You might have heard in the news might have heard that the US economy has contracted in the first quarter of 2022. When we talk about economic contraction or expansion, we look at the % change in the most widely used statistic to measure the overall economic health of a country, also known as the GDP. Many were surprised by this decline, and it’s said as the worst quarter since the pandemic started in March 2020. To know more about what GDP is, please click here.
The official source of publishing GDP numbers in the US is the Bureau of Economic Analysis. In their April 28, 2022 press release, they projected an annual 1.4% decline in the real Gross Domestic Product of Q1 2022 vs a growth projection of 6.9% in Q4 2021. If you want to see the details about the calculation, data, and assumptions, you can check this page here. https://www.bea.gov/data/gdp/gross-domestic-product
What were the reasons for this decline?
The main reason that made the GDP growth negative was the trade deficit, meaning imports were far more than our exports, as US domestic supply couldn’t keep up with the domestic demand. In addition to the trade deficit, the GDP was also deflated by the omicron variant of COVID that shut down some businesses, and the government-funded pandemic relief to businesses and households decreased or stopped altogether by the first quarter of 2022.
Should we worry about this slowdown?
Despite the projection, economists are saying that there is no reason to panic yet because this GDP decline happened due to the net export component. In the chart below, data collected from BEA shows the percent shares of each of the four main contributors to the US GDP in the 2022 Q1.
The two major contributors to the US GDP have been consumption and investment, and both remained strong. Consumption, which is the most important driver of the US economy (contributing to almost 70%) increased during the first quarter at a rate of 2.7% annually, compared to 2.5% during the fourth quarter of 2021. Similarly, the business investment such as capital expenditure on factories, equipment, software, etc. remained robust and hence should increase productivity for the remainder of 2022. Firms’ investment had grown at a rate of 9.2% in the first quarter of 2022 which is a significant increase from the 2.9% increase in the last quarter of 2021.
In summary, even though the GDP first quarter fell, it is not indicating a recession coming. A recession is defined as a fall in GDP in two successive quarters. And we may only hope for a better future and some happy news in the economy.
Both gasoline and diesel prices are still up. Drivers across the US and globally are feeling pain when they visit gas stations to pump gas. You can see that both gas and diesel prices have been trending up in each of the regions in the entire US from October 2021, with a steep rise after Russia started the Ukraine war. I got these charts from the US Energy Information Administration, which is the US official source of data for energy information.
And since gasoline and diesel both are needed for the transportation of many goods, the increase in fuel prices has several linkages to other industries as well. In this image, taken from the US EIA website, you can see, that the national average for a gallon of gas in the United States was $4.11 and $5.12 for diesel as of April 2022.
What has caused the continued rise in fuel prices?
In most simple terms, it is the imbalance between the supply and demand of crude oil. There is an increasing oil demand, while there is not enough supply. Gasoline and diesel both are made from crude oil. The petroleum refineries make gasoline and other petroleum products from crude oil.
You might ask why the gas price is high in the US when it only imports a very small percent of crude oil from Russia. The answer to this lies in the fact that crude oil prices are set in the global market.
In this chart, you can see the supply and demand imbalance.
On the x-axis, we have the quantity of crude oil demanded and supplied and on the y-axis is the price of crude oil. For any commodity, an equilibrium price is set, where the upward-sloping supply curve and the downward-sloping demand curve intersect. That is the quantity that the producers are willing to supply and the quantity the consumers are willing to buy at a price that works for both.
If the producers supply more than what consumers demand, then the price of that commodity will fall because there is excess supply. On the other hand, if demand for a commodity is more than what the producers can supply, it causes price to increase because there is excess demand and consumers are willing to pay more. In the case of oil price hike, the latter has happened. This has led to both a rise in price of crude oil and a lower equilibrium quantity of crude oil consumed and supplied. The above chart shows that as Q1 and P1.
The economic sanctions put on Russia by the United States and the European Union in response to Russia’s invasion of Ukraine have had a shattering effect on the Russian oil supply to the world. Many countries have cut trade ties with Russia, leading to a lower supply from Russia. Even though, US has become the largest producer of crude oil. Russia is still one of the biggest crude oil producers in the world, so it has a significant influence on the total industry output in the global oil market.
When Russian oil is not available to its full capacity, the world supply of crude oil has dramatically decreased. This has caused crude oil prices to rise significantly. During the early part of 2020, when the demand for transportation dropped significantly due to the lockdown, crude oil was at an average price of $39 a barrel. This was its lowest price since 2003.
However, as the lockdown eased and economies returned to normal, there has been an increasing demand for crude oil. With people commuting to work again, traveling on vacation, and going out more, the demand for gasoline has resumed. While the suppliers are not able to increase the supply of crude oil, there is an increasing demand. The price of crude oil in the international market exploded to $139 before settling at $123 a barrel. Much of the inflation is due to a rapid rise in crude oil.
