1. Economics Basics: Introduction
  2. Economics Basics: What Is Economics?
  3. Economics Basics: Supply and Demand
  4. Economics Basics: Utility
  5. Economics Basics: Elasticity
  6. Economic Basics: Competition, Monopoly and Oligopoly
  7. Economics Basics: Production Possibility Frontier, Growth, Opportunity Cost and Trade
  8. Economic Basics: Measuring Economic Activity
  9. Economics Basics: Alternatives to Neoclassical Economics
  10. Economics Basics: Conclusion

One important part of macroeconomics is measuring the economy. Knowing if the economy is growing and by how much is an important metric for policy makers, financial professionals, corporate strategy and everyday citizens. Here we will bring up just a few of the most important measures of economic activity at the national level.

Gross Domestic Product (GDP)

Gross domestic product, or GDP, is one of the main indicators used to measure a country's economic activity. It represents the total aggregate dollar value of all goods and services produced in a country each year, and is often equated with the size of the economy. GDP is often measured quarterly, but expressed as an annualized figure. For example, if 3rd quarter GDP is reported to be up 3%, this tells us that economy has grown by 3% over the last year starting from the 3rd quarter.

GDP is tabulated either by adding up what everyone working within a county (citizens or non-citizens) earned over the course of a year (the income approach), or else by adding up what everyone spent (expenditure method). In theory, both measures should arrive at roughly the same total since your spending is somebody else’s income.

The income approach, which is sometimes referred to as GDP(I), is calculated by adding up total compensation to employees, gross profits for incorporated and non-incorporated firms, and taxes less any subsidies and government transfers (such as welfare checks). The expenditure method is the more common approach and it is calculated by adding up total consumption (C), investment (I), government spending (G), and the net difference between imports and exports (X-M). Sometimes economists express this as the GDP equation, where Y is the national income, or GDP.

Y = C + I + G + (X - M)

Consumption is typically the largest GDP component in the economy, consisting of private expenditures on the wants and needs of a nation’s citizens. Investment is what businesses spend on things like equipment purchases or new construction of factories. Government spending includes items such as salaries of civil servants and government contractors, purchase of weapons for the military, and any investment expenditure by a government. Exports are the goods produced in a country but sold abroad, and imports are goods produced abroad but purchased here.

When the economy is healthy and growing, you will typically see steady increases in a county’s GDP. If GDP falls, the economy is contracting. Investors worry about negative GDP growth, which is one of the factors economists use to determine whether an economy is in a recession. The rule of thumb is that two consecutive quarters of shrinking GDP is the signal for a recession.

Unemployment

The unemployment rate measures how many people in a country are out of work. It is the share of the labor force that is jobless, expressed as a percentage. Unemployment generally rises or falls in response to changing economic conditions, making it a lagging indicator. When the economy is in poor shape and jobs are scarce, the unemployment rate will rise. When the economy is growing at a healthy rate and jobs are relatively plentiful, it can be expected to fall.

To calculate the unemployment rate, the number of unemployed people is divided by the number of people in the labor force, where the labor force consists of all employed and unemployed people. The ratio is expressed as a percentage. This represents the so-called headline unemployment figure, or U3 unemployment. Some have criticized this measure for not accurately reflecting the employment picture of a country. This is because it includes people who are working part time but would rather work full time, and more importantly because it excludes people who are no longer looking for work – and therefore are no longer considered in the labor force. Some discouraged workers that have given up looking for work would probably like to work but have lost hope. A more inclusive unemployment measure that includes discouraged and part time workers is the U6 unemployment figure, and this is typically quite a bit higher than the headline rate.

Unemployment in a growing economy is never actually zero percent. This is because some people choose not to work (voluntary unemployment), some are in between jobs (frictional unemployment), or some skilled workers find their skills are no longer in demand (structural unemployment). Full employment is a situation where all available workers in the labor force are being used in the most efficient way possible. Full employment embodies the highest amount of skilled and unskilled labor that can be employed within an economy at any given time. Any remaining unemployment is considered to be frictional, structural, or voluntary. In the contemporary United States, the headline unemployment rate associated with full employment has been around four to six percent.

Inflation

Inflation measures the change in the price levels of goods and services in an economy over time. Inflation is defined as a sustained increase in the general level of prices for goods and services in a country, and is measured as an annual percentage change. Under conditions of inflation, the prices of things rise over time. Put differently, as inflation rises, every dollar you own buys a smaller percentage of a good or service. When prices rise, and alternatively when the value of money falls you have inflation.

Inflation can be caused for a number of reasons, but what is important to understand is that a rate of inflation that is too high or too low is bad for economic stability. Typically an inflation rate between one and four percent annually is ideal. If inflation rises too high, the prices of things in an economy can surge even if wages don’t catch up. In extreme cases, hyperinflation can wreck a nation’s economy. At the same time, if price levels decline, in what is known as deflation, people may stop spending money and companies may halt investments. They anticipate that things will be cheaper tomorrow, so why spend today? This mindset can lead to a dangerous deflationary spiral that can also wreck an economy.

Measuring inflation is a difficult problem for government statisticians. To do this, a number of goods that are representative of the economy are put together into what is referred to as a market basket. The cost of this basket is then compared over time. This results in a price index, which is the cost of the market basket today as a percentage of the cost of that identical basket in the starting year. These measures are commonly the consumer price index (CPI) and the producer price index (PPI).


Economics Basics: Alternatives to Neoclassical Economics
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