Macroeconomic Essentials: GDP, Welfare, and Capital Markets

Gross Domestic Product (GDP) Components

GDP can be measured using different approaches:

Expenditure Approach

This approach sums up all spending on final goods and services in an economy. Key components include:

• Consumption: Household spending on goods and services.
• Investments: Business spending on capital goods, inventories, and structures.
• Government Spending: Government expenditures on goods and services (domestic demand).
• Net Exports: Exports minus Imports (external demand).

Income Approach

This approach sums up all income earned from the production of goods and services, often referred to as the income approach to production or added value.

GDP and Economic Well-being: Limitations

While GDP is a widely used economic indicator, it is not a perfect measure of economic well-being or welfare. Many elements contribute to a good quality of life but are not captured by this metric. Conversely, some elements that harm society are not negatively reflected in GDP.

As an indicator, GDP does not measure what is not valued by the market, such as good weather or beautiful beaches. It also fails to account for the leisure of citizens; the loss caused by a reduction in leisure time may offset the benefit from producing and consuming a greater quantity of goods and services.

Specific limitations include:

• It does not include non-market work (e.g., household chores, volunteer work).
• It does not account for the quality of the environment or environmental degradation.
• It does not provide information on the distribution of income. While it indicates what the average person receives, there is a wide variety of personal experiences behind that average value. Generally, in societies with significant income distribution distortions, a very small percentage of the population absorbs a disproportionately high percentage of income, and vice versa.

The Loanable Funds Market

The loanable funds market is where funds offered by those who want to save money meet the demand from those who want to borrow to invest. In this market, a single interest rate (i) approximates the equilibrium level, where the supply and demand for loanable funds are exactly equal.

Key Dynamics in the Loanable Funds Market

• Savings Incentives: An increase in savings leads to a greater supply of loanable funds, which tends to reduce interest rates and, consequently, increases investment.
• Investment Incentives: An increase in investment demand for funds would raise interest rates, which in turn can stimulate an increase in savings.

Government Fiscal Policy and Loanable Funds

• Government Budget Deficit (G > T): When the state spends more than it collects, a budget deficit occurs. This reduces the supply of loanable funds, raises interest rates, and reduces private investment (a phenomenon known as crowding out). When the government borrows to finance its budget deficit, it effectively displaces private borrowers who are trying to finance their investments. Therefore, government budget deficits tend to reduce the rate of economic growth.
• Government Budget Surplus (T > G): When the state spends less than it collects, a budget surplus occurs. This increases the supply of loanable funds, reduces interest rates, and stimulates private investment. Therefore, government budget surpluses tend to increase the rate of economic growth.