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AP Macroeconomics
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Table of Contents
Unit 2 Overview: Economic Indicators and the Business Cycle
2.1 Circular Flow and GDP
2.2 Limitations of GDP
2.3 Unemployment
2.4 Price Indices and Inflation
2.5 Costs of Inflation
2.6 Real vs Nominal GDP
2.7 Business Cycles

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2.2 Limitations of GDP

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Uses of GDP in Economics

We've covered what GDP is, but how do economists actually use GDP? 

Economists use gross domestic product (GDP) in a variety of ways as an economic indicator and comparative tool. One use of GDP is to measure the overall economic performance of a country. GDP reflects the amount of goods and services produced in the economy, and is often used as a broad measure of a country's economic growth. 

Economists use GDP to track changes in the economy over time, and to compare the economic performance of different countries. For example, if a country's GDP is growing, it is generally considered to be a sign of a healthy and expanding economy.

GDP is also used to make international comparisons of economic performance. By comparing GDP data for different countries, economists can get a sense of how different economies are performing relative to one another. This can be useful for policymakers and businesses looking to invest in different countries.

Finally, GDP is used to help inform fiscal and monetary policy decisions. For example, if a country's GDP is declining, policymakers may implement expansionary fiscal or monetary policies to try to stimulate economic growth.

Overall, GDP is a widely used and important economic indicator that helps economists and policymakers understand and compare the economic performance of different countries.

However, GDP isn't perfect. We'll be discussing a few ways GDP falls short of a perfect economic indicator.

Limitations of GDP

There are 4 main areas of the limitations of GDP (Gross Domestic Product). In order to remember these we use the acronym P-I-E-S.

1. Population

When populations are different from country to country and the countries are producing a similar amount of a product than it gives us an inaccurate picture of the standard of living because one country is taking the same amount of production and distributing it amongst a larger population. For example, if one country is producing 15 million computers but has a population of 15 million than each person only has access to 1 computer but if another country produces the same amount of computers but has a population of 3 million than each person in that country has access to potentially 5 computers. This is why economists use GDP per capita as a better measure of standard of living. GDP per capita is the GDP of a country divided by its population. This helps economists understand if a country is truly rich, or is just very large.

Even GDP per capita, however, is not perfect. A country with high GDP per capita may be very rich on average, but may be corrupt or have harsh social conditions. Many organizations use the Human Development Index to show overall standard of living. Here's a graph of the two measures. You may notice that some of the highest GDP per capita countries actually have a lower HDI. This is because many of these countries are rich with oil, but are high in corruption.

2. Inequality

Inequality is also a limit to the use of GDP to measure the standard of living. Two countries can have the same GDP per capita but if income is not evenly distributed to all families then it is not an accurate measure of production and economic stability. In the unequal society, the market will be less resilient and the governing bodies will be less sustainable due to famine, conflict, and unemployment. 

3. Environment

Another limitation regarding using GDP as a measure of the health of our economy is with regard to the various environmental situations. For example, if a factory is polluting during production they are still adding to GDP but GDP does not separate out the costs of this pollution from the actual production, even if the pollution is negatively impacting human life and ecology. These external costs of production are called externalities, and if you take AP Micro you'll learn about them in depth.

4. Shadow Economy

The final limitation has to do with the shadow economy. The shadow economy involves the production of items that are not reported so they are not counted in GDP. This shows us that GDP is not always accurate because there are some things not counted. An obvious example of the shadow economy is the black market which are aspects of the economy deemed illegal and therefore excluded from formal reporting, but there are many other aspects of the shadow economy that are perfectly legal. 

Key Terms to Review (10)

Black Market: The black market refers to the illegal trade of goods and services that occur outside government regulation or control. This market thrives in environments where legal restrictions, such as taxes and price controls, create an incentive for buyers and sellers to engage in transactions that evade regulations. The existence of a black market can lead to significant distortions in the economy, affecting accurate measures of economic activity like GDP.
Economic Growth: Economic growth refers to the increase in the production of goods and services in an economy over time, usually measured by the rise in real Gross Domestic Product (GDP). It is an essential indicator of economic health, indicating improvements in living standards and overall wealth within a society.
Expansionary Fiscal Policy: Expansionary fiscal policy is a government strategy aimed at stimulating economic growth by increasing spending and/or cutting taxes. This approach is typically used during periods of economic downturn or recession to boost demand, increase consumption, and reduce unemployment, helping the economy return to its potential output level.
Externalities: Externalities are the positive or negative consequences of economic activities that affect third parties who are not directly involved in the transaction. These effects can lead to market failures, where the true cost or benefit of a product or service is not reflected in its market price, ultimately impacting overall welfare and economic efficiency.
GDP per capita: GDP per capita is a measure that calculates the economic output per person in a specific area, typically a country, by dividing the Gross Domestic Product (GDP) by the population. This metric provides insight into the average economic productivity and living standards of individuals within that area, highlighting disparities in wealth and development when comparing different regions or countries.
Gross Domestic Product (GDP): Gross Domestic Product (GDP) is the total monetary value of all final goods and services produced within a country's borders in a specific time period. This measure helps gauge the health of an economy and is closely connected to various economic concepts such as inflation, economic cycles, and the flow of money within the economy.
Human Development Index (HDI): The Human Development Index (HDI) is a composite statistic of life expectancy, education, and per capita income indicators used to rank countries into four tiers of human development. It provides a broader perspective than GDP alone, highlighting quality of life and well-being, and addressing the limitations of solely using economic output to measure a country's progress.
Inequality: Inequality refers to the unequal distribution of resources, wealth, and opportunities within a society. It can manifest in various forms such as income inequality, wealth inequality, and access to essential services like education and healthcare. This concept is crucial when examining the limitations of GDP as it highlights how GDP growth does not necessarily translate to improvements in living standards for all citizens.
Monetary Policy: Monetary policy refers to the actions taken by a country's central bank to manage the money supply and interest rates to achieve macroeconomic goals such as controlling inflation, managing employment levels, and stabilizing the currency. It influences economic activity by affecting how much money is available for businesses and consumers to spend and invest, which can also impact international trade and capital flows.
Shadow Economy: The shadow economy refers to economic activities that occur outside the formal market and are not captured by official statistics. These activities can include unreported income, informal jobs, and illegal transactions, which result in lost tax revenue and hinder effective economic planning. The existence of a shadow economy highlights significant limitations of GDP as a measure of economic performance since it fails to account for all productive activities in a country.
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2.3 Unemployment