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Demand and output

GDP: three measures in one
total output of goods and services - GDP(O)
total expenditure on goods and services - GDP(E)
domestic demand and the balance of trade
consumer spending
investment
inventories (stocks)
public spending
external demand
total income from goods and services - GDP(I)

We have already said a great deal about demand and output in earlier sections. The Inflation Outlook section explained why it is important to look at aggregate demand and output in the economy. This part of The Economy section looks in more detail at the main components of demand and output, and some relevant data series. It does this by working though the different measures of total economic activity - Gross Domestic Product (GDP).

GDP - three measures in one        

The rate of growth of the economy is a key piece of information that the MPC considers when it is setting interest rates. GDP data provide the most comprehensive measure of economic growth. They capture different aspects of economic activity - such as how much is produced in the economy and how much is spent. Most of the time you will see references to GDP as a single measure of economic activity, but there are in fact three approaches: one for total output - GDP(O); one for total expenditure - GDP(E); and one for total income - GDP(I). Each provides a different way of arriving at the same figure - GDP.

The three measures of GDP are equal in principle. GDP(O) is the total output of goods and services; GDP(E) is the total expenditure on that output; and GDP(I) is the total income generated by producing that output. But, in practice, the measures always differ to some degree. This happens because it is not possible to measure everything perfectly, and different information is used to construct each measure. And, for initial estimates, data sources are often incomplete. To avoid the confusion of having three different growth rates, the Office for National Statistics publishes an average measure of GDP.

the average measure of GDP

The published measure of GDP combines information from the output, expenditure and income measures - it is an average based on the three approaches. For the initial estimates of GDP, the output measure tends to have the largest influence. Output data are thought to provide the most accurate initial indication of economic activity. So, for early estimates of GDP, adjustments are often made to the expenditure and income measures. If the latest data show GDP rising by 0.5% in the most recent quarter, that will tend to reflect the measured growth of output.

But, in terms of assessing demand conditions in the economy, most attention is devoted to the expenditure measure and its components. The main components of expenditure provide the framework for assessing demand conditions and most economic forecasts, including the MPC's, are organised around them. The income measure receives less attention, though some parts of it provide important information.

GDP is most commonly expressed in chained volume measures, ie in real terms. It is normal to measure output in chained volume measures. Expenditure, which is measured in current prices, can be deflated to provide expenditure in chained volume measures. Income is usually presented in current prices, ie nominal terms, though for the purposes of producing an average measure of GDP, it is also deflated to provide a measure in chained volume measures. Once you are using the data, all this should become clearer.

GDP releases

Each quarter the MPC receives three sets of data releases for GDP. Each successive one gives more accurate and detailed information about economic activity and its make-up.

The first release is called the 'GDP preliminary estimate', available around three weeks after the end of the latest quarter. This provides an estimate of GDP growth and output growth in the production industries and the service sector. Because this estimate is produced quickly, it is usually subject to revision as more information becomes available.

The second release is called 'UK output, income and expenditure'. It is available about a month later, some seven weeks after the end of the relevant quarter. It includes a revised estimate of GDP growth for the quarter and a breakdown of total output by sector. It also provides estimates of total expenditure in chained volume measures and current prices, along with the main components of spending, as well as total income in current prices, along with its main components.

The third release is called 'Quarterly National Accounts'. It provides details of any further revisions to the previously released estimates and a lot more detail about the different components of GDP. For example, it includes a breakdown of consumers' expenditure into a number of categories, a breakdown of investment and inventories, and information about personal and corporate income.

total output of goods and services - GDP(O)        

The output measure of GDP - GDP(O) - measures everything that is produced in the economy. This is not simply the value of every firm's production added together. This would result in counting some output more than once because many goods and services are incorporated as inputs into other goods and services - for example, part of the output of firms producing tyres will be included in the value of the output of car producers. GDP(O) aims to measure what is called 'value added'. This is the difference between the value of what firms purchase, ie their inputs, and their output. Value added measures each firm's contribution to total output. But measuring this from quarter to quarter is a difficult task and so it often has to be approximated using sales and other information.

sectoral output

The change in total output in each quarter is estimated by combining the volume of output in each of the different sectors of the economy. Manufacturing output accounts for around 15% of the economy. Services output accounts for around 74%. Other sectors include agriculture, energy and construction.

Each quarter, there are usually differences in the growth rates of different sectors. Even average growth rates tend to vary from sector to sector. For example, manufacturing output has grown by less than other sectors over recent decades. Amongst the fastest-growing areas of the economy in recent years has been communications, part of the services sector.