Crude oil is used to produce gasoline, so fuel refining companies like Exxon, Chevron and others are passing the higher costs of production on to consumers by raising prices at the pump. This is the inflation caused by supply factors.
Million dollar question in everyone’s mind is when will the fuel prices go back to normal?
The sad news is that Economists don’t expect gas prices to fall anytime soon, unless war in Ukraine comes to an end and and some sort of order is restored in Europe. Until then, the world oil market will continue to struggle to provide an adequate supply to meet worldwide demand meaning that crude oil prices will remain high. This of course will keep prices inflated at the pump and drivers will struggle to fill their tanks.
Additionally, as summer approaches, the demand for travel will continue to rise and the average cost of a gallon of gas might peak at $5. Many economists believe that even if supply issues are fixed and prices start to decline in the coming months, the average is still expected to remain over $4 nationally until at least November, as the adjustments take time.
Going forward the best strategy for countries will be to keep extra reserves when the crude oil price is low. Investment in alternative energy sources will be the strategy for the future to withstand such supply shocks.
If you want to know more about it, you can also refer to CNN’s article on June 1. Is it just a coincidence that a famous news channel published this article a few days after I did? It is not. This is just what everyone wants to know. https://www.cnn.com/2022/06/01/energy/record-gas-price-causes/index.html
We know economics is all about putting resources to their best use, so we get the most out of it. Economists use a fancy term called “allocative efficiency” to describe it. By resources, we mean land, labor, capital, entrepreneurial ability, and time.
Now, you may ask could there be different types of economies or economic systems to make the best use of limited (scarce) resources? Yes, indeed. These economic systems help to answer the three essential economic questions of what to produce, how to produce, and for whom to produce?
Let’s take a quick look at the three most common economic systems around the world: they are 1. free market, also called the market economy, 2. centrally planned economy also called the command economy, and 3. mixed economy or Keynesian economy
I don’t want to bore you with lots of text, so briefly I will explain these. But before you leave, make sure to scroll down to check an interesting chart comparing different countries in 2022. I know we all like visuals to better understand something.
So here are the three famous systems:
Market economy: In this type of economy, goods and services exchange freely through market supply and demand forces. In economics, it’s called Laizzes Faire, which means a policy of letting things happen their way, without interference. So, in this system consumers and firms interact freely and maximize their incentives without government intervention. Now, you as a consumer should typically act to satisfy your utility by demanding products you want or need. Similarly, all consumers will do the same. So, consumers signal the producers in the market about what to make and what not to make based on their demand. This helps to answer the question of what goods and services to produce.
Firms act to satisfy their profit motives by producing products at a minimal cost. Because businesses want to get maximum profits, they will adjust the production process to minimize costs so there’s less wastage of resources. This helps to answer the question of how to produce goods and services. Also, no single producer is required to know all the information in terms how many competing producers are there, and what is alternative use of his resources. Prices set by demand of consumers, and supply of every other producer can give him that signal to produce in the best possible way. Because if he charges more than others or don’t make the products people demand, people will not buy his product and go to the one next to him, given the other producer is local and they sell identical products. This has become easier with so many online shops now a days. Thus, the invisible hand or natural market forces will answer the question for whom goods and services are produced.
Let’s take an example, if more people demand more of a specific good, like iPhone, its price tends to rise as well. This happens because we as consumers are willing to pay more for that good. Acting in response, producers wanting more profit, will increase production to satisfy the demand of people. As a result, a market economy tends to naturally balance itself.
Whenever we see a rise in prices in one sector of an industry due to high demand, the scarce resources, such as land, labor, capital, and entrepreneurship shift to those areas where they’re needed the most. In the free market economy., the role of the government is only limited to protecting property rights, this way there is a guarantee of fair competition in the marketplace. People can protect their ideas through patents and copyrights, and this encourages innovation. Thus, a free-market economy is the one with the least amount of government intervention.
Command economy: On the opposite spectrum is the command economy, where the entire price set up and distribution of goods and services are controlled by a central planner or the government. All economic and political decisions are taken by the government or a central committee of very limited people. They decide how to allocate the country’s limited resources. North Korea is one example of this type of economic system. This type of economy is commonly seen in communist countries. Natural market forces of supply and demand can’t decide the price and quantity of goods and services produced and consumed.
Generally, people living in these countries don’t have a high standard of living and don’t enjoy economic freedom. By “economic freedom” we mean the ability to choose to produce something or consume something based on your ability and need. Since the government fails to collect all the information correctly about what to produce and how to produce, a lot of wastage happens. People who advocate a command economy think this system is more equitable because everybody gets an equal share. But at the core of economics is the belief that people want to act for their self-interest. As a result, there is less incentive for businesses to work hard and employ better production techniques to maximize profits. Because if someone doesn’t get to keep the extra share, why work hard for it?
