Measuring output: GDP and its variants

GDP = the total value of goods and services produced within a country's borders in a period. Economic growth = the rate of change of REAL GDP.

• Nominal (money) GDP is measured at current prices. Real GDP is measured at constant prices — it strips out inflation. Only real GDP tells you whether more stuff was actually produced.
• Total vs per capita. GDP per capita = GDP ÷ population. A country whose GDP grows 2% while its population grows 3% is getting poorer per person. Per capita is what matters for living standards.
• Value vs volume. Volume = the physical quantity produced. Value = quantity × price. Value can rise while volume falls, if prices rise fast enough.
• GNI (Gross National Income) = GDP plus net income from abroad (profits, interest and dividends earned by residents overseas, minus those paid to foreigners). For Ireland, with huge foreign multinationals repatriating profits, GNI is far below GDP — GDP flatters the country badly.
• PPP (Purchasing Power Parity) adjusts for the fact that a pound buys more in Delhi than in London. Converting GDP at market exchange rates makes poor countries look poorer than they are; PPP-adjusted figures are the right ones for international comparison.

Your turn — real vs nominal growth

Your turn — GDP per capita

Why GDP is a poor measure of living standards

• It ignores distribution. GDP per capita is a mean. If all the growth accrues to the top 1%, the median household feels nothing.
• It ignores the hidden economy. The black market and unpaid work (childcare, housework, volunteering) are excluded. Ironically, if you pay a nanny, GDP rises; if you look after your own child, it does not.
• It ignores quality and externalities. A country that pollutes heavily, clears its forests and then pays to clean up the mess records higher GDP for all three activities. Environmental degradation is not netted off.
• It ignores leisure and hours worked. A country that produces the same output with far shorter working weeks is better off — GDP cannot see it.
• Data problems: figures are revised, are less reliable in developing countries, and comparisons need PPP adjustment.

National happiness. Since 2011 the ONS has published UK national wellbeing data (life satisfaction, worthwhileness, happiness, anxiety). The Easterlin paradox is the key finding: within a country at a point in time, richer people report higher life satisfaction — but as a country grows richer over time, average reported happiness rises far less than income does. Above a threshold of income, relative income, health, employment status and relationships matter more than absolute GDP. So GDP is a means, not the end.

Real, nominal, per capita

Inflation, deflation, disinflation

• Inflation — a sustained rise in the general price level (i.e. a fall in the value of money).
• Deflation — a sustained fall in the price level (a negative inflation rate).
• Disinflation — inflation is still positive but the rate is falling (e.g. from 8% to 4%). Prices are still rising, just more slowly. This is the classic exam trap.

How the UK builds the CPI

1. The ONS runs the Living Costs and Food Survey on ~5,000 households to find out what people actually buy.
2. From this it builds a basket of around 700 representative goods and services.
3. Each item is given a weight reflecting its share of typical household spending. (Housing costs more than mustard, so it carries more weight.)
4. ~180,000 prices are collected each month. The price change of each item is multiplied by its weight; the results are summed to give the index.
5. The inflation rate = the % change in the index over 12 months. The basket and weights are updated annually.

Your turn — build a price index

Your turn — inflation from the index

Your turn — a weighted index

Limitations of CPI, and RPI

• It is an average. Nobody buys the average basket. A pensioner spending heavily on energy faces a very different inflation rate from a young renter.
• Sampling error. The Living Costs and Food Survey has a limited sample and a low response rate.
• Slow to reflect new goods and changing tastes. The basket is revised only annually, so it lags behind.
• It struggles with quality change. If a laptop's price is flat but it is twice as fast, its real price has fallen — this is hard to capture and CPI tends to overstate inflation as a result.
• CPI excludes most housing costs — notably mortgage interest payments and council tax. (CPIH includes owner-occupiers' housing costs, which is why the ONS now prefers it.)

RPI is the older measure. It includes mortgage interest payments and council tax, excludes the highest and lowest earners, and uses the arithmetic mean where CPI uses the geometric mean. The arithmetic mean produces a higher figure — the "formula effect" — so RPI typically runs about 0.5–1 percentage point above CPI. It is no longer a National Statistic, but it is still used to index rail fares, student loans and index-linked gilts. Watch the perverse incentive: raising interest rates directly raises RPI (through mortgage payments), so tightening policy appears to worsen the very inflation it is fighting.

Causes and effects of inflation

Causes:

• Demand-pull — AD rises faster than the economy's ability to supply. "Too much money chasing too few goods." Caused by a consumer boom, tax cuts, low interest rates, a fall in the exchange rate boosting exports. On an AD/AS diagram: AD shifts right, price level rises, real output rises.
• Cost-push — the costs of production rise, shifting SRAS left. Caused by rising oil, gas or commodity prices, higher wages not matched by productivity, a depreciation of sterling raising import prices, or higher indirect taxes. On the diagram: price level rises AND real output falls — this is stagflation, the nastiest case, because the policy cures for inflation and for recession point in opposite directions.
• Growth of the money supply — the monetarist view (Friedman): "inflation is always and everywhere a monetary phenomenon." If the money supply grows faster than real output, the price level must rise.

