Measuring economic growth is based on three important pillars that are GDP, inflation and unemployment rate. These pillars are globally considered as the best measure to determine the economic condition of an economy and assess whether economy is experiencing growth or contraction. In the global marketplace, GDP has always been one of the best measures to determine economic activity.
Purpose of this paper is to evaluate the role of GDP in measuring economic growth of Australia. Relationship between GDP and inflation has been presented to understand how these two relate with each other and help an economy to experience growth. In addition relationship between GDP and unemployment has also been described. Moreover, this paper attempts to explain how global financial crisis of 2008 as an economic event and changes in government policies have plausible influence on these relationships.
GDP explains the market value of goods & services produced in a specific time period within a country (Andolfatto, 2005). It includes only final good and services produced that are available for sale in the market. However some non-market services are also included such as education or defense services. GDP is widely considered as the part of national income and product accounts and measured by national statistics agencies. Policy makers and analysts consider GDP as the most useful tool to determine the actual position of the economy to understand whether it is experiencing growth or contraction (Dornbusch, et al, 1996). Most commonly, it is measured as a sum of total value of consumption (C) within the economy, gross domestic investments (I), government purchases (G), and net exports (NX) during a year.
“GDP= C+ I+ G+NX”
|Total Gross Fixed Capital Expenditures||50||150|
|Change in Inventories||50||-50|
|Gross Private Domestic Investments
(Capital Exp. + Change in inventory)
From the Calculation above, GDP for country A as well as country B is $520 billion. While measuring GDP, transfer payment is not included as they are not considered part of current production. GDP has been calculated using Expenditure Approach.
An economy experience recession when there is a substantial decline in aggregate demand. There are various factors that affect fall in aggregate demand such as higher interest rates that can cause to reduction in borrowing and investments, falling asset prices, declining income level, fall in consumer spending, currency appreciation causing to reduction in exports and overall financial crisis in the market (Abel et al, 2011).
According to Keynesian analysis, aggregate demand is composed of GDP (C+I+G+X-M). If there is any negative change in any of these factor, would result in declining GDP and can cause to recession (Fischer, 1993). It can be understood with an example of increase interest rate decision taken by the government. Higher interest rates will increase cost of borrowing for consumers or investors and it will affect spending as well as investment level. Therefore, gross domestic investments will decline and GDP will be contracted. Higher interest rates in the market results in increase in consumer savings as they feel to save more. Consequently, it causes to reduction in consumption level and thus GDP gets down.
Net Export is another important element to measure GDP however, an economy experiencing appreciation in currency exchange can result in reduction in demand of exports as it will lower the net receipts of the exporters in domestic currency value (Rodrik et al 2008). As a result, net export will be down causing to reduction in GDP.
Country A has all the values in positive with GDP at $520 billion and country B also has same value of GDP however, it can be seen that Total Gross Fixed Capital Expenditures in country B is $150 billion that is much higher as compared to country A with $ 50 billion. Country A has increased value of inventory investments with $50 billion and this is where country B is experiencing reduction in inventory. It is causing to decline in overall gross domestic investments (I). In order to find out recession for any country, it requires data of at least last two year period and that is why it won’t be really possible to confirm which economy is experiencing recession however it can be stated that country A has better economic situation as compared to country B.
In Australian economic history, 2013 was the year when GDP was recorded at its all time high level at $1560.39 billion. Growing consumption level in Australia, rising service sector and strengthening exports have led Australian GDP to grow year-on-year. In the year ended 2014, total value of GDP was worth $1454.68 million.
Figure 1: Value of GDP of Australia
Australia’s GDPhas expanded with an average growth rate of 3.5% over the period of 1960 to 2014.Strong economic growth and increasing service sector have accelerated gross domestic production within Australia. According to World Bank Data, growth rate of Australian GDP was 2.5% annually. For December quarter in 2015, 2.8% growth was recordedby Australian Bureau of Statistics. As of now, annual growth rate of GDP for 2015 is not available.
Figure 2: GDP Growth Rate and CPI
A consumer price index (CPI) is considered as a tool to measure these changes in prices of household consumption. Changes in the price of household goods or services directly affect the real purchasing power of income level of consumers (McConnel and Brue, 2008). It is widely used to measure change as an inflation rate.
Consumer Price inflation was 1.5 in 2015 in Australia (World Bank, 2015). Australia’s central bank is targeting core inflation to be between 2.0 to 3.0 for the year 2016. Cost of alcohol and tobacco increased significantly with 6% change in Q4 in 2015 y-o-y. Second important household service was education that witnessed an increase of 5.5 % in Q4 in 2015. Over the last decade, rising number of foreign students visiting to Australia for higher education have accelerated the demand of education from Australian universities and thus overall cost of education has increased in the education. Another important element was cost of health that experienced a rise in Australia in 2015 as compared to 2014. Cost of health increased with 5.3 % in Q4 in 2015 from Q4 in 2014 (ABS, 2016). Rising global demand for education from Australia and growing business opportunities have created a crunch for accommodation. Consequently, cost of housing has increased significantly over the years (Mohammad et al, 2015). As compared to Q4/2014, cost of housing increased by 2.2% in Q4/2015.
