2.1 - Measuring growth and living standards

Growth and the policy objective

Economic growth is an increase in an economy's real output over time, commonly measured by the percentage increase in real GDP.

Actual growth means more output is produced; potential growth means sustainable productive capacity expands. They can differ: bringing idle machines into use raises actual output without adding machines, while installing useful new machinery can increase potential before firms use it fully. The next lesson develops these demand and capacity mechanisms. Distinguish a large economy from a rapidly growing one: size is a level and growth is a rate of change.

Growth is a policy objective because higher production can provide more goods and services and, if incomes and tax receipts rise, more resources for public services. Growing real incomes can reduce material deprivation and help finance investment. Sustained productive capacity growth can make higher output possible without mounting resource pressure. However, the objective is not an instruction to maximise the headline GDP number at any cost. Distribution, population, environmental damage, working time and the quality of output affect whether people benefit.

Suppose illustrative real GDP rises from £100 billion to £105 billion. The economy produces 5% more output valued at comparable prices. That does not mean every person's income rises 5%, or that pollution, leisure and health all improve. A useful objective can therefore be sustained growth compatible with wider living standards; measurements establish the production change before evaluation weighs its consequences.

Nominal output and real output

Nominal GDP values output at current prices; real GDP removes price changes so production volumes can be compared over time.

An illustrative economy produces 100 units at £2 each in Year 1 and 105 units at £2.20 in Year 2. Nominal GDP rises from £200 to £231, or 15.5%. At Year 1 prices, Year 2 output is £210, so real output rises 5%. The extra 10% unit price rise explains why the money increase is much larger than the volume increase. Real values are not nominal figures minus a number labelled inflation; they require a comparable price basis.

If nominal GDP is £660 billion and the GDP deflator is 110, real GDP is $660/110\times100=£600$ billion at base-year prices. Dividing by 110 without multiplying by 100 loses the scale. A GDP deflator describes prices of domestic output; a consumer price index covers a different basket. Use the deflator supplied for GDP rather than silently substituting CPI. Official national accounts may use chain-linked volume measures rather than a permanently fixed basket; the supplied-index method is a transparent learning model.

Real growth is positive if the volume rises, even if nominal GDP falls when prices fall sufficiently. Conversely, a nominal increase alone cannot prove growth. Before comparing countries, consistent currency and purchasing-power measures are also needed; a market exchange-rate change can alter a foreign-currency GDP total without changing domestic production.

Growth rates and index numbers

A growth rate compares the real-output change with the earlier real-output level, while an index expresses each level relative to a chosen base.

Illustrative real output of £500 billion, £520 billion and £509.6 billion gives growth of 4% then −2%. With the first year set to 100, the indexes are100,104 and101.92. The final index shows output 1.92% above the base, although the latest annual growth is negative. A slowdown from 4% growth to 2% growth means output still rises, just more slowly; it is not a2% output fall. The growth rate falls by 2 percentage points. Two annual rates cannot usually be added to give the cumulative change: multiplication gives $1.04\times0.98=1.0192$.