Comparing the performance of different economies

Overview

Current account deficit not automatically a sign of poor performance, why institutions and the rule of law affect economic performance and how openness to trade and investment affects an economy's performance.

What you need to know

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Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Which indicators are normally used to compare the performance of different economies?

   Model answer

   The usual set covers the standard objectives. Growth of real GDP shows how fast output is expanding, and GDP per head shows whether output is growing faster than population. The inflation rate shows whether price stability is being maintained. The unemployment rate, together with the employment rate and the number of hours worked, shows how fully labour is being used. The current account balance shows whether the country is living within its external means. Beyond these, productivity measured as output per hour worked indicates the sustainable basis of living standards, the debt ratio indicates the health of the public finances, and measures of inequality, of human development and of environmental impact indicate whether growth is being shared and whether it can continue.

2. 2

   Why is GDP per head a better basis for comparison than total GDP?

   Model answer

   Total GDP measures the size of an economy, not the prosperity of the people in it, so a populous country with modest incomes can have a far larger GDP than a small rich one. Dividing by population gives the average output available per person, which is much closer to the concept of a standard of living, and it also corrects for the fact that an economy whose output is growing at the same rate as its population is producing no improvement at all for its citizens. The measure is still an average, so it says nothing about how the output is distributed, and a country with rapidly rising GDP per head can contain large groups whose incomes have not moved.

3. 3

   Why must incomes be adjusted for purchasing power when comparing living standards across countries? Illustrate with figures.

   Model answer

   Converting incomes at market exchange rates measures what they would buy if the whole income were spent on internationally traded goods, but a great deal of spending goes on housing, transport, services and food, which are cheaper in poorer countries because wages there are lower. Suppose a country's GDP per head is 30,000 units of its currency and the market exchange rate is 2 units to the dollar, giving 15,000 dollars. If a representative basket of goods actually costs 1.5 units where a dollar's worth costs one dollar in the comparison country, the purchasing power rate is 1.5, and income per head is 30,000 divided by 1.5, which is 20,000 dollars. Comparing at the market rate would have understated real living standards by a quarter. Adjusting for purchasing power therefore systematically raises the measured incomes of low-income countries relative to high-income ones.

4. 4

   Why is productivity, measured as output per hour worked, treated as the fundamental indicator of long-run performance?

   Model answer

   Total output can be raised either by using more inputs or by getting more from each one. Raising output by working longer hours or drawing more people into work is limited, because hours and the population of working age cannot expand indefinitely, and it does not by itself raise income per hour, so it does not raise living standards in the sense of what an hour of work commands. Raising output per hour has no such ceiling and is the only source of sustained increases in real wages, because in the long run pay can only grow as fast as the value each hour produces. It is also what allows an economy to enjoy both higher incomes and more leisure. Differences in productivity, rather than differences in effort, explain almost all of the gap in living standards between rich and poor countries.

5. 5

   What are the limitations of the unemployment rate as a measure of how well an economy is using its labour?

   Model answer

   It counts only those without work who are actively seeking it and available to start, so it excludes people who have given up looking, those on incapacity or training schemes, and those who have retired earlier than they wished; a fall in the rate can therefore reflect discouragement rather than improvement. It says nothing about underemployment, so people working part time who want full-time work, or in jobs far below their skill level, are counted as employed. It gives no indication of the quality, security or pay of the work being done. And it is an average that hides very large differences between regions, age groups and levels of qualification. For these reasons the employment rate and total hours worked are usually examined alongside it.

6. 6

   Why is a low and stable inflation rate treated as a mark of good performance?

   Model answer

   Stable prices allow relative prices to convey information: when almost all prices are steady, a rise in the price of one good genuinely signals that it has become scarce or more valued, and resources move accordingly. High or volatile inflation obscures that signal, so resources are misallocated. It also erodes the value of money savings and of fixed incomes, arbitrarily redistributing between debtors and creditors, and it discourages long-term contracts and investment because no one can be confident what a sum of money will be worth. Firms divert effort into repricing and into protecting themselves from price movements rather than into production. Very low inflation or deflation is not good either, since falling prices encourage buyers to postpone purchases and raise the real burden of debt, which is why the objective is a low positive rate rather than zero.

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