IB DP Economics: Measuring economic activity, unemployment and inflation – Revision Notes

These notes fill in the measurement content of sub-topics 3.1 (Measuring economic activity and illustrating its variations) and 3.3 (Macroeconomic objectives) of Unit 3. They follow the IB Diploma Programme Economics guide (first assessment 2022, published February 2020), the course examined from the 2022 session onwards. The business cycle, the AD-AS model and the list of macroeconomic objectives are in the measuring and managing the economy revision notes; read those first. Constructing a weighted price index is HL only; everything else here is SL and HL. For full explanations read the study guide, then test yourself with the practice set. The course page is IB DP Economics and the printable checklist tracks your progress. All data below is from Tavoria, an invented country, and is illustrative.

Core definitions (3.1)

Term	Meaning
Circular flow of income	Model of income and spending flowing between households and firms, with leakages (saving, taxes, imports) and injections (investment, government spending, exports)
Gross domestic product (GDP)	Total value of all final goods and services produced within a country in a given period
Gross national income (GNI)	GDP plus net income from abroad (income residents earn abroad minus income paid to non-residents)
Nominal GDP	GDP valued at current prices, not adjusted for inflation
Real GDP	GDP adjusted for inflation, valued at the prices of a base year
GDP deflator	A price index used to convert nominal GDP into real GDP
Per capita	Divided by the population: an average per person
Purchasing power parity (PPP)	An exchange rate at which a set basket of goods costs the same in each country, so values reflect what incomes actually buy

Three ways to measure GDP. The output, income and expenditure methods all measure the same flow, so in principle they give the same total. The expenditure method adds the spending components:

GDP = C + I + G + (X - M)

Formulas and calculations (3.1 and 3.3)

Item	Formula	Example
Nominal GDP (expenditure)	C + I + G + (X - M)	620 + 180 + 240 + (210 - 250) = 1,000
GNI	GDP + net income from abroad	1,000 + (-35) = 965
Real GDP	nominal GDP / deflator x 100	1,000 / 125 x 100 = 800
Per capita	total / population	800 bn / 40 m = 20,000
Growth rate	(new - old) / old x 100	(824 - 800) / 800 x 100 = 3.0%
Unemployment rate	unemployed / labour force x 100	1.5 m / 30 m x 100 = 5.0%
Inflation rate	(new index - old index) / old index x 100	(130.0 - 125.0) / 125.0 x 100 = 4.0%
Weighted price index (HL only)	sum of (weight x price index) / sum of weights	(60 x 110 + 40 x 95) / 100 = 104.0

Method: real GDP and real growth

1. Write down nominal GDP and the deflator for each year.
2. Divide nominal GDP by the deflator and multiply by 100 for each year.
3. Calculate growth using the real figures, never the nominal ones.

Tavoria: nominal GDP rises from 1,000 (deflator 125) to 1,071 (deflator 130). Real GDP: 1,000 / 125 x 100 = 800, then 1,071 / 130 x 100 = 823.8. Real growth = 23.8 / 800 x 100 = 3.0%, while nominal growth was 7.1%.

Comparing countries: why per capita and PPP

Country	Real GDP	Population	Real GDP per capita
Tavoria	800 bn	40 m	20,000
Neighbour	300 bn	10 m	30,000

Tavoria’s total GDP is larger, but output per person is higher in the neighbour. Converting at PPP rather than the market exchange rate then adjusts for differences in the cost of living, so the comparison shows what incomes can buy in each country.

GDP and well-being (3.1)

GDP per capita is a poor guide to well-being on its own, because it:

• is an average that hides how income is distributed;
• leaves out unpaid work (such as caring and housework) and much of the informal economy;
• ignores leisure time and the quality of goods and services;
• counts output that damages the environment or uses up resources, with no deduction;
• says nothing directly about health, education or happiness.

Composite indices of well-being and happiness try to capture more of these dimensions than GDP alone.

Unemployment (3.3)

Definition. Unemployment is the number of people of working age who are actively seeking work but cannot find a job. The labour force is the employed plus the unemployed.

