Measuring economic activity and illustrating its variations

• Explain, using the circular flow of income with its leakages and injections, why output, income and expenditure give one measure of national income.
• Calculate nominal GDP by the expenditure approach, and nominal GNI from GDP and net income from abroad.
• Convert nominal GDP and GNI into real values with a price deflator, and express them per capita.
• Explain what purchasing power parity corrects for when incomes are compared between countries.
• Draw the business cycle and distinguish its short-term fluctuations from the long-term growth trend.
• Discuss how appropriate GDP and GNI statistics are for comparing economic well-being over time and between countries.
• Describe the OECD Better Life Index, the Happiness Index and the Happy Planet Index, with a strength and a limit of each.

National income accounting is the system a country uses to measure the value of its economic activity over a period, usually a year or a quarter. Its totals, of which Gross domestic product (GDP) is the best known, are used to measure Economic growth, to compare economies, to decide whether policy needs to change, and as a first indicator of living standards.

The accounts rest on the Circular flow of income model. Households own the Factors of production and supply them to firms. Firms use them to produce goods and services, and pay households factor incomes in return: wages for labour, rent for land, interest for capital and profit for entrepreneurship. Households spend their incomes on the output of firms. Money therefore moves in a circle: from firms to households as income, and back to firms as spending.

Because of this circle, every sale of a final good or service is three things at once: the value of something produced, spending by the buyer, and income for the factors that produced it. All of a firm's revenue is paid out as wages, rent and interest, and what is left is profit. National income can therefore be measured at three points of the flow.

• Output approach: add the Value added by every firm in every sector. Value added is the value of a firm's sales minus the value of the goods and services it bought from other firms. Counting only value added avoids double counting: the flour in a loaf is counted once, in the price of the loaf, and not again as the sales of the miller.
• Income approach: add all the factor incomes earned in producing the output: wages, rent, interest and profit.
• Expenditure approach: add all spending on final goods and services produced in the country: consumption, investment, government spending, and exports minus imports.

The three approaches measure the same flow, so in principle national output = national income = national expenditure. Two details keep the totals equal. Output that is produced but not sold is counted as investment in stocks by the firm that holds it, so spending still equals output. Only final goods and services are counted in spending, so intermediate goods, which firms buy and use up in production, are not counted twice. In practice each total is estimated from different surveys and tax records, so the published figures differ slightly. The difference is an error of measurement, not a difference in what is being measured.

Three more sectors complete the model: the financial sector, the government and the foreign sector. Not all income is passed on as spending on domestic output. Leakages (also called withdrawals) are the parts of income that leave the loop between households and firms: saving (S), which goes to the financial sector; taxes (T), which go to the government; and spending on imports (M), which goes to the foreign sector. Injections are spending on domestic output that does not come from household consumption out of current income: investment (I) by firms, financed through the financial sector; government spending (G); and export revenue (X) from the foreign sector.

The size of the flow changes when the two totals differ. If injections are greater than leakages, more spending enters the loop than leaves it, firms raise output and pay out more income, and national income rises. If leakages are greater than injections, spending on domestic output falls, firms cut output, and national income falls. National income has no tendency to change when I + G + X = S + T + M. Only the totals need to be equal: a government can spend more than it collects in tax (G greater than T) with national income unchanged, provided that saving and import spending together exceed investment and export revenue by the same amount.

Gross domestic product is the total value of all final goods and services produced within a country in a given period, usually a year. 'Domestic' refers to the country's borders: output produced inside them counts, whoever owns the firm that produced it. Nominal GDP is GDP measured at the prices of the period in question (current prices), with no adjustment for inflation.

The standard calculation uses the expenditure approach: nominal GDP = C + I + G + (X − M). Each letter is a category of spending on final output.

• Consumption (C): spending by households on goods and services, from food to haircuts.
• Investment (I): spending by firms on capital goods such as machinery and buildings, plus the construction of new housing and the change in firms' stocks of unsold goods. Buying shares or bonds is not investment in this sense: it transfers the ownership of a financial asset and produces nothing.
• Government spending (G): spending by the government on goods and services, such as teachers' salaries, medicines and roads. Transfer payments, such as pensions and unemployment benefits, are left out, because nothing is produced in exchange for them. They enter GDP only when the people who receive them spend them, as consumption.
• Net exports (X − M): exports are produced at home and bought by foreigners, so they are added. C, I and G all include some spending on goods and services produced abroad, so imports are subtracted, once, to remove it.