There are flaws in both pure market economy and command economy
Let’s investigate, why both these economic systems are not perfect. We just discussed why the command economy is not a great system, but we also need to know what the limitations of a free-market economy are as well.
In a free market, sometimes, markets can waste scarce resources by producing products at higher than necessary costs. This usually happens when there is very less competition or if one producer displays a monopoly. Due to a lack of competition, there’s no real pressure to bring down costs as a result, prices are inflated. The second type of market failure happens in the case of public goods. Private businesses don’t want to produce these public goods, even though we all collectively enjoy these, and are very necessary for the safety and well-being of our people. Since these types of investments are usually not profitable for private firms to produce, they don’t do that. Services like infrastructure or military, police services or fire departments, parks, basic k-12 education and healthcare for the poor. So, if we are only left to the free market, the people would go without these goods and services and not have basic needs and wants met. Also, there will be more unequal distribution of income and people may have extreme inequalities. So, to solve this problem, some role of government is vital. This type of system is called a Mixed economy.
Mixed economy: Thus in the real world, pure market economies rarely exist because there is usually some government regulation or intervention needed for smooth function. In most countries, like the US, public education, security, law and order, nuclear energy, social security benefits, public goods like parks, and defense are provided by the government. The government also provides regulation, so businesses don’t create monopolies and exploit people by charging very high prices. The government also invests in scientific research to develop future businesses and industries. Additionally, when the economy is not behaving optimally, ie. when a lot of people are unemployed (as in a recession) or if the prices are too high (inflation), government intervention is needed to get the economy back to full employment and achieve stable prices.
How much role the government plays in an economy can vary between countries, but in countries with higher real GDP per capita, there has been less government intervention and more free-market play. In this economic system, the government or the public sector and the free market also known as the private sector, work together to meet social needs. The free-market system is allowed to work independently, but the government intervenes to avoid market failures. Thus, we see this mixed economic system as the most common economic system around the world today.
Here’s a chart from Heritage Index showing how different countries enjoy economic freedom. In their study, they used twelve economic freedom categories. Within these categories, they graded the freedom of doing it on a scale of 0 to 100. It’s interesting to see the twelve economic freedom indicators, which they use to calculate a country’s overall score. Here is the list, I got from their website. https://www.heritage.org/index/about
Rule of Law (property rights, government integrity, judicial effectiveness)
Government Size (government spending, tax burden, fiscal health)
Open Markets (trade freedom, investment freedom, financial freedom)
The study gives equal weight to each of the above factors.
Economic systems and economic freedom experienced in countries of the world
As you can see, countries with the highest score in economic freedom from 80-to 100, are in darker green. Countries with the least economic freedom are in red.
From the chart, you can see China, North Korea, Zimbabwe, Cuba, and Venezuela have the least economic freedom because of a command economy.
On the other hand, Singapore, New Zealand, Ireland, Switzerland, Luxembourg, Taiwan, and Estonia have the most economic freedom. When we look at the real GDP per capita of these countries, the people living there mostly have a higher standard of living. All these countries are highly advanced, free-market economies, mainly because of their open and corruption-free business environment. In all these countries, there is a well-secured property right to stimulate entrepreneurship and innovation. There is also a very high level of transparency and government accountability.
Many other countries, like India, Mexico, Brazil, and Russia show poor to moderate levels of economic freedom. Even though countries like India are opening from their initial planned structure, there is still a lot of bureaucratic red tape that hinders setting up new businesses easily there. In addition, there is a lot of political corruption and scandals. Unfortunately, many of them are not even reported.
Originally from India, I can’t stop noticing the score India got in this ranking. Unfortunately, it still got very low score in the economic freedom index. Despite considerable liberalization since 1990s, India still has a lot of government controlled sectors and capital market. International participation in many industries is still limited compared to many other countries that rank higher in the economic freedom index. Also, In India, property rights are not very well established, which hinders free enterprise and technological innovation. Reservation system based on cast, instead of socio economic status is another deterrent in its economic performance. All of this combined has caused the infamous brain-drain, where a lot of highly skilled class move to other countries for a better lifestyle. Unless all these changes are made, India is still has a long way to catch up in the economic freedom score.
The US and the UK and many advanced countries are mixed economies. They are under the “mostly free category” denoted in the light green color. According to their report, the US economic freedom score is 72.1, which makes it the 25th freest country in the world to do business in. The US private property rights are secured, and contracts are protected and enforced.
It’s interesting to note that countries with higher economic freedom also have higher GDP per capita and higher happiness indexes. So, we can conclude that, overall, less government intervention (only limited to areas where the market fails), is needed for countries to do better economically.
Has it ever happened to you while listening to the news that there is some big scary vague thing called the economy that’s just out there? You might think you have no control over it, as most of it is based on business and government decisions. You are wrong here!
You are also a very important player in the economic game. The economy is just all of us together, acting in our own individual best interests, deciding how to use the limited resources we have, to get the maximum happiness. By pursuing our selfish interests, we indirectly contribute to the growth of society, by the magic of some invisible hand.
