What does it mean if GDP is rising?

This article by Angela Monaghan for the Guardian outlines the UK’s GDP growth reports from 2013 – particularly the improvements throughout the fourth-quarter: http://www.theguardian.com/business/2014/jan/28/uk-economy-2013-fastest-growth-fourth-quarter-gdp

But what does it mean if GDP is rising and why is it a sign that we are recovering from recession?

First off, let’s establish the meaning of GDP – Gross Domestic Product.

Gross (Total/pre-tax)
Domestic (Home country i.e. not foreign)
Product (Goods/services produced)

GDP is one of the most important measures of economic performance; it is the value of all the final goods and services which are produced in a country. The UK posts their GDP figures quarterly and if the value of GDP for the current period exceeds the previous period then the economy is said to be growing.

If you Google search UK GDP you will get a figure for the current gross domestic product within the UK which is around 2.5 trillion US Dollars. The graph below (taken 17/02/2014) shows the significant growth of the UK’s GDP and the drastic drop following the 2007 recession.

Rising GDP simply means that the economy is expanding as the Guardian explains; the increase in the number of goods and services being produced is a reflection of a healthy economic model where people are spending more and unemployment is likely to be falling. Although it may create rising inflation, as mentioned in my previous blog, this is just a sign that an economy is growing.

What actually is Inflation?

Inflation is one of the most important aspects of economics and something that is constantly being referred to in the news. In December, the UK’s inflation rate fell to the government-set target of 2%.

http://www.bbc.co.uk/news/business-25726621

This article from the BBC outlines the reactions towards the news and the causes of the fall in the inflation rate. But what actually is inflation?

Inflation is the general increase in prices over time.

An inflation rate of 2% means that the general price level of goods and services has increased by 2%. Approximately, if you’re weekly shop cost £100 last year, it now costs £102 and if the inflation rate remains stable at 2%, you know that your weekly shop next year will be £104.04.*

Effectively, inflation represents the ‘purchasing power’ of money. If inflation is very high and prices are going up, the money that you have in your bank accounts and that you hold in cash is losing its value (and it’s ‘purchasing power’). For example, say the inflation rate is 80% and you want to save up to buy something that costs £1000. If it takes you a year to save up a thousand pounds, the high level of inflation means that whatever you wanted to buy now costs £1800! You can think of this as the money that you have losing value over time because of inflation.

Clearly, it would be ideal to have a stable rate of inflation. People would know the rate that prices are increasing and would be able to determine how much they should spend and how much they need to save.

In a perfect world, wages would rise at the same rate inflation does but this is not the case.

Why not aim for an inflation rate of zero?

It may seem like a good idea to have no inflation within an economy. However, this means that the economy is not growing and is susceptible to fall into deflation meaning the economy would shrink. At the same time, it is vital to not aim for a high level of inflation as this could create an unstable economy. This is why it is challenging, yet important, for the Government to maintain a stable rate of inflation – whilst it also focuses on an endless list of other pressing matters.

How is inflation measured?

Inflation is measured in the UK using the Consumer Prices Index (CPI) and the Retail Prices Index (RPI). The UK inflation target is officially 2% +/-1% (i.e. between 1% and 3%) according to the CPI.

The CPI takes into account over 600 goods and services and gives weighting to the items which people buy more of e.g. food. It then calculates, using an index, the increase in prices from the previous year and ends up with a percentage figure for the level of inflation.

*in my example the figure £104.04 is because you calculate the 2% from the current year (£102) and not the previous year (£100). So the price would increase to £106.49 (£104.40 x 1.02).