Some transactions are not part of GDP, because they are not payments for newly produced final output: sales of second-hand goods (they were counted when they were first produced), purely financial transactions, and intermediate goods (their value is already inside the price of the final good). Some production is left out because it is not sold in a recorded market: unpaid work in the home and most of the Informal economy. These omissions matter when GDP is used as a measure of well-being.

Gross national income (GNI) is the total income received by a country's residents in a period, wherever in the world it is earned. GNI = GDP + net income from abroad, where net income from abroad = income received from abroad − income paid abroad. The income concerned is factor income: profits, dividends, interest and rent from assets owned in other countries, and the wages of residents who work abroad for short periods.

The two measures differ when ownership crosses borders. Where foreign-owned firms produce much of a country's output and send their profits to owners abroad, net income from abroad is negative and GNI is below GDP. Where residents own many assets abroad, or many of them work abroad, net income from abroad is positive and GNI is above GDP. GDP is the measure of how much is produced in a country. GNI is the measure of the income available to its residents, which is why comparisons of living standards often use GNI per person.

Nominal GDP is price multiplied by quantity, added over all final output. It rises when more is produced, and it also rises when the same output is sold at higher prices. A comparison of nominal GDP in two years therefore cannot show whether the economy produced more. Real GDP is GDP measured at the prices of a chosen base year (constant prices), so a change in real GDP is a change in the volume of output. Real GNI is GNI adjusted in the same way.

The adjustment uses a Price deflator (for GDP, the GDP deflator): a price index that covers all the goods and services in GDP and is set to 100 in the base year. A deflator of 110 means that the prices of output are on average 10% higher than in the base year. The formula is: real GDP = nominal GDP ÷ price deflator × 100. Real GNI = nominal GNI ÷ price deflator × 100.

• In the base year the deflator is 100, so real and nominal values are equal.
• When prices are higher than in the base year (deflator above 100), the real value is smaller than the nominal value. When the deflator is below 100, the real value is larger.
• A real value is stated with its base year, for example '$1,000 billion at 2020 prices'.
• The formula can be rearranged: price deflator = nominal GDP ÷ real GDP × 100.

The rate of economic growth is the percentage change in real GDP: (real GDP this year − real GDP last year) ÷ real GDP last year × 100. When the data are nominal, each year is deflated first and the percentage change is then calculated from the two real values.

A common shortcut subtracts the rate of inflation from the growth rate of nominal GDP. It is only an approximation. Nominal GDP is real GDP multiplied by the price level, so the growth factors multiply: (1 + nominal growth) = (1 + real growth) × (1 + inflation). Multiplying out, nominal growth = real growth + inflation + (real growth × inflation). The shortcut ignores the last term, so it overstates real growth whenever output and prices are both rising. The error is small when both rates are small and grows as they rise. The deflator method is exact, and it is the method to use.

A total says nothing about how many people share it. Real GDP per capita is real GDP divided by the population: average real output per person. Real GNI per capita is real GNI divided by the population: average real income per person. A country with a large population can have a large GDP and a low GDP per capita.

Over time, real GDP per capita rises only if real GDP grows faster than the population. If real GDP grows by 2% in a year and the population grows by 3%, real GDP per capita falls by about 1%, although the economy is growing.

In a calculation the units must match before dividing: $ billion ÷ million people = $ thousand per person. If the data are nominal, deflate first: comparisons of living standards need real values per capita.

To compare countries, per capita figures in national currencies have to be converted into one currency, usually US dollars. Market exchange rates give a misleading result for two reasons. First, price levels differ. Services that are not traded internationally, such as housing, restaurant meals and haircuts, are usually cheaper where wages are low, so the same sum of money buys more in a low-price country. Conversion at market rates therefore understates what incomes buy in low-price countries, which are usually lower-income countries, and overstates what they buy in high-price countries. Second, market exchange rates move from day to day with capital flows and speculation, so a country's measured income could change with no change in its output.

Purchasing power parity (PPP) corrects for the difference in price levels. A PPP exchange rate is the rate at which a given basket of goods and services would cost the same in two currencies. An illustration with invented figures: a basket costs $100 in Country H and 2,000 pesos in Country L, so the PPP rate is 20 pesos per dollar, while the market rate is 50 pesos per dollar. An income of 100,000 pesos is $2,000 at the market rate and $5,000 at PPP: it buys in Country L what $5,000 buys in Country H. Real GDP or GNI per capita at PPP therefore compares the volume of goods and services that the average person can buy. You do not need to calculate PPP rates, only to explain what they correct for.