We all are in the economy as everyday people, who are going about everyday tasks and decisions. The main point is that we’re all actors in the economy rather than spectators. So, we are not passively looking at this thing called economy but taking an active part in the economy all the time.
In other words, an economy is a large set of interconnected production, consumption, and trade of goods and services that help in determining how scarce resources are allocated. I know in economics some fancy words are often used, such as “scarce”. By scarce we mean limited, something that we don’t have an infinite amount of.
It is true that in the news, macroeconomic indicators are discussed more often, like inflation, GDP, unemployment, etc. But believe it or not, a lot of times, the decision-makers behind these big indicators are millions of small entities like you and me. In microeconomics, we look at how people can make the best decision they can to make their lives better by making good choices.
We apply an essential economic tool called “thinking on the margin” in our daily lives. It essentially means evaluating the benefit of one extra unit of something vs. the cost of one extra unit of the same thing.
For example, should I spend one more hour studying? Should I eat one more pizza slice? Small decisions like that are also economic decisions. Households, businesses, and governments all think about tradeoffs and marginal cost vs marginal benefit analysis while taking many decisions in life.
For an individual, it is a personal decision like should I spend a few additional minutes reading this article or should I switch to some other activity that may give me more marginal benefit? Similarly, firms must decide whether to hire additional labor to increase production and by how much? Will the extra revenue generated from hiring that extra labor to be enough to cover his cost of wages?
Lastly, on a macro (aggregate) level, governments make the monetary and fiscal policies to make more significant decisions by doing the same marginal analysis. Should they build an extra park or use the money on healthcare? We need to remember that the principles of economics can provide guidance across all sectors, be it at the micro-level or macro level.
The most talked-about topic affecting everyone for now almost a year is inflation. Your money loses its purchasing power, you need more money to buy the same amount of goods and services you purchase or use. If you are hiding a lot of money under your mattress or in a safe place at home, trust me it’s a bad idea. You will only be able to buy fewer items with that in the future than now.
The easiest way to define inflation to a layman is the sustained increase in the average prices of a basket of goods and services that we buy over a specific period. So, when there is inflation, the cost of living goes up. This becomes a real problem if your income doesn’t rise as quickly as inflation, then with your current income, you will only be able to buy less same stuff than before.
The inflation rate is expressed as a percent change from the previous period. Below is the actual inflation rate in the US in the last 6 years. So if the annual inflation is 6%, it means on average, prices have risen 6% from the last year. As you can see, the inflation slope became steeper in 2020, after the pandemic hit the global economy.
So, what causes inflation?
This can happen in two ways: either through demand-pull factors or through cost-push factors.
The quantity theory of money explains inflation caused by demand-pull factors.
Demand-pull inflation
This occurs when people have too much money and they want to buy more, whereas there is not enough supply to meet that demand. Or in other words, too much money is chasing too few goods. This usually happens when the economy is at (or very close to) full employment/full capacity. By full employment, we mean people who are looking for jobs can find one. Also, in this situation, the country’s GDP grows at a rate faster than its long-run trend rate. This happens when there is too much money in circulation. If the bank interest rates are too low, people, both households and businesses can borrow easily and as a result, can buy more goods and services than what the firms can supply. We call this phenomenon “too much money chasing too fewer goods”. Producers increase prices and profit because they can’t increase supply in the short run.
Using the demand and supply curves, I explain this idea. You see that the demand curve always slopes downwards, meaning people always want to buy more items at a lower price, Also, note that the supply curve faces upward, which means the firms producing those goods would like to supply more at higher prices, With the same assumption that is everything else staying the same. Equilibrium price and quantity are established at P and Q where the supply and the demand curve meet. We call them P and Q.
To explain this graphically, let’s look at the demand and supply model. On y axis, we denote the general price level, since inflation reflects general price level rise. On x asis we will show the real quantity of goods and services or real GDP. In the graph below, demand will be aggregate demand as this is represents demand from the whole economy. This demand is also downward sloping curve, as the demand for any normal item will be. It shows people overall demand lower quantities when the prices are high and demand more quantities when the prices are low. With the same assumption that nothing else is affecting the demand and everything else stays constant. The aggregate supply curve always is upward sloping meaning producers are willing to supply more at higher prices, so they can get more profits and vice versa. With the assumption that everything else is staying the same, the price level and quantity are set where aggregate demand meets aggregate supply at e. This is the price level consumers are willing to pay and producers are willing to accept and is denoted by P. And the corresponding quantity supplied and demanded is denoted by real production of goods and services or real GDP at Q. Economist call this equilibrium price level and quantity.
If there is excess money in circulation in the economy, people can afford to buy more, so for each price level, there is an increased demand. Or in other words, too much money is chasing fewer goods.
