Output measures, spending and the multiplier

Pearson Edexcel International AS Economics (WEC12), specification Issue 2, June 2018. This topic covers spec sections 2.3.1–2.3.5 in full: measures of economic performance (four rows), aggregate demand (five rows), aggregate supply (three rows), national income (four rows) and economic growth (four rows) — 66 lettered objectives in total. Worked numbers are original unless labelled SAM (Sample Assessment Materials, WEC12/01), and every calculation below is internally consistent.

Must-know for this topic:

Economic growth is the rate of change of REAL Gross Domestic Product — the value of output produced within a country (2.3.1.1a); Gross National Income 国民总收入 (GNI) adds net income earned abroad by residents and is an alternative measure of national income. Distinguish REAL (deflated) from NOMINAL (current prices), TOTAL from PER CAPITA (divided by population), and VALUE from VOLUME (quantity) measures (2.3.1.1c): with nominal GDP index 112 and a price deflator of 108, real GDP $= \tfrac{112}{108} \times 100 = 103.7$; dividing by a population index of 102 gives real GDP per capita $= 101.7$ — a growth of 1.7% in living standards against 3.7% real growth (2.3.1.1a). Compare growth rates across countries and over time, and use Purchasing Power Parities 购买力平价 (PPP) — exchange rates that equalise the price of identical baskets — to make fair international comparisons of real GDP/GNI, since market exchange rates understate living standards in low-price countries (2.3.1.1d–e). Positive growth raises output; negative growth cuts it, and a recession 经济衰退 is two consecutive quarters of negative growth (2.3.1.1f–g). GDP/GNI limitations for living standards: non-market activity, the shadow economy, income distribution, working hours, environmental damage, and price differences (2.3.1.1h); national happiness and wellbeing indicators (life expectancy, corruption perception, reported happiness) complement it — above a threshold, higher real income buys little extra SUBJECTIVE happiness (2.3.1.1i).

Inflation 通货膨胀 is a sustained rise in the general price level; deflation 通货紧缩 is a sustained fall; disinflation 通胀放缓 is a slower rate of RISE — prices still rising (2.3.1.2a). (SAM WEC12/01 Q12(b), adapted) India's CPI inflation fell from about 12% in 2010 to about 9% in 2011 and from about 11% in 2013 to about 6% in 2015: each year prices ROSE, but the rate of increase fell — disinflation, never deflation, since the rate stayed positive. Calculate a consumer price index 消费者价格指数 (CPI) from a weighted basket: weights 50/30/20 over three goods with price relatives 110/100/120 give CPI $= 0.5 \times 110 + 0.3 \times 100 + 0.2 \times 120 = 109$, so inflation is 9% (2.3.1.2b). CPI limitations: a fixed basket, quality change, and the representative household (2.3.1.2c); the producer (wholesale) price index signals FUTURE inflation because producer costs pass through to consumer prices (2.3.1.2d). Causes of inflation: DEMAND-PULL (AD beyond capacity), COST-PUSH (input costs raising prices), and excessive money supply growth (2.3.1.2e); deflation comes from falling AD, a rise in AS, or a falling money supply (2.3.1.2f). Effects of inflation and deflation hit consumers (real incomes, savings), the government (tax receipts, debt values), firms (planning, costs), workers (real wages), income distribution (borrowers gain, lenders lose), investment (uncertainty), UK competitiveness, and the current account (2.3.1.2g).

Unemployment 失业 is measured by the ILO definition: those without work who are available and actively seeking (2.3.1.3a). Causes: FRICTIONAL (between jobs), SEASONAL, STRUCTURAL (skills mismatch), DEMAND-DEFICIENCY, and REAL-WAGE inflexibility (wages stuck above equilibrium) (2.3.1.3b). Effects: consumers lose income, firms lose demand, workers lose skills, public finances lose tax and pay benefits, the economy operates INSIDE its PPF, and society carries costs of crime and exclusion (2.3.1.3c). Underemployment 就业不足 — employed people wanting more hours or a job matching their skills — is distinct from unemployment (2.3.1.3d). Watch rates of employment, unemployment AND economic inactivity together, and note net migration's significance for labour supply (2.3.1.3e–f).

The balance of payments 国际收支 records transactions with the rest of the world; the CURRENT ACCOUNT trades goods and services, plus primary and secondary income (2.3.1.4a); a deficit on trade in goods and services means imports exceed exports; a current-account deficit or surplus is the balance on the whole account (2.3.1.4b–c).

