of real GDP and real income.

Worked example

From nominal to real GDP with a price index

Nominal GDP rises from 2,000 bn to 2,100 bn pounds, while the GDP price index (deflator) rises from 100 to 103. Calculate real GDP in year 2 at base-year prices and the real growth rate.

Deflate the nominal figure
Real GDP (year 2) = nominal / price index x 100 = 2,100 / 103 x 100 = 2,038.8 bn pounds at base-year prices.
Compare with year 1
Year 1 real GDP is 2,000 bn (the base year, index 100). Real growth = (2,038.8 - 2,000) / 2,000 x 100 = 1.94%.
Interpret
Although nominal GDP rose 5%, once the 3% price rise is stripped out, real output grew by only about 2% - the true measure of growth. The rough shortcut (nominal growth minus inflation, 5% - 3% = 2%) confirms it.

Result: Real GDP in year 2 is about 2,039 bn pounds and real growth is about 1.9% - well below the 5% nominal rise, because 3 points of it were inflation.

Typical mistakes

Describing a rise in nominal GDP as economic growth - growth is a rise in REAL GDP, net of inflation.
Using total GDP rather than GDP per capita to compare living standards between countries of different population sizes.

Active revision

An economy's nominal GDP rises by 6% while the price level rises by 4%. Explain what has happened to real GDP, and calculate the approximate real growth rate.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

Measuring inflation: CPI, RPI and price indices#

StandardAQA 7136 4.2.1DfE GCE Economics - the measurement of inflation

A rising consumer prices index

Fig. 2The CPI tracks the weighted average price of a representative basket; the annual inflation rate is the percentage change in the index. Values are illustrative (base year = 100).

Inflation is a sustained rise in the general (average) price level, which reduces the purchasing power of money. Related terms must be kept distinct: deflation is a sustained FALL in the general price level (a negative inflation rate); disinflation is a FALL in the RATE of inflation (prices are still rising, but more slowly). The UK's inflation target is 2% a year on the Consumer Prices Index. Inflation is measured by tracking the change in the price of a representative 'basket' of goods and services bought by a typical household.

The Consumer Prices Index (CPI) is the UK's main measure. It is constructed in two stages. First, a survey of household spending (the Living Costs and Food Survey) establishes what a typical household buys, so that a representative basket of several hundred goods and services can be selected and each item can be given a weight reflecting its share of spending - more is spent on housing and food than on postage, so they carry more weight. Second, the prices of the items in the basket are collected each month, and a weighted price index is calculated; the annual inflation rate is the percentage change in this index over twelve months. The basket and the weights are updated each year to reflect changing spending patterns (new products enter, obsolete ones leave).

The Retail Prices Index (RPI) is an older measure that differs from the CPI in coverage and method: it includes some housing costs that the CPI excludes (notably mortgage interest payments and council tax) and uses a different averaging formula, so it usually reports a slightly higher figure than the CPI. The CPI is used for the inflation target and, increasingly, for uprating benefits and pensions, while the RPI is still used in some contracts and index-linked bonds. Knowing that different measures give different numbers is itself an evaluation point.

No price index measures inflation perfectly, and the limitations are examinable. Because the basket and weights are fixed for a year, the index can be slow to capture substitution (as consumers switch away from goods whose prices rise) and the arrival of new goods, tending to overstate inflation. It reflects the spending of a 'typical' household, so it misrepresents the cost of living for households whose spending differs markedly (pensioners, the poor), and it struggles to adjust fully for improvements in quality (a more powerful computer at the same price is really a price fall). Sampling and measurement errors add further imprecision. These caveats matter because the index guides monetary policy, wage bargaining and the uprating of benefits, so small biases have large consequences.

\text{Inflation rate} = \frac{CPI_{\text{this year}} - CPI_{\text{last year}}}{CPI_{\text{last year}}} \times 100

The annual inflation rate

The percentage change in the price index over twelve months. A positive figure is inflation, a negative figure deflation; a falling positive figure is disinflation.

Worked example

Calculating inflation from a price index

A country's CPI is 102 in year 1, 106 in year 2 and 111 in year 3 (base year = 100). Find the inflation rate in year 2 and year 3, and state what has happened to the rate.

Year-2 inflation
Inflation = (106 - 102) / 102 x 100 = 3.92%.
Year-3 inflation
Inflation = (111 - 106) / 106 x 100 = 4.72%.
Interpret the trend
The price level is rising throughout (inflation is positive), and the RATE has increased from about 3.9% to about 4.7% - accelerating inflation, not disinflation.

Result: Inflation is about 3.9% in year 2 and 4.7% in year 3 - prices are rising faster, so this is accelerating inflation.