In our graph, you will see the aggregate demand shifting to the right or upwards. Now we get the new equilibrium e1, where the new demand and supply meet, and you can see that the new price and the quantity both have increased to P1 and Q1. This happens in the short run when producers don’t increase the supply of goods and services but instead, charge more prices because of increased demand.
Over time when producers can increase their production, the supply will be increased. In the graph below, this will mean the supply curve shifts to the right. So we can see at the new equilibrium, the prices will fall back. How much the prices fall, will depend on how much adjustment (increase) in supply is made in the long run. If the supply is adjusted enough to meet the increasing demand, then the prices will back to level P and the quantity demanded and supplied will be even higher, as shown at Q2. And the increase in the general price level is controlled.
Cost-push inflation
When the supply of the good is reduced due to an increase in the price of inputs in making that good or service. Supply shocks can cause cost-push inflation. Supply can fall due to a variety of reasons, such as if the cost of inputs for production goes up or if there is a natural calamity. Most recently after the pandemic, lockdown jams in major ports have contributed to a slowdown in the supply of a lot of items.
In the graph above, supply shock has pushed the price up to P1, and Quantity is reduced to Q1.
How to calculate the inflation rate?
Inflation is expressed as a % change in the price level of a market basket of goods and services over a period. To understand how inflation is calculated, let’s start with a very simple economy, where people only bought and consumed 3 items – bread, internet, clothing, and a house. You spend 30% of your yearly income on bread, 10% on clothing, 10% on the internet and 50% on renting an apartment. Then let’s assume the price of bread in year 1 is $2 and the price of internet is $45, price of clothing is $10, and rent is $25000. The price of bread in the year 2022 goes up to $2.5, price of internet becomes $60, price of clothing increases to $15 and rent in year 2 is $30000. We also, in the table below, list the proportion of income or weight they spend on all these items. The sum of these weights needs to add to 100%.
Inflation from year 1 to year 2 is calculated as (CPI2 – CPI1)/ CPI1 * 100 where CPI1 is the price level in year 1 and CPI2 is the price level in year 2. CPI is a weighted average price of many day-to-day goods and services that a typical American person living in a city buys at a particular time. Don’t be frightened by the term “weighted average”. Weight here refers to the importance of spending on a particular item compared to total expenditure. It simply means more weight is given to goods and services where you spend more money of your income. This could be because you buy that thing more often like, daily or you spend a lot of money buying it.
If we change the weight of some things from table 1, even with the same absolute increase in price, the inflation % will change. As you can see in table 2, it became 20.02%.
If the change in prices is more compared to that from table 1, even with the same % of weight, the inflation % will be greater.
BLS calculates and publishes inflation in the US
However, our consumption is not just restricted to these four items. In fact, a typical American urban consumer consumes a wide variety of goods, known as the market basket of goods.
In the US, the Bureau of Labor Statistics calculates something called the CPI (consumer price index). To collect the monthly price data, BLS-trained representatives make personal visits, phone calls, and get online surveys to collect data on what goods and services American people are buying.
The price and weight info are essentially based on a survey of people of what proportion of their income people spend on a given good or service. BLS tries to calculate the prices of the same basket of goods and services. Now, here some people will argue that what if people don’t consume the same things after some years? That is a subject of further investigation, but the general idea is that the BLS tries to calculate the prices of the same goods and services consumed by the average person over a period for which it is calculating the inflation rate.
Since CPI is a sample of retail prices and does not cover the complete universe of all prices, it is subject to some errors. However, that sampling error is not statistically significant to change the calculation by a lot. You will have to get into statistics class to understand the more technical aspects of what is considered a significant error or not, but for now, you can understand the error possibility is very small, so it is a reliable indicator of how the prices are behaving in general.
But when do we need to worry about inflation?
Well, some inflation is not bad and is considered healthy for the economy. Since our salary/wages have also increased over time and in most cases, some general rise in price level doesn’t hurt our purchasing power.
The BLS calculates this measure at 1-month, 3 months, 6 months, and 1-year intervals, and publishes that data. Over the last 40 years, we have seen this inflation % on average staying close to 2% annually. That means the same basket of items that you buy is 2% more expensive from 1 year to the next. The goal of monetary policy is to keep the inflation number close to this target-rate.
But in some countries like Zimbabwe and Venezuela, the prices had risen to a level making it very difficult for people to hold on to their currency. That situation where general prices rise at a rate of 50% per month is called hyperinflation. People know that they won’t be able to buy the same set of goods with that amount of money, even the very next day, so they demand more wages to cope with it. This, in turn, causes firms to pass this burden by increasing the prices of goods and services they provide. This, in turn, causes an increased demand for higher wages and the spiral continues. This is called the wage-price spiral. This can cause a severe crisis in any country.
To know more about how the Fed uses monetary policy to control inflation, click here.