Effects — who wins and who loses:

• Consumers: real incomes fall if wages lag prices. Savers lose (the real value of savings erodes if the interest rate is below inflation); borrowers gain (the real value of their debt shrinks) — including the government, the biggest borrower of all.
• Firms: uncertainty deters investment; menu costs and shoe-leather costs; and if domestic inflation exceeds competitors', exports lose price competitiveness and the current account worsens.
• Workers: may face real wage cuts; unions push for higher pay, risking a wage–price spiral as expectations become embedded.
• Government: fiscal drag pulls people into higher tax bands (raising revenue), but index-linked benefits, pensions and debt interest cost more.

Types of inflation

Two ways to count the unemployed

• The claimant count — the number of people claiming unemployment-related benefits (now Universal Credit while searching for work). ✅ Cheap, fast, 100% coverage of claimants. ❌ It measures eligibility for benefits, not joblessness: it excludes people who want work but do not qualify (e.g. a partner earns too much) and includes some fraudulent claims. Change the benefit rules and the figure moves without any change in the real economy. It therefore understates true unemployment.
• The ILO measure / UK Labour Force Survey — a quarterly survey of ~60,000 households. A person is unemployed if they are out of work, have actively sought work in the last four weeks, and are able to start within two weeks. ✅ Internationally comparable, and independent of the benefit system — so it is the preferred measure. ❌ Costly, subject to sampling error, and published with a lag.

Under-employment is different again: people in work but working fewer hours than they want, or in jobs far below their skill level. It does not show up in the unemployment rate at all, but it represents real wasted capacity.

Inactivity = people of working age who are neither employed nor seeking work — students, carers, the long-term sick, the early-retired. A falling unemployment rate can be entirely bogus if it is caused by people leaving the labour force into inactivity. Always check the employment rate and the inactivity rate alongside it.

Your turn — the unemployment rate

The five types of unemployment

• Structural — a mismatch between the skills or location of the unemployed and the jobs available. Caused by long-run change in the pattern of demand (coal, steel, shipbuilding; now automation and AI). Involves occupational immobility (wrong skills) and geographical immobility (cannot afford to move). The most persistent and damaging type — it lowers LRAS.
• Frictional — short-term unemployment while people move between jobs. A graduate job-hunting, someone who quit to find better pay. It is voluntary and temporary, and a healthy economy always has some. Higher benefits or poor job information lengthen it.
• Seasonal — regular, predictable demand variation: ski instructors in summer, agricultural and tourism work in winter.
• Cyclical (demand-deficient) — caused by a fall in AD in a recession. Firms cut output and lay off workers across all sectors. This is the type Keynesian demand-side policy is designed to fix.
• Real-wage inflexibility — wages held above the market-clearing level (by a minimum wage set too high, or by strong unions), so the quantity of labour supplied exceeds demand. A classical/free-market explanation; the size of the effect is heavily contested.

Effects: for workers — lost income, deskilling and hysteresis (the longer you are out of work, the less employable you become, so a temporary shock leaves a permanent scar on LRAS). For firms — lower demand, but a larger pool of labour. For the government — higher benefit spending and lower tax revenue, so the budget deficit widens. For society — lost output (the economy sits inside its PPF), plus links to poor health and crime.

Sort the causes of unemployment

Ask: is it a mismatch (structural), a gap between jobs (frictional), or a fall in AD (cyclical)?

The current account

The balance of payments records all transactions between UK residents and the rest of the world. It has three parts: the current account, the capital account and the financial account. Theme 2 focuses on the current account, which has four components:

• Trade in goods (visible trade) — the UK runs a large, persistent deficit here.
• Trade in services (invisibles) — finance, insurance, education, tourism. The UK runs a substantial surplus here.
• Primary income — interest, profits and dividends flowing in and out, plus wages of workers abroad.
• Secondary income — transfers with no quid pro quo: foreign aid, remittances sent home by migrants.

A deficit means the value of what the UK buys from abroad exceeds what it sells. It must be financed — by borrowing, or by selling UK assets (property, shares, companies) to foreigners. That is fine while foreigners are happy to hold sterling assets, but it is not sustainable indefinitely: it implies rising external liabilities and vulnerability to a sudden loss of confidence and a sterling crisis.

Links to other objectives (2.1.4c). A current account deficit is often the by-product of strong growth — as real incomes rise, the UK sucks in imports (a high marginal propensity to import), so growth and the current account conflict. Similarly, high domestic inflation makes exports uncompetitive and worsens the deficit. And note the accounting identity: net trade (X − M) is a component of AD, so a widening deficit is a drag on AD and growth. The interconnectedness runs both ways.

Match the measure to its definition

Tap a measure on the left, then its definition on the right.

Reading the labour market data

Comparing living standards

The big ideas to know

Press Finish to see your score.