Aggregate demand 总需求 is the total planned spending on domestic output: $AD = C + I + G + (X - M)$ — with C = 60, I = 20, G = 20 and net trade 0, AD = 100 (2.3.2.1a–b). The AD curve slopes DOWN with the price level (wealth, trade and interest-rate effects); a price-level change moves ALONG it, any change in C, I, G or net trade SHIFTS it (2.3.2.1c). Consumption responds to disposable income, interest rates, consumer confidence, welfare payments, wealth effects and the availability of credit; whatever is not consumed is saved — the savings ratio 储蓄率 is saving as a share of income, and it changes with confidence, interest rates and wealth (2.3.2.2). Investment distinguishes GROSS from NET (net = gross minus depreciation) and responds to economic growth, interest rates, business confidence, credit and corporation tax; governments promote it through tax relief, subsidies and lower corporation tax (2.3.2.3). Government expenditure follows fiscal policy, the level of activity (benefits fall in booms), market-failure correction and political priorities (2.3.2.4). The net trade balance moves with real income (imports rise when Y rises), the exchange rate, the global economy, protectionism and non-price factors such as quality and design (2.3.2.5).

Aggregate supply 总供给 is the total planned output at each price level; the AS curve rises with the price level, price changes move ALONG it, and cost or productivity changes SHIFT it (2.3.3.1). Short-run AS shifts with raw material and energy costs, exchange rates (imported inputs) and tax rates (2.3.3.2). The LONG-RUN AS curve comes in two shapes: the KEYNESIAN curve is horizontal with spare capacity, curves up as full employment approaches and turns vertical at capacity; the CLASSICAL curve is vertical at the full-employment output — the classical economy always tends back there (2.3.3.3a). LRAS shifts with technology, productivity, education and skills, regulation and tax, demography and net migration, and competition policy (2.3.3.3b).

The circular flow of income 收入循环流 links households and firms: households supply factors and buy output; INCOME equals OUTPUT equals EXPENDITURE. Wealth is a stock of assets; income is a flow (2.3.4.1). INJECTIONS add spending — investment, government expenditure, exports; WITHDRAWALS remove it — saving, taxation, imports (2.3.4.2a–c). Net injections raise the equilibrium level of real national output; net withdrawals lower it, and equilibrium returns when $I + G + X = S + T + M$ (2.3.4.2d). Equilibrium real output sits where AD meets AS, and shifts in AD or AS move it — the (70, 55) model economy moves to (85, 62.5) with an injection of 15 (2.3.4.3).

The multiplier 乘数 turns an injection into a larger change in income: each round of spending becomes income, part is re-spent, and the process accumulates (2.3.4.4a). The marginal propensity to consume 边际消费倾向 (MPC) drives it; withdrawals drain it through MPS, MPT and MPM (2.3.4.4b). $k = \tfrac{1}{1 - MPC} = \tfrac{1}{MPW}$ (2.3.4.4c). (SAM WEC12/01 Q9, adapted) With MPC = 0.5, $k = \tfrac{1}{1-0.5} = 2$, so a £30 billion investment raises national income by $2 \times 30 = £60$ billion. With $MPW = MPS\,0.1 + MPT\,0.15 + MPM\,0.25 = 0.5$, $k = \tfrac{1}{0.5} = 2$ again; with MPC = 0.8, $k = 5$ and an injection of 20 raises income by 100 in total — the rounds 20, 16, 12.8, 10.24 … sum to 100 (2.3.4.4d). The bigger the multiplier, the bigger the AD shift a given injection buys — which is why the SAME stimulus works differently in economies with different import propensities.

ACTUAL growth is a movement towards the PPF (more output from given capacity); POTENTIAL growth is an outward shift of the PPF (more capacity) (2.3.5.1a). Actual growth comes from any component of AD rising — consumption, investment, government spending or net trade — and international trade matters because export-led growth adds demand from abroad and, while spare capacity lasts, raises output with less inflationary pressure (2.3.5.1b–c). Potential growth comes from domestic and foreign direct investment, innovation, a growing labour force (including net migration) and stronger competition (2.3.5.1d); PRODUCTIVITY growth is the deepest driver of long-run growth rates (2.3.5.1e). Benefits of growth: higher living standards, lower unemployment, higher profits, more investment, higher tax revenues and better public services (2.3.5.2). Costs: opportunity costs (investment instead of consumption), environmental damage, trade deficits as imports surge, greater inequality, and inflation if growth runs past capacity (2.3.5.3). An OUTPUT GAP is the difference between actual output and the long-term trend (2.3.5.4a): a POSITIVE gap means actual output above trend — inflationary pressure; a NEGATIVE gap means spare capacity and unemployment (2.3.5.4b–c). Gaps are hard to measure because the trend itself is estimated, data arrives late and is revised (2.3.5.4d).

Extract. In 2015 Ireland's official figures showed real GDP growth of about 26% in a single year. Little of this was new production by Irish workers. Several large multinational companies had moved valuable assets, such as patents and intellectual property, to their Irish subsidiaries, and some aircraft-leasing firms were based there. The profits from these assets were counted in Irish GDP, but much of them was later paid out to foreign owners. Because GDP had become a poor guide to living standards, Ireland's statistics office created a new measure in 2017, modified gross national income (GNI*), which removes most of these effects. GNI* is far smaller than GDP. Ireland's GDP per head is among the highest in the world, yet household consumption per head is close to the EU average.