Economists have some simple key models to understand our complex economies. One such model is the circular flow model. This model comes handy when we understand why GDP from income method and expenditure method should equal.
There are two main ways of calculating nominal GDP and will discuss these in detail later in this article. These methods are known as the expenditure method and the income method.
But first, we should understand the relationship between the income method and expenditure method of calculating GDP in a circular flow model. The circular flow model shows the linkages between two groups of economic decision makers, households and businesses. It also tells us that there are two types of economic markets, the resource or factor market, and the product market for goods and services. Once we understand this simple circular flow model, it will be useful to understand the complex economy and the GDP computation. In order to learn more about what GDP is, please click here.
The model begins by assuming a simple economy with two markets:
Factor or resource market: a market for factors of production that the firms demand.
Product market: a market for goods and services that the households demand.
By household, we mean people living in a house. Businesses are privately owned entities producing goods and services to sell in exchange for money. It is important to understand that the households and businesses are both buyers and sellers.
Households are sellers in the factor market. They sell land (including any natural resource like trees), labor, capital, and entrepreneurial ability in exchange for money. Households are buyers in the market for goods and services. Households give money to businesses for goods and services.
Businesses are sellers in the market for goods and services. Businesses sell goods and services in exchange for money, which they call revenue. At the same time, businesses are buyers in the market for resources. Businesses exchange the revenue earned in the market for goods and services to buy factors of production i.e., land, labor, capital and entrepreneurial ability in the resource market. Here, the money they spend is called the cost of production.
Let’s understand it better with a simple example.
When you go to your local pizzeria to eat your favorite pizza, you give your money to the owner for the pizza you buy from him. When you pay your bill, you are buying goods and services. But the money doesn’t remain with the pizzeria owner for long. The pizzeria owner uses part of this money to buy resources such as wheat flour from a farmer. He also pays wage/salary to the server who took your order and also might spend money to purchase a new equipment for his pizzeria. For the pizzeria owner, all these expenditures are costs of production. After he pays his costs of production, the remaining income is his profit. This is the money he earns as being an entrepreneur owning and operating his business with his skills. Now let’s say your money went to the farmer and that for her, is her income. But that money won’t remain with her for long as well. She will spend it too on other things she wants to buy, and the entire cycle will start again.
Thus, this circular flow keeps going on and on. Here’s an animation explaining the model, you can see the circular flow between the product market and factor market. You will also see the flow of money between the two. Money flows in one direction while goods and services and resources flow in the other direction. Through this model, we can see the relationship between households and businesses and how these different decision-makers fit together in our big economy.
In reality, our economy is more complex and has more elements, like, government, foreign trade etc. and we can expand the model to include all these players. But the basic idea won’t change.
I hope this made sense. Let’s go back to the two ways of calculating GDP and we can see why these two methods will yield similar results.
Expenditure method: Since GDP is the market value of all final goods and services produced in a country at a given period, if we add the total spending done by all the people in a country, we can get a number close to nominal GDP. We usually categorize these total expenditures done by these four sectors:
Household spending includes any new good or service we buy, big or small. So, we will add all our expenditures be it on buying an apple or a new house, in a given period, to get the private consumption component of GDP. We can denote it with C.
Spending by firms/businesses on capital and inventory, which we call investment or I. Investment here refers to investment by a firm in machinery, research& development, inventory, etc. We only include investments done by businesses in real assets in the calculation of GDP. We don’t include any financial investments, like buying a company’s stock or bond or a financial asset.
Government, like us, spends money on various things. These include big expenditures on building infrastructure, public parks, public-funded education, hospital, nuclear energy, defense, salaries paid to government officials and small expenditures on office supplies, and many more. All of those will be part of the G component of GDP. But we won’t include government spending on any transfer payments, such as pensions to retired people or on welfare programs and subsidies. Those payments are not counted in GDP because no good is produced or service is exchanged against these payments.
Spending by the rest of the world (Exports – Imports or net exports). We denote it with NX. Sometimes, a country produces some goods more efficiently than other countries and can sell them to other countries for profit. Those are called Exports. Similarly, the things a country has a comparative disadvantage in making, it can buy from other countries, which can make it relatively cheap.Since GDP, includes only goods produced “within the boundaries of a country.” we will include foreign people’s expenditure on things made in our country or our exports. At the same time, we won’t include us buying any foreign-made goods or our imports.
So, GDP = C + I + G+ NX
Let’s look at the second approach of calculating the GDP.
Income method: Here we add the total income earned by all the people living within the boundaries of a country. Economists classify income earners into four broad categories. Labor, land, capital, and entrepreneurship. These are called factors of production- the inputs used in the production of goods and services. Thus, we sum up all the income earned in a given year by these four factors of production using this formula.
Wages/salary (earned by labor) + Profits (earned by an entrepreneur) + Rent (earned by landowners) + Interest income (earned on capital equipment).
There is another method, which is less frequently used and is called the value-added method.