Typical mistakes

Confusing disinflation (a falling rate of inflation, prices still rising) with deflation (falling prices).
Saying inflation 'measures the price level' - it measures the RATE OF CHANGE of the price level.

Active revision

The CPI rises from 106 to 111 over a year. Calculate the inflation rate, and explain why the CPI might overstate the true rise in a pensioner's cost of living.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

Measuring unemployment and the balance of payments#

StandardAQA 7136 4.2.1DfE GCE Economics - unemployment and the balance of payments

The working-age population and the unemployment rate

Fig. 3The unemployment rate is the unemployed as a percentage of the labour force (employed plus unemployed), not of the whole population. Values are illustrative (millions).

Unemployment refers to people who are able and willing to work and are actively seeking a job but cannot find one. Two measures are used in the UK. The Labour Force Survey (LFS) measure, based on the internationally comparable International Labour Organisation (ILO) definition, surveys a large sample of households and counts as unemployed those without a job who have looked for work in the past four weeks and are available to start; it is the headline measure. The claimant count measures only those claiming unemployment-related benefits, so it is narrower and can be affected by changes in benefit rules. The unemployment RATE is the number unemployed as a percentage of the economically active labour force (the employed plus the unemployed) - NOT of the whole population, which is a common error.

The labour force (economically active population) is made up of those employed and those unemployed; the economically inactive (students, the retired, carers, the long-term sick, and discouraged workers who have given up looking) are outside it. The distinction matters because a fall in measured unemployment can reflect people leaving the labour force into inactivity rather than finding work, and because the participation rate (the share of the working-age population that is economically active) affects the economy's productive potential. Neither measure captures under-employment (people working fewer hours than they want) or the quality of jobs.

The balance of payments is a record of all financial transactions between a country's residents and the rest of the world over a period. Its most examined part is the current account, which records trade and income flows: the trade in goods (the visible balance), the trade in services (the invisible balance), primary income (interest, profits and dividends on investments abroad and payments to foreign investors), and secondary income (transfers such as foreign aid). A current-account deficit means the country is spending more on imports and payments abroad than it earns from exports and receipts - importing more than it exports overall - while a surplus is the reverse. (The capital and financial accounts record flows of investment and financial assets, which broadly offset the current account.)

These measures, like GDP and the CPI, are imperfect guides that must be interpreted with care - an evaluation skill. A low unemployment rate looks healthy but may hide rising inactivity, under-employment or poor-quality work; a current-account deficit is not necessarily a problem in the short run (it may finance investment or reflect strong domestic demand) but a large and persistent one can signal a lack of competitiveness. The four indicators together - real GDP, inflation, unemployment and the current account - are the dashboard by which macroeconomic performance is judged, and the next chapters explain what drives them and how policy can influence them.

\text{Unemployment rate} = \frac{\text{number unemployed}}{\text{labour force}} \times 100

The unemployment rate

The labour force is the employed plus the unemployed (the economically active). The rate is measured against the labour force, not the total population.

Worked example

Calculating the unemployment rate

An economy has 33.0 million employed, 1.4 million unemployed and 8.7 million economically inactive. Calculate the size of the labour force and the unemployment rate.

Find the labour force
The labour force (economically active) is the employed plus the unemployed: 33.0 + 1.4 = 34.4 million. The 8.7 million inactive are excluded.
Compute the rate
Unemployment rate = 1.4 / 34.4 x 100 = 4.07%.
Interpret
About 4.1% of the labour force is unemployed. Note that using the whole working-age population (34.4 + 8.7 = 43.1 million) would wrongly give 3.2% - the rate is measured against the labour force.

Result: The labour force is 34.4 million and the unemployment rate is about 4.1%, measured against the labour force (not the total population).

Typical mistakes

Calculating the unemployment rate as a percentage of the whole population rather than the labour force.
Assuming a current-account deficit is always harmful - it depends on its size, persistence and cause.

Active revision

In an economy 1.4 million people are unemployed and 33 million are employed. Calculate the unemployment rate, and explain one reason it might understate the true extent of labour underutilisation.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

References & sources

Sources

Department for Education

GCE AS and A level subject content for economics

AQA

AQA A-level Economics 7136 specification

The measurement of macroeconomic performance

4 sections~17 min reading time4 competenciesLevel Foundation 1 · Standard 3

The measurement of macroeconomic performance

Key points

Spotting a policy conflict

Key points

From nominal to real GDP with a price index

Key points

Calculating inflation from a price index

Key points

Calculating the unemployment rate

Sources

The measurement of macroeconomic performance

Key points

Spotting a policy conflict

Key points

From nominal to real GDP with a price index

Key points

Calculating inflation from a price index

Key points

Calculating the unemployment rate

Sources