Measurement of economic growth: real Gross Domestic Product (GDP)

Measurement of Economic Growth – Real Gross Domestic Product (GDP)

1. Economic growth – definition

• Economic growth is a sustained increase in the amount of goods and services produced by an economy over time.
• In the IGCSE syllabus growth is measured by the change in real GDP (or real national income) from one period to the next.
• For living‑standard analysis the syllabus uses real GDP per head (real GDP ÷ population). It shows how the average output available to each person changes, removing the effect of population growth.

2. Why use real GDP instead of nominal GDP?

• Nominal GDP is measured at current market prices, so it reflects changes in both output and the overall price level (inflation or deflation).
• Real GDP values output at constant (base‑year) prices, thereby removing the effect of price changes.
• Because real GDP shows the true change in physical output, it is the appropriate indicator of economic growth and of changes in living standards.

3. The three approaches to measuring GDP

All three methods give the same total – the “three‑method framework” required by the syllabus. In exam questions the expenditure approach is most frequently used.

4. Converting nominal GDP to real GDP

Real GDP is obtained by adjusting nominal GDP for changes in the overall price level using the GDP deflator:

Real GDP_t = (Nominal GDP_t ÷ GDP Deflator_t) × 100

• The deflator is a price index that measures the average price of all goods and services that make up GDP.
• The base year is assigned an index of 100; the factor “× 100” converts the ratio into an index number.

4.1. The GDP deflator

GDP Deflator_t = (Nominal GDP_t ÷ Real GDP_t) × 100

• Unlike the Consumer Price Index (CPI), the deflator also includes prices of investment goods, government services and net exports.

5. Worked examples

5.1. Converting nominal GDP to real GDP

Real‑GDP growth between 2015 and 2020:

Growth % = [(1,200 – 1,091) ÷ 1,091] × 100 ≈ 10 %

5.2. Converting real GDP to nominal GDP (reverse calculation)

Country Y’s real GDP in 2022 = US$ 2,500 bn; GDP deflator = 130.

Nominal GDP = (Real GDP × Deflator) ÷ 100 = (2,500 × 130) ÷ 100 = 3,250 bn

5.3. Real vs. nominal growth rates

If nominal GDP rises from US\$ 1,200 bn to US\$ 1,500 bn (a 25 % increase) while the deflator rises from 110 to 125 (a 13.6 % increase), the real‑GDP growth is only about 10 % (see Example 1). This illustrates why exam questions always ask you to state whether a growth rate is “real” or “nominal”.

6. Interpreting real‑GDP growth and macro‑economic aims

• Positive real‑GDP growth → expanding economy, higher employment, potential rise in living standards.
• Negative real‑GDP growth for at least two consecutive periods is the official definition of a recession. It usually brings higher unemployment, lower income and reduced consumer confidence.
• Very high growth can “over‑heat” the economy, creating inflationary pressure and threatening the aim of price stability.
• All growth policies should be evaluated against the four macro‑economic aims: economic growth, full employment, price stability, and balance‑of‑payments stability.

7. Causes and consequences of economic growth

• Causes

  • Increase in the quantity of resources (labour, capital, land).
  • Improvements in the quality of resources – better education, health, more skilled labour, and higher‑quality natural resources.
  • Population growth – more workers and consumers.
  • Technological progress – more output from the same inputs.
  • Higher levels of investment (new factories, machinery, infrastructure).
  • Improved human capital – better education and training.
  • Greater demand for domestic goods (rising population, higher export demand).
  • Environmental sustainability – rapid growth can increase pressure on natural resources and cause pollution; sustainable growth aims to minimise these effects.

• Positive consequences

  • Higher per‑capita income and living standards.
  • More resources for health, education and public services.
  • Potential for poverty reduction.

• Possible negative consequences

  • Inflation if demand outstrips supply.
  • Environmental degradation and depletion of natural resources.
  • Unequal distribution of the benefits – growth may not reach all groups.

8. Recession – definition, causes and consequences

• Definition (syllabus): a fall in real GDP for at least two consecutive periods (usually measured annually or quarterly).
• Causes

  • Sharp fall in aggregate demand (consumer confidence, investment, exports).
  • Large increase in interest rates or a sudden cut in government spending.
  • External shocks – oil‑price spikes, financial crises, natural disasters.