Value-added Method: In this method, we add up all the value-added at various stages of production. For example, to make a dress, we will calculate the value of the raw material that a fabric company sells to the dress manufacturer ($10), which he combines with his skill and capital ($40) to make a dress worth $50.
So, these were all the ways of calculating the nominal GDP. To learn more about US GDP, please click here.
IMF projects lower global GDP growth of 3.6% for the next two years
IMF’s World Economic Outlook report published on April 19, 2022 has predicted a drop in the GDP growth of the world economies in the years 2022 and 2023 to 3.6%. This downward revision is from their previous estimate of 6.1%, largely because of the war in Ukraine. IMF publishes this report twice every year.
Below is the chart from IMF showing these growth projections by region. These projections are for real GDP growth and not nominal GDP growth. As changes in real GDP are the most popular indicator of a country’s overall economic condition. If you want to know more about the US GDP and its components, please click here.
Countries, like the United States, the EU, Japan, the UK, Canada, and other advanced countries are projected to grow on an average of 3.3% in 2022 and only 2.4% in 2023.
The emerging market and developing countries such as India are projected to grow at 8.2% in 2022 and 6.9% in 2023. Whereas because of the lockdown in Shanghai, China, the projected growth is slightly lower at 4.4% in 2022 and it is expected to be 5.1% in 2023, as the lockdowns are eased.
As expected, there is a severe double-digit drop (-35%) in GDP projection for Ukraine in 2022. They also project a contraction for Russia due to sanctions and European countries’ decisions to reduce energy imports. The war has also severely impacted emerging and developing Europe, which shares proximity to the war area with an expected fall of 2.9% in their real GDP in 2022. There is a hope of some recovery in 2023 with GDP growth returning to 1.3%. Russia will see a GDP growth of -8.5% in 2022 and -2.3% in 2023.
The two charts below show the GDP growth comparison in some major countries of the world after the start of the global pandemic. The first chart shows the performance in the years 2020 and 21.
The second chart shows the projections by IMF for the years 2022 and 2023.
Sadly, the war just doesn’t affect the countries directly involved, its economic costs and implications are widespread. Through commodity markets, trade, and to some extent financial interlinkages of the countries, the war can indirectly affect so many more countries.
Globally we are seeing rise in fuel and food prices since late 2021. The fear of War is aggravating high inflation problem even further. Unfortunately, the world’s poor population, particularly in low-income countries is getting the most impacted by this. To know more about inflation, please click here.
Many leading economists propose mutual efforts by countries to respond to the war crisis and prevent further economic fragmentation. At the same time, it is important to manage the debt problem, tackle climate change and end the pandemic to bring back economic growth.
Fighting inflation without slowing down the economy is the toughest challenge many central banks are facing currently. To know more about monetary policy and the role of a central bank, in controlling inflation, please click here.
The most widely used indicator for the overall health and size of an economy is its GDP statistics. Government and businesses use these statistics to see how our economy is doing. Usually, a higher GDP of a country indicates a higher standard of living for its people.
Even though it’s not a perfect measure of the happiness and there are some limitations of GDP, an increase in real GDP over time means the economy is growing overall.
Let’s start with understanding its literal meaning. GDP stands for gross domestic product. Here the word gross doesn’t mean bad, but it refers to total/aggregate, domestic means within the boundaries of a country and product includes the market value of all newly produced final goods and services.
By “goods” we mean any tangible product that we can touch, like food, clothing, cars, computers, phones, houses, and numerous other things, which businesses produce to sell for people to consume. So, if you are producing corn on your land but are not selling it to other people for money, it will not be counted in GDP.
Services, as the name suggests are non-tangible actions that provide us value. These range from a variety of services, such as those provided by a doctor, lawyer, internet provider, teacher, hairdresser, police officer, gardener, cleaner, and many more for which we pay them to be able to use it.
GDP is the total market value of newly-produced final goods and services produced within a country during a specific period, typically one year. In this definition, it is important to note that GDP will only include final goods and not intermediate goods such as raw materials used to produce that good or service. So, for example, if bread is bought by a consumer, it will be included in GDP. However, the same bread bought by a diner, which uses it as a raw material to make sandwiches, will not be counted in GDP. The reason is that the value of bread in the latter case is already included in the value of sandwich.
Also, any type of second-hand sale of a product is not included. The goods and services also have to produce within the country. If American cars are produced in China, they will not be included in the GDP of the US. Similarly, Japanese cars produced in America will be included in US GDP and not in Japan’s GDP.
Two important things to note here are the distinction between real vs nominal GDP and the population size of a country.
Real GDP or Nominal GDP: Which one should I care about?
Nominal GDP is calculated at nominal prices or current prices. Here, we sum the expenditure on all newly produced goods and services at the prices prevailing at that period when we calculate it. However, real GDP is GDP calculated at base-year or constant prices. If we see a higher nominal GDP number than last year’s, we need to examine what is the main reason behind the increase.