Why the official rate can mislead

• Hidden unemployment: discouraged workers who have given up looking are not counted.
• Underemployment: part-time workers who want full-time work, or people in jobs below their skills, count as employed.
• Informal work: people working in the informal economy may be counted as unemployed.
• Averages: the national rate hides large differences by region, age, gender, ethnicity and education.

Types of unemployment

Type	Cause	Possible remedy
Structural	A mismatch between workers’ skills or location and the jobs available, often after an industry declines	Education and training, help with relocation (supply-side)
Frictional	Workers between jobs, searching for a new one	Better information on vacancies
Seasonal	Demand for labour varies with the season	Encourage off-season activity
Cyclical (demand-deficient)	A fall in aggregate demand in a downturn	Expansionary demand-side policy

Natural rate of unemployment = structural + frictional + seasonal. It is the unemployment that remains when the economy is producing at its potential output, with no cyclical unemployment. On an AD-AS diagram cyclical unemployment appears as a recessionary gap: real GDP below potential.

Consequences of unemployment

• Economic: lost output (the economy produces below potential), lower tax revenue, higher spending on unemployment benefits, and loss of skills the longer people are out of work.
• Personal and social: lower income and more poverty, stress and poorer health, and possible rises in crime and social tension in badly affected areas.

Inflation, disinflation and deflation (3.3)

Term	Meaning
Inflation	A sustained increase in the general price level
Disinflation	A fall in the rate of inflation: prices still rise, but more slowly
Deflation	A sustained decrease in the general price level

A fall in inflation from 5% to 2% is disinflation. Steady 2% inflation still means a rising price level.

Measuring inflation. A consumer price index (CPI) tracks the cost of a basket of goods and services bought by a typical household, with each item weighted by its share of spending. The inflation rate is the percentage change in the index.

Problems with the CPI

• Households buy different baskets, so one index may not reflect everyone’s experience (for example, low-income households spend a larger share on food).
• Spending patterns change, and new products appear, faster than the basket is revised.
• Quality improvements are hard to separate from price rises.
• Countries build their baskets differently, which makes international comparisons harder.

Other measures. Core (underlying) inflation leaves out items with volatile prices, such as food and energy, to show the longer-term trend. A producer price index tracks the prices firms pay or receive and can give an early signal of consumer price changes.

Method: weighted price index (HL only)

1. Multiply each category’s price index by its weight.
2. Add the results.
3. Divide by the total of the weights.
4. Compare with the base (100) or the previous index to find the inflation rate.

Tavoria: weights 50 (food), 30 (transport), 20 (other); indices 108, 102, 95. (50 x 108 + 30 x 102 + 20 x 95) / 100 = (5,400 + 3,060 + 1,900) / 100 = 103.6, so prices rose 3.6% since the base year. Categories with a bigger share of spending move the index more.

Causes: demand-pull versus cost-push

	Demand-pull	Cost-push
Cause	AD increases faster than productive capacity, for example from rising consumer or government spending	Higher costs of production, for example wages, imported raw materials or energy
AD-AS diagram	AD shifts right	SRAS shifts left
Price level	Rises	Rises
Real GDP	Rises (towards or beyond potential)	Falls
Unemployment	Falls	Rises

Consequences of inflation. Loss of purchasing power for people whose incomes do not keep up; savers lose if interest rates are below inflation; borrowers gain because the real value of debt falls; uncertainty makes firms less willing to invest; exports become less price-competitive if inflation is higher than in trading partners; firms face menu costs of changing prices.

Consequences of deflation. Consumers may put off purchases expecting lower prices, which cuts AD further; the real value of debt rises, so borrowers struggle and bankruptcies can increase; firms’ revenues fall while wages are hard to cut, so they reduce output and jobs; monetary policy has little room once interest rates are close to zero. Deflation caused by a rise in aggregate supply (for example from new technology) comes with rising output and is less harmful than deflation caused by falling AD.

Must-know distinctions

• GDP vs GNI. Produced within the country vs earned by its residents wherever they are.
• Nominal vs real. Current prices vs adjusted for inflation.
• Total vs per capita. Size of the economy vs average per person.
• Market exchange rate vs PPP. Currency value in the market vs what the currency can buy.
• Disinflation vs deflation. A falling inflation rate vs a falling price level.
• Natural vs cyclical unemployment. Present at potential output vs caused by too little AD.
• Hidden unemployment vs underemployment. Not looking, so not counted vs in work, but wanting more.
• Demand-pull vs cost-push. AD right with output rising vs SRAS left with output falling.