• The basket is a compromise: what is typical spending in one country is not typical in another, so no single basket fits every country equally well.
• The price surveys behind PPP rates are carried out only every few years, and the estimates are revised when new surveys arrive.
• PPP corrects for prices only. A figure at PPP is still an average, and it is silent about distribution, leisure and the environment.

Real GDP does not grow at a steady rate. The Business cycle is the pattern of short-term fluctuations in real GDP around its long-term growth trend: periods in which real GDP rises alternate with periods in which it falls.

The long-term growth trend is the average path of real GDP over many years. It represents the growth of Potential output: the real GDP the economy can produce when its resources are fully employed. The trend slopes upward because potential output grows as the quantity and quality of the factors of production increase: a larger labour force, more capital, better education and better technology. These change slowly, so the trend is drawn as a smooth line.

Actual output departs from the trend mainly because total spending in the economy (aggregate demand) grows faster or more slowly than productive capacity. When spending grows quickly, firms use their workers and capital more intensively and output rises above the trend. When spending falls, firms cut output and leave resources idle, and output falls below the trend. The fluctuations are therefore changes in how fully existing resources are used, while the trend is the growth of the resources themselves.

1. Recovery: real GDP begins to rise from its lowest point. Firms raise output by using workers and capital that were idle, so unemployment starts to fall and there is little upward pressure on prices.
2. Boom: real GDP grows quickly and rises above the trend. Unemployment is low, firms compete for scarce labour and materials, and wages and prices come under upward pressure.
3. Slowdown: real GDP is still rising, but its growth rate falls as the economy approaches the peak.
4. Peak: the turning point at which real GDP stops rising.
5. Recession: real GDP falls. The usual working definition is two consecutive quarters of falling real GDP. Firms cut output and jobs, cyclical unemployment rises and inflationary pressure weakens.
6. Trough: the turning point at which real GDP stops falling. The next recovery starts from here.

Two sets of names describe the same picture. The whole rise from a trough to the next peak is the expansion, which contains the recovery, the boom and the slowdown. The fall from a peak to the next trough is the contraction, which is the recession. Either set is acceptable if it is used consistently.

The vertical distance between actual output and the trend is the output gap. When actual output is above the trend the gap is positive: the economy is producing more than it can sustain, which is the situation called an inflationary gap. When actual output is below the trend the gap is negative: resources are unemployed, which is a deflationary gap. Potential output cannot be observed directly and has to be estimated, so the size of the gap at any moment is uncertain.

Real cycles are irregular. Expansions and contractions differ in length and in depth, so the diagram describes a pattern and does not predict the date of the next turning point. Because the trend rises, each peak and each trough is usually at a higher level of real GDP than the one before it.

Economic well-being is wider than income: it is the extent to which people have the resources, opportunities and conditions needed for a decent and fulfilling life. National income statistics are used as indicators of it in two ways: to compare one country over time, and to compare countries with each other.

Real GDP or GNI per capita does measure something that matters. It shows the average command over goods and services, and a higher income makes better food, housing, health care and education affordable, both for households and, through tax revenue, for governments. It is also produced in almost every country by a common method and published regularly, so it is available when other indicators are not.

What the figure leaves out is the reason it can mislead. Each omission pushes the figure in a known direction.

• Distribution. The figure is an average. Where income is very unequal, or where growth goes mainly to high-income households, the typical household has much less than the average, so the figure overstates its well-being.
• Non-marketed output. Housework, care of relatives, volunteering and subsistence farming produce goods and services that are not sold. The figure understates well-being, most of all in lower-income countries, where more production takes place inside households.
• The informal economy. Unrecorded paid work is missing from the accounts, so living standards are understated where the informal sector is large.
• Negative externalities and depletion of resources. Pollution, congestion and the running down of forests, fish stocks and minerals are not subtracted, and spending on cleaning up damage is counted as output. The figure overstates well-being and says nothing about whether it can be sustained.
• Composition of output. Military goods and capital goods add to GDP without adding to current consumption, so the figure overstates current living standards where their share is high.
• Leisure and working conditions. Two countries can produce the same output per person with very different working hours. The figure overstates well-being where output is achieved with longer hours or harsher conditions.
• Quality and new products. Improvements in quality and wholly new goods are recorded imperfectly, so growth over long periods understates the gain to consumers.
• Health, education, safety and freedom. These depend on how income is used and on institutions, and are not measured by income at all.
• GDP against GNI. Where a large part of profits flows to owners abroad, GDP per capita overstates the income of residents. GNI per capita is then the better starting point.