From the figure-2 above it can be seen that trend in GDP growth has been straight for a period of 1981-2015 whereas CPI trend is downward sloping. There is a reverse relationship between the GDP growth and inflation as presented in the figure 2. It can be noticed from the trend that GDP has gone up with declining trend in inflation for period mentioned. Inflation rate for a period of almost 20 year (1981 to 2001) was averaging above 5 and it can be seen from figure-1 that during this period, GDP value was less than $400 billion every year. With high inflation, cost of household goods and services was higher as economy would be experiencing low spending level (Ghosh, 2000).
However, Australian GDP started witnessing an upward trend in the value from 2001 onwards when inflation rate was less than an average of 3% between the years 2002-2015. With low inflation rate, economy has experienced less impact on consumption level due to change in the price level of household goods or services. Although the growth rate of GDP was 3% as an average of 2002-2015, value of GDP was increasing every year. GDP of Australia has reached to $1,454.68 billion in 2014 from $394.20 billion in 2002. For sustainable economic growth of an economy having a positive inflation is regarded essential as it helps to improve purchasing power of consumers and strengthen consumption level with increased money supply in the market. Ultimately, with low impact of change of prices on consumption level encourage consumers to spend more rather focusing on saving when there is high inflation, thus enable economy to witness growth in GDP year on year (Krugman, et al, 2011).
Mortgage crisis and subprime issue in developed countries started from the US have led to global economy face global recession and financial crisis in 2008. Banking and financial sector was severely hit in the US that further led to experience sharp decline in Australian Stock Exchange as foreign investors from the UK and US were withdrawing huge amount from the capital market to manage the crisis affect.Capacity raising new capital from the share market was largely affected for Australian business. Global economies experiencing challenges with this crisis have reduced consumption level thus demand for Australian products have also affected leading to reduction in export volume as well as prices.
Impact of this economic event was seen in the performance of Australian economy as CPI for the year 2008 gone up to 4.4% from a level of 2.3% in 2007. High prices of households good and services have affected consumption level and higher cost of borrowing has affected investment level in the country. Consequently, overall GDP value has gone down in 2009 at $926.56 billion from $1,142.25 billion in 2008 (see Appendixfor GDP value). Therefore, impact of financial crisis proves that there is a reverse relationship between GDP growth and inflation.
Financial crisis has largely affected the economic growth with major hit on financial market. In order to sustain in this crisis, Reserve bank of Australia was the first that made a significant change in the policy by cutting cash rates by 4% in just five months between October to February 2009. A switch in the policy can was seen as ‘highly expansionary’ from ‘quite restrictive’. It was aimed to increase the borrowing from the market and enhance spending as well as investment level. The then Rudd Government has announced $10.4 billion package as its first fiscal stimulus for pensioners, parents and careers. It was estimated by treasury that GDP would increase by 1% from this step. Keynesian approach was adopted by the government as a change in fiscal policy to allow automatic stabilizers to support economic stability.
These changes in government policy have supported the Austrian economy significantly to encounter the crisis challenges. Economic impact of such change can be seen as GDP in the year 2010 was reached to $1,142.25 billion with from a decline in the previous year. Inflation also reduced to 1.8 by the end of 2009 that helped to revive consumption level, investments and export level resulting in rise of $215.69 billion in GDP value in 2010.
Unemployment rate is another important element to determine the economic condition of a country (Abel, et al, 2011). Most commonly, unemployment rate is defined as the % of unemployed people of total labor force who are actively involved in getting employment. According to International Labor Organization (ILO), people who are look for a job actively are considered unemployed. Unemployment rate is also regarded as a lagging indicator.
Figure 3: Unemployment Rate in Australia
In 2015, Australia’s seasonally adjusted unemployment rate was 5.8% that is low as compared to the unemployment rate in 2014 with 6.1%. According to Australian Bureau of Statistics, total number of employed persons was 11,902,300 in December 2015 whereas unemployed persons were 727,500 in Australia. For the period of 1981 to 2015, unemployment rate is averaged 7.2%. In 1993 unemployment was at the highest level in history at 10.9% and on the other hand, lowest unemployment rate of 4.2% was recorded in 2008 (Appendix).