It is often important to look at output in different sectors to assess whether a change in total output reflects lasting or temporary influences. Energy output, for example, is often volatile from quarter to quarter because of the weather. So it may be useful to consider the underlying situation by excluding temporary effects. You might also be interested in the balance of overall growth in the economy. Imbalances between sectors have been a feature of the economic situation over recent years - strong service sector output growth has contrasted with weaker growth in manufacturing output. In part, this has reflected the contrast between relatively strong domestic demand and relatively weak overseas demand for UK goods and services.

industrial production

Data covering the production industries are published more frequently than GDP data. The Index of Production is published monthly, consisting of output data for the manufacturing, energy and water sectors. Industrial production represents just under a fifth of total output.

surveys

A variety of surveys provide information about trends in output. These include surveys from the Confederation of British Industry (CBI), the British Chambers of Commerce (BCC) and the Chartered Institute of Purchasing and Supply (CIPS). Collectively, these and other surveys cover all sectors of the economy, although there tend to be more surveys for the manufacturing sector.

In addition to information about recent output, many surveys ask companies about their orders and what they expect output to be in the near future. This can give us some idea about future trends in output and whether the current situation is likely to continue or change. A selection of survey data is included in the datasheets.

Key data: output

GDP
Index of Production
CBI Industrial Trends Survey
CIPS Report on Manufacturing
CIPS Report on Services
BCC Quarterly Economic Survey

total expenditure on goods and services - GDP(E)        

The expenditure measure of GDP - GDP(E) - measures total spending on UK produced goods and services. Spending in the economy is made up of consumers' expenditure, investment expenditure and spending on stocks of goods by companies, government spending on goods and services, and spending on imports and exports. GDP(E) excludes spending on imported goods and services as they are produced outside the UK, but includes spending on exports by overseas firms and consumers.

The proportion of GDP accounted for by each category varies from year to year. Spending on some categories is particularly variable - for example, investment spending tends to fall as a proportion of total spending in economic downturns. Generally, spending by consumers accounts for around 65% of GDP. Government spending - both central and local government - accounts for about 22%, and investment accounts for 17%. Imports are equivalent to around 30% of GDP and exports to around 26%. The amount spent on stocks of goods can vary greatly from year to year, but tends to be small on average.

domestic demand and the balance of trade        

Combining consumer and government spending, investment expenditure and spending on stocks gives domestic demand. You will often see references to the growth of domestic demand. This tells us about spending in the domestic economy.

Some spending by consumers and firms will be on imports, ie not UK produced goods and services. Exports might also include some spending on imported goods - such as materials and components. Imports are therefore subtracted from total spending. So total expenditure on UK goods and services - GDP(E) - is equal to domestic demand plus exports minus imports. The difference between exports and imports is called the balance of trade. GDP(E) is equal to domestic demand plus or minus the balance of trade.

You'll see the following identity or similar versions in many textbooks:

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

where C is consumer spending
(or consumption)

I is investment
(including stockbuilding)

G is government consumption

X is exports

M is imports

final domestic demand

You will also see references to final domestic demand. This is domestic demand minus what is spent on inventories (or stocks). Expenditure on inventories is not final demand - rather it is intermediate demand by companies, such as manufacturers and retailers. Changes in the level of stocks can reflect changes in other components of demand and also firms' expectations of future demand. They can also be large and volatile from quarter to quarter, making changes difficult to interpret.

Each of the components of total spending is now considered in turn, along with some of the factors that influence them.

consumer spending        

In 2005, consumers spent around £790 billion, in current prices. The fortunes of the economy are therefore very much tied up with consumer demand. Small percentage changes can amount to billions of pounds.

Consumer spending largely depends upon household income and wealth. It can also be affected by confidence - how optimistic or pessimistic consumers are feeling - and by interest rates, as we discussed in the Inflation section. It is possible to build up an impression of potential future trends in consumer spending by looking at these factors.

income and spending

What people earn is the main determinant of what they spend and so changes in income are an important part of any assessment of demand conditions. Total spending in the economy will be affected by wage increases and other earnings, and the levels of employment and unemployment. These data are considered under 'The labour market'.

Consumers are unlikely to make spending decisions based solely on their current income. They probably take into account their likely income over time - their expectations of future income as well as current income. So changes to current income might only impact on spending insofar as the changes are viewed as permanent or long-lasting.

spending and tax

Of course, consumers will spend out of their incomes after taxes and other deductions have been paid. This is referred to as disposable income. In this sense, changes in the amount of tax paid are also relevant to consumer spending. If the Chancellor increases income tax, this is likely to reduce consumer spending, though the extra tax revenues might be used to finance higher public spending, so the overall impact on demand need not change.

spending and saving

Consumers do not spend everything they earn - some part of their disposable income will be saved. What part of income is spent and what part is saved are important economic decisions.