The balance of these points is that real GDP or GNI per capita at PPP is an appropriate first indicator of material living standards and a poor sole measure of well-being. It is most informative when the economies or dates compared are alike, and it should be read with data on distribution and with broader indicators such as those in the next section.

There are three main alternative measures. Each responds to a different weakness of national income statistics: the first widens the range of things measured, the second asks people directly, and the third brings in the environmental cost of the way people live.

The OECD Better Life Index is published by the Organisation for Economic Co-operation and Development (OECD). It compares well-being between countries across eleven topics, which together cover material living conditions and quality of life, and does not reduce them to one income figure. Its strength is breadth: a country can be seen to do well on income and badly on another topic. Its limits follow from the same breadth. The topics are measured in different units, so any single overall score needs a weight for each topic, and the ranking changes with the weights chosen. The index also needs far more data than a national income figure, which restricts the countries and years for which it can be compiled.

A Happiness Index measures well-being by asking people how they rate their own lives. The best-known index of this kind is the ranking in the World Happiness Report. People in each country are asked to place their life on a ladder from 0 (the worst possible life) to 10 (the best possible life), and countries are ranked by the average answer over three years of the Gallup World Poll, which interviews about 1,000 people per country each year. The report then uses six factors to explain why the averages differ: GDP per capita, having someone to count on, healthy life expectancy, freedom to make life choices, generosity and freedom from corruption. The six factors explain the scores; they are not used to calculate them.

The strength of a happiness index is that people weigh the parts of their lives by their own values, so nothing has to be assumed about what matters. Its limits come from the same source. The answers are subjective and may be shaped by culture and by what people expect, and the samples are small, so countries that are close together in the ranking are not reliably different.

The Happy Planet Index measures how efficiently a country achieves long and satisfying lives relative to the environmental resources it uses. In the 2026 edition the method is: life expectancy × self-reported well-being (the same 0 to 10 ladder question) ÷ Ecological Footprint per person, with statistical adjustments. The Ecological Footprint measures the demand that the average resident's consumption places on the environment. A country scores highly when people live long lives that they rate well and the footprint is small; a rich country with long, satisfied lives scores poorly if its footprint is large. In the 2026 edition, which covers 134 countries, Costa Rica ranks first, and the report notes that wealthy countries such as Singapore, Luxembourg and the USA perform poorly because of their environmental impact.

The strength of the Happy Planet Index is that it is the only one of the three that builds in sustainability. Its limits are that it leaves out income, education, rights and inequality within a country, and that its method has changed between editions, so scores from different editions cannot be compared and any description of the index should name the edition it refers to.

In an argument these measures are evidence for the limits of GDP: a country's position by income per person and its position on one of these indices can differ widely. They do not show that income is irrelevant. GDP per capita is one of the six factors that explain differences in life evaluations, so the evidence supports the view that income is necessary for well-being without being sufficient for it.

• National output = national income = national expenditure, because each is the same circular flow measured at a different point.
• Leakages are S, T and M; injections are I, G and X. National income rises when injections exceed leakages.
• Nominal GDP = C + I + G + (X − M). GNI = GDP + net income from abroad.
• Real value = nominal value ÷ price deflator × 100. Per capita value = real value ÷ population.
• PPP conversion removes differences in price levels between countries; a deflator removes changes in the price level over time.
• The business cycle is the short-term fluctuation of real GDP around a rising long-term trend, which represents potential output.
• Real GDP or GNI per capita at PPP is a first indicator of material living standards, not a complete measure of well-being.

• Using nominal figures to compare output between years, or totals to compare living standards between countries.
• Subtracting the inflation rate from nominal growth when a deflator is given.
• Mixing up the two adjustments: PPP is for comparisons between countries, the deflator for comparisons over time.
• Mixing up net exports (inside GDP) and net income from abroad (the step from GDP to GNI).
• Calling slower growth a recession.
• Listing what GDP leaves out without saying whether each omission makes the figure too high or too low.