Question

An economist wants to know whether the "average person" in country \(\mathrm{X}\) has more goods and services to consume than the "average person" in country \(Y\). Do you recommend that the economist look at per capita GDP or per capita real GDP? Explain your answer.

Short answer

The economist should look at per capita real GDP. This is because per capita real GDP accounts for inflation and gives an accurate representation of the purchasing power of the average person in a country. It shows how much goods and services the average person can actually consume, considering changes in the price level.

Step-by-step solution

Understanding GDP and Real GDP

Gross Domestic Product (GDP) is the total value of goods and services produced within a country in a given period. Per capita GDP is the GDP divided by the total population, which gives the average value of goods and services each person has. However, GDP does not account for inflation, which is the general increase in prices and fall in the purchasing value of money. To account for inflation, we calculate the Real GDP, which is the inflation-adjusted value of GDP. Per capita Real GDP is thus a better indicator of the average standard of living or the average value of goods and services each person has in real terms (accounting for inflation).

Recommending the Economists

Considering the above, the economist should look at the per capita Real GDP. This is because it gives an accurate representation of the purchasing power of the average person in a country. It accounts for inflation, showing how much goods and services the average person can actually consume, i.e., affords to buy, taking into account changes in the price level. Both countries may have the same per capita GDP, but if one country has more inflation, the average person there would be able to consume fewer goods and services than their counterpart in the other country.

Final Explanation

By looking at per capita Real GDP, the economist can make a more accurate comparison of the living standards between two countries. This data adjusts for changes in price levels (inflation) and therefore indicates the actual amount of goods and services that an 'average person' in either country can afford to buy.

Key concepts

Purchasing Power

Purchasing power is a vital concept when comparing economic wellbeing between different populations or countries. It refers to the ability of individuals or households to purchase goods and services. This ability is directly influenced by the amount of money people have and by the prices of these goods and services. If prices increase due to inflation, purchasing power decreases because each unit of currency buys fewer goods and services.

It's important to consider purchasing power when comparing economic metrics like GDP because these numbers alone don’t tell the whole story. For instance, a higher GDP might imply more wealth, but if inflation is also high, the real value or the purchasing power of this wealth may be low.

When economists evaluate purchasing power, they often use metrics like Real GDP, as it accounts for inflation and provides a clearer picture of the true standard of living. Real GDP helps determine how much the average person can actually consume, adjusting for price increases over time.

Per Capita GDP

Per Capita GDP is an economic indicator that measures the average economic output per person in a country. You calculate it by dividing the country's total GDP by its population. This figure offers a general sense of the average wealth of each individual in the country. However, while it provides a snapshot of potential economic productivity, it doesn't take inflation into account.

Because it doesn't adjust for inflation, per capita GDP might overestimate the actual economic well-being if prices have risen significantly. For comparisons across countries, it might illustrate disparities in economic conditions, but it lacks information on the real content of people's wallets due to price shifts.

Therefore, when resource allocation or living standards are being evaluated, economists often choose per capita Real GDP over simple per capita GDP. This is to ensure that the data reflects true economic realities post-inflation, giving a more accurate representation of the average person's economic prospects.

Inflation Adjustment

Inflation adjustment is the process of removing the effects of inflation from nominal economic figures to reveal real values. This is crucial for comparing economic data over time or between countries to ensure the relativity of figures holds despite changes in price levels.

For example, Real GDP is calculated by adjusting Nominal GDP (not adjusted for inflation) using a price index to account for the change in price levels. By removing inflation's skew, you can compare the output or income in one period to another in constant prices, showing the true increase or decrease in wealth or productivity.

In the context of comparing living standards between different countries, inflation adjustment reveals the true capacity of individuals to purchase goods and services. It effectively allows economists like the one in our scenario to compare per capita Real GDP rather than just per capita GDP, delivering a comprehensive and honest appraisal of economic well-being, adjusted for inflationary pressure.