Since GDP is the market value of all final and newly-produced goods and services. Hence, the price and quantity of a product both will play roles in affecting the direction of GDP. A higher nominal GDP might simply be due to high prices without any change in the number of goods and services produced.
If we see prices rising over time, it will give us a higher nominal GDP number, even though the quantity of goods and services produced by a country hasn’t changed much.
For real growth to happen, the economy needs to be producing more goods and services. So, the real GDP is what matters, GDP that is adjusted for inflation.
Real GDP Per person is what matters for the standard of living
GDP can be higher if there are more people in a country, so more goods and services are needed to be produced. To measure the standard of living of people, we need to adjust for population size. When we divide real GDP by its total population, we get Real GDP per capita.
This calculation comes in handy when we want to compare different countries, and when we want to see how well a country is doing overtime. It is the most widely used indicator of economic growth.
So when we are looking at GDP numbers, we either look at them either in comparison to other countries or how the GDP over time is trending. I pulled data from the World Bank to show the trend of Real GDP in some of the world’s largest economies.
Another important factor to look at is the real GDP growth rate. GDP growth is the % change of GDP in a given year from GDP in the previous year. In the US, these calculations are done using the National Income and Product Accounts (NIPA) guidelines and published by the Bureau of Economic Analysis. Here is the chart showing US Real GDP over time. As of May 26, 2022, the US GDP is Q1 2022: 19,731.119 billion (chained dollars at 2012 prices).
During a period of rapid economic growth, the real GDP of a country usually grows at a rate of 7-8% or more per year. As the country reaches a developed or advanced economy status, GDP growth becomes more stable at 2-3% a year.
Many factors can contribute to continued GDP growth, including natural resources, capital, human capital, technological advancements, and good institutions. Countries that exhibit higher GDP growth, typically have all these factors contributing to it.
A lot of people think economics is all about money, banks, complicated graphs, and mathematical modeling, but truly speaking it is much more interesting than that.
So, what exactly is Economics?
Economics is a study of human behavior, understanding the choices people make with their limited resources. By resources, we mean the tools needed to produce goods and services for humans consumption for a comfortable life. These resources are usually classified into 1)land, 2)labor, 3)capital such as tools and machinery, 4)human capital or entrepreneurship, and 5)our precious time.
We don’t usually have an infinite amount of these resources, so how do we allocate the limited resources to make us better off and happier? In short, Economics deals with our struggle to achieve happiness in a world full of constraints and limitations.
The word Economics comes from the Greek word oikonomia, which means household management. It starts with an individual making a tradeoff, choosing the best option that satisfies their wants, and forgoing the other best alternative use of their resources. From individual households, it moves to businesses, deciding what and how much to produce and sell. And lastly, government and the central bank decide when and how to intervene to ensure maximum happiness for its citizens.
We are making choices every single day. For example, if you are reading this, you have chosen to gain some knowledge vs. maybe, watching a TV Show or doing something else.
While reading this, you think you are making the best use of your time. (or at least I hope you do 😉 In short, you apply economics every minute (even when you don’t know it).
What does the field of Economics cover?
As you learn Economics, you can find answers to some fascinating questions such as:
How the price of anything is set?
How do we measure a country’s prosperity?
Why are some countries rich, while others are still poor?
What is inflation?
How do we understand business cycles?
What tools do the central bank and government use when the economy is facing inflation or a recession?
Is international trade a good thing?
And is reading this article even worth my time?
Trust me, the list is endless. There is a wide variety of areas that economics can cover. Economists try to solve many of these problems our world is facing today by simply understanding human behavior and the choices people make. I might have used the word choice a lot here, but hope you got the idea?
You will understand our rapidly evolving complex economies and how the economic fundamentals can still explain the changes.
You can apply Economics in your day-to-day life, such as while analyzing the cost and benefits of a particular decision you are going to make and managing your finances.
Similarly, you will also understand how economic principles apply to the businesses around us from a small local donut shop to a big company like Apple.
Understanding economics will enable you to evaluate the feasibility of promises made by politicians to get your vote.
Believe it or not, Economics can also help us understand the best strategy to deal with environmental issues, such as global warming and pollution.
Last but not least, since Economics is based on human behavior, there can be more than one view on any economic issue. It’s not an absolute science and many times economists differ on how a certain situation should be handled.
When you study Economics, you can acquire the necessary skills to argue why a specific viewpoint makes more sense to you.
Some key principles of economics are:
Everything has an opportunity cost and experiences diminishing returns.
People are rational (for the most part) and act in their self-interest (even charity is considered self-interest since it gives you some happiness).
Supply and demand interact through an invisible hand.
Comparative advantage fosters trade.
People think on the margin.
I will explain the above points in detail in my other posts. We will also dig into the two main subdivisions of economics: macroeconomics and microeconomics. We are only getting started!