• Consequences

  • Higher unemployment and under‑utilised resources.
  • Lower household incomes and reduced tax revenues.
  • Potential rise in poverty and social unrest.

9. Policies to promote economic growth (evaluation framework)

When evaluating a policy, consider:

• Effect on the four macro‑economic aims (growth, employment, price stability, balance‑of‑payments).
• Time lag – demand‑side effects appear quickly; supply‑side effects take longer.
• Possible side‑effects such as higher inflation, larger fiscal deficits, or increased income inequality.

10. Employment & unemployment

• Employment – the number of people aged 16 + who are working for pay or profit.
• Unemployment – people aged 16 + who are not working, are actively seeking work, and are available to start within the next month.
• Unemployment rate = (Number of unemployed ÷ Labour force) × 100.
• Four main types of unemployment:

  • Frictional – short‑term job search between jobs.
  • Structural – mismatch between workers’ skills and job requirements.
  • Cyclical – caused by a fall in aggregate demand (recession).
  • Seasonal – linked to regular seasonal changes in demand (e.g., tourism).

• Typical policies:

  • Training and education programmes – target structural unemployment.
  • Fiscal stimulus (e.g., increased public spending) – reduces cyclical unemployment.
  • Active labour‑market policies (job‑search assistance, subsidies for hiring).

11. Inflation

• Inflation – a sustained rise in the general price level of goods and services in an economy.
• Measured most commonly by the Consumer Price Index (CPI):

  CPI = (Cost of market basket in current year ÷ Cost of market basket in base year) × 100

• Two main causes:

  • Demand‑pull inflation – aggregate demand rises faster than aggregate supply.
  • Cost‑push inflation – rising production costs (e.g., wages, oil) shift the aggregate‑supply curve leftward.

• Policy tools:

  • Monetary policy – raise interest rates, increase reserve requirements, or sell government securities to reduce money supply.
  • Fiscal policy – reduce government spending or increase taxes to cool demand.
  • Supply‑side measures – improve productivity, reduce trade barriers, or encourage competition to lower costs.

12. Economic development (living standards, poverty, population, cross‑country differences)

• Living standards are usually measured by real GDP per head or by the Human Development Index (HDI), which combines income, education and health indicators.
• Poverty

  • Absolute poverty – people living on less than a set income threshold (e.g., US$ 1.90 a day).
  • Relative poverty – people whose income is significantly below the average for their country (often < 60 % of median income).

• Population factors – size, growth rate and age structure affect both the supply side (labour force) and the demand side (consumption).
• Cross‑country differences – arise from variations in resource endowments, institutions, technology, education, health, and openness to trade.
• Development policies may include:

  • Investing in health and education to raise human capital.
  • Improving infrastructure and governance to attract foreign investment.
  • Trade liberalisation and technology transfer.

13. Suggested diagram

14. Summary checklist (what you must be able to do)

• Define economic growth and real GDP per head; explain why real (not nominal) GDP is used.
• State the three approaches to measuring GDP and write the expenditure‑approach formula (C + I + G + (NX)).
• Use the formulas

  
  Real GDP = (Nominal GDP ÷ GDP Deflator) × 100

  
  GDP Deflator = (Nominal GDP ÷ Real GDP) × 100

  to convert between nominal and real values and to calculate growth rates.

• Calculate a real‑GDP growth rate and distinguish it from a nominal‑GDP growth rate.
• Explain the official recession definition (two consecutive periods of falling real GDP) and list its main causes and consequences.
• Identify the main causes of economic growth, including population growth, improvements in resource quality, and technological progress, and discuss both positive and negative consequences (including environmental sustainability).
• List and evaluate demand‑side and supply‑side policies for promoting growth, linking each to the four macro‑economic aims.
• Define employment, unemployment and the unemployment‑rate formula; describe the four types of unemployment and give two relevant policy examples.
• Define inflation, show how the CPI is calculated, differentiate demand‑pull and cost‑push inflation, and name the main monetary and fiscal tools used to control it.
• Explain how living standards are measured (real GDP per head, HDI), distinguish absolute and relative poverty, and discuss why cross‑country differences exist.
• Interpret a line graph of nominal vs. real GDP and comment on the effect of inflation on the measurement of growth.