Notesale: Turn your study into money

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2 The UK economy: performance and policies
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1 GDP as a measure of economic growth
→ Gross domestic product (GDP) is the measure of output of goods and services in a country in a year
→ It is given as a level of output, in the local currency
→ On its own it is almost meaningless; we need to know how many people there are, what the
currency is worth in terms of its spending power in the local economy and what the changes have
been since the previous measure
→ There are two meanings of the term economic growth:
▪ Actual economic growth refers to an increase in real incomes or GDP
▪ Potential economic growth is an increase in the productive capacity of an economy
→ Potential economic growth may be caused by an increase in the labour supply, or increased
investment or productivity – the difference between actual and potential economic growth is known
as an output gap
→ Although it is a useful measure, potential economic growth is hard to record and calculate
→ GDP is the sum of all goods and services produced in a country in a year
→ It is also the sum of all incomes earned in a country in a year, and the sum of all expenditure in a
year
→ GDP does not include earnings by its residents while they are abroad, i
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the earnings of a British
engineer who is working and being paid in Russia do not count toward British GDP
→ A country’s GDP can be considered as a circular flow of income where for everything that is earned,
something must be produced and something must be spent
→ The government measures all three flows: goods, income and expenditure – in theory these should
be equal, all at around £1
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2 Distinction between various terms
→ If economic growth is measured using national income, the value is meaningless unless the figures
and given in real values rather than nominal values, i
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adjusted for inflation

→ Another important distinction that needs to be made is to look at values rather than volumes – it is
meaningless to talk about the number of shoes being made in a country without considering the
price at which those shoes are sold for
→ For example, in terms of volume of exports, China far eclipses Germany, yet because German
exports are in high-value goods and services, Germany has the highest value of exports in the world
– Germany, then, gets more benefit from their exports, despite actuallt exporting less than China in
terms of volume
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4 Comparison of rates of growth between countries and over time
→ An increase in GDP of 10% in one country does not mean that country is doing better than a country
with 5% GDP growth
→ Equally, a comparison of growth rates over time must bear this is mind – Japan saw annual growth
rates of 10% in the 1960s compared to just 4% in the 1980s, but the 1980s figure is based on a much
larger economy
→ An evaluation of growth figures depends on:
▪ How well-off the country is in the first place
▪ How much of the output is self-consumed, so does not appear as GDP
▪ Methods of calculation and reliability of data
▪ Relative exchange rates – do they represent the purchasing power of the local currency?
▪ Type of spending by government – is money spent on warfare or quality of life issues such as
education and health?
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6 Limitations of using GDP to compare living standards between countries and over time
→ There are a number of limitations of using GDP to compare living standard, both between countries
and over time:
▪ Subsistence, barter and the hidden economy – if farmers consume their own output, if
goods are traded without the price system or if goods are paid for without being declared
for tax purposes, they will not be included in GDP; the size of the hidden economy is
estimated at 7% of GDP in the UK, 30% in Italy, 50% in Russia and up to 60% in sub-Saharan
Africa
▪ The informal economy – wagwan, capitalism? Some output is not recorded because it is not
bought or sold, but is still output, like volunteering at a charity shop or growing potatoes in
your garden and then giving them to your neighbours for free
▪ Currency values – when trying to compare countries, there is a difficulty in knowing whether
to use the official value of a currency (the exchange rate) or the purchasing power of that
currency
▪ Income distribution – when comparing countries’ income per head, some sense of the
income distribution should also be taken into account; if a large proportion of income is
earned by very few people, then the general standard of living in a country can seem higher
than it is due to a skewed mean
▪ Size of the public sector – if much of the spending in the economy is by government, it may
have positive effects (guaranteeing stability) or it may not (driving inefficiency)
▪ Consumer and capital spending – spending on investment goods might mean standard of
living increases in the future, at the expense of living standard today
▪ Quality issues – spending on schools might be high, for example, but how can we measure
the quality of education? Are improving results enough to show that the quality of the good
being purchased is actually better, or is the price simply becoming inflated?
→ These limitations mean that comparisons of living standards are likely to be inaccurate if they are
based solely on GDP
→ However, real income growth per head is a good guide to actual growth if these others factors are
taken into account
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1 Inflation, deflation and disinflation
→ Inflation is a sustained rise in the general price level
→ The general price level is measured using the consumer prices index (CPI) – the reason for using an
index is that percentage changes can be shown easily
→ Deflation is a fall in the general price level
→ It is problematic in a number of ways:
▪ It is a problem for people with debts, because the real value of money becomes higher, and
so the real size of any debt they face becomes larger – it is harder for them to pay back their
debts
▪ It also stops firms from wanting to invest in that country because the value of goods
produced by any investment is likely to reduce relative to the cost of the initial costs
▪ Deflation is also likely to reduce consumption, creating a shock to aggregate demand – why
buy an expensive consumer item when you know the prices are going to come down?
→ Disinflation occurs when prices rise more slowly than they have done in the past
→ For example, inflation might fall from 3% to 2%, meaning that prices are rising (there is inflation) but
it as at a slower rate than previously
→ Disinflation can be a sign that inflation is coming under control, but on the worrying side it can mean
that investment and confidence are low in the economy, and deflation might occur in the near term
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3 The government’s target for CPI inflation
→ The UK government has a symmetrical target for CPI inflation of 2% - the shorthand for this is CPI
inflation of 2% (±1%)
→ As a result, small price rises are acceptable to the UK government, but if prices rise by more than 3%
then they start to become a concern

→ Equally, if they start to rise by less than 1% then there is a risk of deflation and the Bank of England is
tasked with returning it to within the 1-3% acceptable range
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5 The RPI as an alternative measure
→ For many people, wage increases are linked to the rate of inflation, and, if the CPI measure is used,
wage increases will fail to account for one of the most significant elements of household costs
→ A more appropriate measure for wage determination is the retail prices index (RPI)
→ This is more inclusive that the CPI in that it includes housing costs, but it is not as reliable for
international comparisons because it is only used in the UK
→ Moreover, because RPI includes the costs of mortgage payments (which include interest payments),
any increase in interest rates will have the effect of increasing the value of mortgage payments,
increasing RPI
→ Changes to interest rates can therefore have a one-off sudden impact on the RPI
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2 Current account imbalances and other macroeconomic objectives
→ On its own, a balance of payments deficit on the current account is not a problem so long as it can
be funded by the capital account
→ It can be a sign that living standards are rising
→ It becomes a problem when reserves of foreign currencies begin to run low and we say that a
country is not paying its way
→ It might mean that the currency falls in value, which is inflationary, since imports become more
expensive
→ It may be a sign that the country is becoming uncompetitive – costs are rising relative to trading
partners – which can cause unemployment in the domestic economy
→ In the long-run this might mean a painful re-adjustment, i
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tax increases, to stop people
overspending – higher taxes and cuts in government spending are likely to solve the current account
deficit and are likely to cause a slowdown in economic growth
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2 AGGREGATE DEMAND AND SUPPLY
→ Aggregate refers to the totalling of the individual elements discussed in microeconomics
→ Aggregate demand and supply analysis brings together the amount that consumers wish to spend
and producers wish to produce at any given price level
→ Aggregate demand (𝐴𝐷) is the total planned expenditure on goods and servi

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