Figure 4: GDP growth and Unemployment Rate
For the year 1992 and 1993, unemployment rate was 10.7% and 10.9% respectively. With such a high level of unemployment rate, Australian economy experienced a low or reduction in total value of GDP. In 1992, GDP was valued at $325.25 billion that reduced to $311.95 billion in 1993. Unemployment cannot be zero even though an economy is experiencing full capacity utilization of its work force. Unemployment rate helps determine how well a country is managing to utilize resources. Unemployment simply means number of people not contributing to economic growth. Higher number of unemployed people results in low consumption level as such people don’t have any earning to spend. They are considered unproductive and play no role in strengthening economy.
Arthur Okun (1962) has first introduced connection between unemployment and GDP growth. He has stated that 1% rise in unemployment results in 2% decline in GDP. Unemployment rate increased at 5.7% in 2013 from 5.2% in 2012. As a result GDP growth has gone down from 3.6% in 2012 to 2.4% in 2013. Employed people produce goods and services whereas unemployed people have no role in increasing production level.
Okun has derived a correlation between GDP and unemployment. He has stated that demand and supply play a vital role in determining GDP growth. Increase in demand in an economy results in rising GDP. In order to meet out demand for products or services in the market, it becomes important to utilize resource of work force to the maximum level so to enhance productivity and employing maximum people for higher level of production so that market demand can be achieved with improved production. GDP and unemployment rates are used to gauge the state of an economy (Krugman et al, 2011).
Rising level of employment directly results in increased GDP level due to higher consumer demand for goods and services. Rising trend of GDP and employment signifies that the economy is experiencing sound financial position and booming. With these sentiments, investors develop strong confidence in the economy and therefore more investments in service, manufacturing and other sectors are made to enjoy the growth of the economy and gain return on investments.
Seasonally adjusted employment level in Australia in Dec 2015 was up by 2.6% from the level of employment in Dec 2014 (ABS, 2015). Unemployment rate was 5.8% also down by 0.3 points in 2015 from 6.1% in 2014. It highlights and confirms that Australian economy has been focused to reduce unemployment by generating new employment sources so that labor force can be utilized to the maximum level possible. Declining unemployment will strengthen gross domestic product of the economy and an economy will be considered positive for investments and production.
Considering recession and financial crisis of 2008 as an economic event, relationship between unemployment and GDP can be best understood. Any economic event has various impacts on the performance of the economy. Financial crisis of 2008 is seen the recent economic downturn when many of the global market have witnessed negative or low economic growth. Australia was also not untouched with the impact of recession in 2008. Financial crisis have caused to various shut down in the industry and increasing layoffs have resulted to increase in unemployment level in Australia.
Companies were focusing on cost cutting methods to sustain in the market. Global demand for Australia’s export was down that resulted in falling volumes and prices causing to decline in Australia’s terms of trade, and the exchange rate. As an impact of recession, there was 10% fall in the terms of trade between December 2008 and March 2009 quarters (Gittings, 2009).
Australian labor market is recognized as flexible that restricts unemployment rate to increase. However, in extended downturn period, increased labor market flexibility results in higher unemployment rate as organizations or employers tend to reduce workforce so to avoid financial affect of downturn. With higher unemployment rate, GDP growth becomes low or negative.
Post recession, an economy is highly concerned to recover from the damages and fall in macroeconomic factors. Significant changes in government policy are aimed to ensure the recovery at the earliest possible and lead the economy to accelerate its growth rate. In order to encounter the challenge of unemployment and its impact on GDP, government is always intended to strengthen labor forces by implementing strategies to reduce unemployment. In this regard, changes in demand side policies are considered important to reduce unemployment caused by recession or any other economic activity globally whereas to reduce structural unemployment, significant changes are made in supply side policies.
Australian Government looks to make changes in fiscal policy in order to increase aggregate demand and economic growth rate and therefore create more job opportunities in the market so to decrease unemployment rate. Focusing on expansionary fiscal policy, government can support consumers to experience lower tax burden and therefore it increases disposable income. As a result on recession in 2008, there was a 15% reduction on VAT in Australia to encourage consumption level and enhance aggregate demand for products or services. Along with the increase in aggregate demand, market requires more workforces to improve production level so that global demand can be met. Consequently, it helps to increase real GDP of the economy. Firms producing more will create demand for workers and this will lower down unemployment rate.
Whether it is developed nation or developing nation, GDP has vital role in measuring economic movements and help policy makers to understand if an economy is growing or declining. With positive and rising GDP over the years, an economy can be considered experiencing growth, however if there is a fall in GDP for a continuous two or more years, it is widely regarded as recession period with negative economic growth. From the discussions made above, it is clear that GDP, inflation and unemployment are vital measure that help policy makers and analysts to understand the relationship between these and their role in determining whether an economy is experiencing growth or contraction.
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|Year||GDP Value||GDP Growth||CPI||UnemploymentRate|
Data Source: World Bank and ABS.