Key Idea: Topic 3.1 explains how we measure the economy (GDP), the difference between real and nominal, and the business cycle — the pattern of booms and recessions over time.
✅ Core definitions
- GDP
- Total monetary value of all final goods and services produced within a country's borders in a given time period.
- GNI
- GDP plus income earned by residents abroad, minus income earned by foreigners domestically.
- Nominal GDP
- Measured at current prices — includes inflation, so can be misleading.
- Real GDP
- Adjusted for inflation using the GDP deflator. Real GDP = Nominal GDP ÷ deflator × 100.
- GDP per capita
- GDP ÷ population — allows cross-country comparison of living standards.
📊 Three approaches to measuring GDP
- Output approach — sum of value added by all firms (avoids double counting)
- Income approach — wages + rent + interest + profits
- Expenditure approach — C + I + G + (X − M)
All three approaches give the same answer in theory. The expenditure approach (C+I+G+X−M) is the one used in AD analysis.
🔄 The circular flow of income
- Households provide factors → firms produce → income flows back
- Injections (I + G + X) increase flow → economy expands
- Leakages (S + T + M) reduce flow → economy contracts
- Equilibrium: injections = leakages (I + G + X = S + T + M)
📈 The business cycle
- Boom — high growth, low unemployment, rising prices (risk of inflation)
- Recession — falling GDP (2+ consecutive quarters), rising unemployment
- Trough — lowest point of the cycle
- Recovery/expansion — GDP starts rising again, unemployment falls
- Output gap — difference between actual GDP and potential GDP
Always use real GDP for growth comparisons. Nominal GDP can rise just because of inflation, not actual output increases.