Questions

• (a) Ireland's nominal GDP rose from €200 billion to €262 billion in a year in which the GDP deflator rose from 100 to 104. Calculate the rate of real GDP growth. [3]
• (b) Explain the difference between GDP and GNI. [3]
• (c) Using the extract, explain why GDP per head may overstate living standards in Ireland. [6]
• (d) Examine two problems in comparing living standards between countries using GDP per head. [8]
• (e) Evaluate whether GDP is a good measure of a country's economic performance. [12]

(The figures in (a) are illustrative.)

Model answers

(a) Real GDP in year 2 $= \tfrac{262}{104} \times 100 \approx €251.9$ billion, in year-1 prices. Real growth $= \tfrac{251.9 - 200}{200} \times 100 \approx 26\%$. Nominal growth was 31%; about 4 percentage points of it was higher prices.

(b) GDP measures the value of output produced within a country's borders, whoever owns the factors of production. GNI adds income earned abroad by the country's residents and subtracts income paid to foreign owners of factors in the country: $GNI = GDP + \text{net primary income from abroad}$.

(c) Much of Ireland's measured output comes from multinational firms' intellectual property and leased aircraft. The profits are counted in GDP but are paid to foreign shareholders, so they do not become income for Irish households. GDP per head therefore includes income that Irish residents never receive. The extract shows the gap: household consumption per head, which reflects what people actually buy, is only about the EU average, while GDP per head is near the top of the world. GNI* removes these effects and gives a far smaller figure.

(d) Exchange rates and prices: converting GDP at market exchange rates ignores differences in the cost of living; the same income buys more in a cheaper country. Using purchasing power parities corrects this. What GDP leaves out: the size of the informal economy, unpaid work, leisure hours and the distribution of income differ between countries, so equal GDP per head can mean very different living standards. (Also: differences in the quality of data and in how multinationals' profits are recorded, as in Ireland.) Evaluation: PPP fixes the price problem but not the others; composite measures such as the HDI add health and education.

(e) GDP is useful: it is measured regularly, in a standard way, for nearly every country, so it allows comparisons over time and between countries. Growth in real GDP is closely linked to jobs, tax revenue and the ability to pay for public services, and recessions show up clearly in it.

GDP has limits: as Ireland shows, it can be distorted by multinationals' accounting, so it may not show the income that residents receive. It ignores distribution, the environment (pollution and resource depletion count as zero or even raise GDP when they lead to clean-up spending), unpaid work and well-being. Revisions can be large.

Alternatives: GNI or GNI* for income received; real household disposable income for living standards; the HDI and well-being measures for broader development; measures that subtract environmental damage.

Judgement: GDP is a good measure of the level of production and of short-run economic performance in most countries, which is why it remains the main headline figure. It is a weak measure of living standards or sustainable performance, and in very open economies such as Ireland it can mislead. The best approach uses GDP together with income- and well-being-based measures.

What examiners reward: a correct real-growth calculation that deflates before comparing, a precise GDP/GNI distinction, use of the extract's consumption evidence, examined (not listed) comparison problems, and a judgement that separates production from living standards.

• Real versus nominal, total versus per capita, value versus volume GDP/GNI; PPP comparisons; recession definition; GDP limitations and wellbeing indicators (2.3.1.1).
• Inflation, deflation, disinflation; CPI from a weighted basket (109 → 9%); PPI as a leading indicator; demand-pull, cost-push and money-supply causes; the eight effect groups (2.3.1.2).
• ILO unemployment; the five causes; effects on six groups; underemployment; employment, inactivity and migration (2.3.1.3).
• Balance of payments components; goods-and-services balance; current-account deficit and surplus (2.3.1.4).
• AD = C + I + G + (X − M); movements versus shifts; the influences on C (and the savings ratio), I (gross vs net), G and net trade (2.3.2).
• SRAS shift factors; Keynesian versus classical LRAS shapes and their shift factors (2.3.3).
• Circular flow; injections and withdrawals; I + G + X = S + T + M; equilibrium from AD/AS (2.3.4.1–3).
• The multiplier: process, MPC/MPS/MPT/MPM, k = 1/(1−MPC) = 1/MPW, SAM's 2 × £30bn = £60bn and the 5 × 20 = 100 example (2.3.4.4).
• Actual versus potential growth; AD-side and capacity-side causes; the six benefits and five costs; positive and negative output gaps and their measurement (2.3.5).

Boundary notes: quantitative skills QS1–QS4 and QS9 are examined throughout (ratios, fractions, graphs and data interpretation); calculators are allowed. Diagrams must label axes, curves and equilibria, and show the SHIFT arrow. Answers to 8+ mark questions earn Application marks by using the context's data (the SAM mark schemes award Knowledge/Application/Analysis separately). Worked examples are original or adapted from the WEC12/01 Sample Assessment Materials (identifiable by the SAM label) with arithmetic re-derived.