Quick self-test

1. Define GDP.
2. GDP is 2,400 and net income from abroad is +60. Find GNI.
3. Nominal GDP is 1,560 and the deflator is 120. Find real GDP.
4. Why is real GDP per capita at PPP better than total nominal GDP for comparing living standards?
5. Give two reasons GDP per capita may overstate well-being.
6. There are 2.1 m unemployed and 32.9 m employed. Calculate the unemployment rate.
7. Explain why the official unemployment rate may understate true unemployment.
8. State the three types of unemployment that make up the natural rate.
9. Which type of unemployment rises when AD falls in a recession?
10. A price index rises from 112.0 to 115.36. Calculate the inflation rate.
11. Inflation falls from 6% to 3%. Name this and say what happens to the price level.
12. Name the curve that shifts in cost-push inflation, and state what happens to real GDP.
13. (HL only) Weights 70 and 30, category indices 105 and 120. Calculate the weighted index.

Answers

1. The total value of all final goods and services produced within a country in a given period.
2. 2,400 + 60 = 2,460.
3. 1,560 / 120 x 100 = 1,300.
4. Real removes inflation, per capita allows for population size, and PPP allows for differences in the cost of living, so it shows what an average person can buy.
5. Any two: it hides the distribution of income; it ignores environmental damage; it leaves out leisure and the quality of life; it does not measure health or education directly.
6. Labour force 35.0 m; 2.1 / 35.0 x 100 = 6.0%.
7. Discouraged workers who have stopped looking are not counted, and underemployed part-time workers count as employed.
8. Structural, frictional and seasonal.
9. Cyclical (demand-deficient) unemployment.
10. 3.36 / 112.0 x 100 = 3.0%.
11. Disinflation; the price level is still rising, but more slowly.
12. SRAS shifts left; real GDP falls.
13. (70 x 105 + 30 x 120) / 100 = (7,350 + 3,600) / 100 = 109.5.

Where marks are usually lost

• Calculating growth from nominal figures when real growth is asked.
• Dividing the unemployed by the population instead of the labour force.
• Calling a lower inflation rate “deflation”.
• Adding cyclical unemployment into the natural rate.
• Drawing cost-push inflation with AD shifting instead of SRAS.
• Listing CPI problems without saying how each one distorts the measured rate.
• Treating all deflation as harmful, without asking whether it came from falling AD or rising AS.
• Unlabelled diagrams: the axes are the price level and real GDP.

What these notes do not cover

The business cycle, the AD-AS model and the full list of macroeconomic objectives are in the measuring and managing the economy revision notes. The relationship between unemployment and inflation (the Phillips curve), the consequences of economic growth and the objective of a sustainable level of government debt are not condensed here; use the study guide and your class notes for them.

Frequently asked questions

How do you calculate real GDP from nominal GDP? Divide nominal GDP by the GDP deflator and multiply by 100. Always calculate growth from the real figures, not the nominal ones, when real growth is asked for.

What is the natural rate of unemployment? The natural rate is structural plus frictional plus seasonal unemployment. It is the unemployment that remains when the economy produces at its potential output, with no cyclical unemployment.

What is the difference between disinflation and deflation? Disinflation is a fall in the rate of inflation, so prices still rise but more slowly. Deflation is a sustained fall in the general price level.

Why is GDP per capita a poor measure of well-being? It is an average that hides how income is distributed, leaves out unpaid work and much of the informal economy, ignores leisure and quality, counts output that damages the environment, and says nothing directly about health, education or happiness.

Why might the official unemployment rate understate true unemployment? Discouraged workers who have stopped looking for work are not counted, and underemployed part-time workers who want full-time work count as employed.

Official syllabus

IB Diploma Programme Economics guide, first assessment 2022, published by the International Baccalaureate Organization, February 2020, sub-topics 3.1 and 3.3. See also the exam preparation page and the free 10-minute diagnostics.