2.1.1 - Economic growth

Measuring Economic Growth

In exam terms, economic growth is usually measured by the percentage change in real GDP over time. That means the published growth rate is mainly about actual growth. A rise in the economy's productive capacity is potential growth, which is related but not exactly the same thing.

GDP matters because higher output usually means more goods and services are available to consume, and that can support higher living standards. However, GDP is only a starting point. To decide whether growth is genuine, economists need to strip out inflation.

Economic growth is measured as:

If the money value of output rises only because prices have gone up, the economy has not actually produced more. That is why the growth rate uses real GDP, not just the cash value of output.

Real, Nominal, and Per Capita

Students often lose marks by treating any increase in GDP as economic growth. The first distinction is between current-price data and inflation-adjusted data.

Nominal GDP can rise even if the quantity of output stays the same, simply because prices have increased.

This is also the difference between the value of GDP and the volume of GDP. The value of GDP is output in money terms. The volume of GDP removes price changes and focuses on the quantity of goods and services produced.

A compact worked example makes the distinction clear. Suppose an economy produces only fish and chips:

Nominal GDP in 2015 is:

Real GDP in 2015, using 2014 prices, is:

Nominal GDP in 2014 is:

So nominal GDP rises from 800 to 1080, which looks like 35% growth. Real GDP rises from 800 to 880, which is only 10% growth. The gap is caused by inflation, not by a 35% increase in output.

Population matters as well. Total GDP may rise while the population rises even faster, leaving less output available per person on average.

GDP per capita is usually a better guide to average living standards than total GDP. A country may have a very large economy overall, but if it also has a very large population, average living standards can still be relatively low.

Comparing Countries and Time

Comparisons over time require real GDP, and often GDP per capita as well, so that inflation and population change do not distort the picture. Comparisons between countries are even harder because currencies, price levels, and data methods differ.

Growth rates also need care because they depend on the starting level. Suppose Country A has GDP per capita of $2,000 and grows by 6$40,000 and grows by 2%. Country A is growing faster, but its extra output is only $120 per person, compared with$800 per person in Country B. A high growth rate from a low base does not necessarily mean the gap in living standards is closing quickly in absolute terms.

One useful distinction is between output produced in a country and income received by its residents.

GNI is often written as GDP plus net income from abroad. In other words, it adds income residents receive from overseas and subtracts income generated domestically that flows to foreign owners. This matters in economies with large multinational sectors or large remittance flows. Ireland is a common example: GDP can be lifted by multinational production recorded there, but some of that income goes to overseas shareholders, so GNI can be a better guide to income available to Irish residents. Ireland's Central Statistics Office now also publishes a modified measure, GNI*, for this reason.

Another problem is that market exchange rates do not tell us what income can actually buy in different countries.

PPP compares the cost of a similar basket of goods and services across countries. If a basket costs $100 in the USA and GBP70 in the UK, the PPP exchange rate would be$1 = GBP0.70, regardless of the market exchange rate on that day. That is why PPP-adjusted GDP per capita is usually better for comparing living standards. It accounts for the fact that a given income often buys more in a low-price economy than in a high-price one. The Economist Big Mac Index is a simple informal example of the same idea.