It is possible to look at past trends to get some feel for the average proportions of income that are spent and saved, and to see how these have changed. It is often useful to look at the balance between household income and spending. This is provided by a statistic called the saving ratio. If consumers seem to be saving relatively little as a proportion of their income compared with the past, you might conclude that spending in the future will moderate as consumers rebuild their savings. Alternatively, if saving appears high, this might mean that spending will rise in the future.

the saving ratio

Saving is what is left from personal disposable income after spending. The difference between income and spending is measured by the saving ratio. It is the proportion of income that is saved in a particular period. It is published alongside estimates of personal income and expenditure as part of the third release of GDP. If household income is £150 billion in a quarter and spending is £142.5 billion, then the saving ratio would be 5%, ie £7.5 billion as a proportion of £150 billion. Because the saving ratio is the difference between two very large totals, it is sometimes revised quite substantially. Nonetheless, it can provide indications about consumers' current and future spending behaviour.

wealth

Developments in household wealth - the value of the assets that people own - also have a bearing on the prospects for consumer spending. Most household wealth consists of financial assets and housing.

Wealth in financial assets, like shares and bonds, largely consists of what is held in pension funds and life assurance policies. Higher share prices might reflect expectations of higher future income from company profits. This might boost current spending, though the implications for inflation will depend on why share prices have risen. For example, investors might expect higher company profits in the future because firms are investing more and increasing the economy's productive capacity.

House prices are slightly different. A rise in house prices increases the value of home owners' existing houses. But it also increases the cost of future house moves, for which households might need to save. So rising house prices do not necessarily result in higher consumer spending.

But rising house prices might be accompanied by higher spending insofar as they are influenced by the same factors, such as confidence and expectations about future income. If people are optimistic about the future, they may increase their demand for houses as well as goods and services. And higher house prices might also allow households to increase the amounts they borrow, secured on the increased value of their homes. The box below discusses some of the data the MPC considers to assess housing market developments.

housing market turnover

The MPC regularly reviews a range of measures of housing market activity and house price inflation from official sources and surveys. This includes information from different stages of the house-buying process - such as estate agent enquiries, mortgage lending and Land Registry details. Data on estate agent enquiries from the Royal Institution of Chartered Surveyors (RICS) and the numbers of people reserving new houses from the House Builders' Federation (HBF) can provide information about future housing market activity, and may be useful in giving an early indication of changes in trends. Data on mortgage loan approvals by banks and building societies provide information about future lending for house purchase. They also give an indication of housing transactions, measured ultimately by Land Registry 'land transaction returns' data when house moves are completed.

house prices

The MPC also reviews a number of measures of house price inflation such as those from the Halifax and Nationwide. House price data are also available on a regional basis. This can provide useful information on regional conditions in the housing market, and help to assess the picture in the UK as a whole.

categories of consumer spending

Spending on goods accounts for around 48% of total consumer spending and spending on services for around 52%. Goods spending is divided into what are called non-durable goods like foods and petrol, and durable goods, like cars and computers. We tend to concentrate on total spending but, as with other data, it is sometimes beneficial to look at the underlying components.

retail sales

In addition to quarterly estimates of consumer spending growth, monthly data are available for retail sales. Retail sales data consist of spending on goods in shops and through mail-order companies. The data measure spending in different types of stores. These include stores that sell mainly food, clothing, footwear or household goods (which includes electrical retailers), and those that sell a range of goods (such as department stores).

Retail sales volumes data are closely related to the goods component of consumer spending in the quarterly GDP data, and so they can provide an indication of changes in spending month by month, in between the quarterly estimates.

In addition to the official data, the CBI Distributive Trades Survey provides information from retailers and wholesalers about their sales, sales expectations, prices and stocks. This is published ahead of the official retail sales data.

variations in spending

Spending on different goods and services will be changing all the time, depending on prices, consumer tastes and other factors. But spending on some items will vary to a greater degree than others over the course of an economic cycle. For example, spending on durable goods and some services, such as eating out, tends to vary more as economic conditions change than spending on non-durable goods. Spending on essential items like food varies less - we eat roughly the same whatever the economic conditions! So changes in overall consumer spending are likely to be driven more by spending on durable goods and other discretionary items than by spending on essential items.

consumer confidence

How optimistic or pessimistic consumers are feeling about their own situation and that of the wider economy can be an influence on their spending behaviour. Changes in confidence are likely to reflect sentiment about factors that affect spending, such as income and wealth. They may also provide indications about what consumers think about their future income, something that we cannot observe directly. The MPC regularly considers data from the GfK and MORI surveys of consumer confidence.

investment        

The amount of spending on new equipment and buildings matters for both an assessment of demand conditions and the economy's supply capacity. Investment that increases firms' capacity will raise the economy's potential output - for example, a new piece of equipment might produce more output in less time. This is one of the main ways in which the economy grows over time. So if total demand is growing strongly due to increasing investment rather than, say, consumer spending, there might be less concern about inflationary pressure because the capacity of the economy would also be rising. However, the extra demand could still put upward pressure on prices in the short to medium term. As ever, it is necessary to judge all these considerations together and take an overall view based on the information available.

Total investment in the economy does not just consist of spending undertaken by companies, ie business investment. It also includes investment by government and by individuals. Investment by individuals largely consists of what is invested in housing. This accounts for around 20% of total investment. Business investment accounts for about 59% of the total. Investment data are available each quarter, initially as part of the second release of GDP. More detailed data for business investment are also published.

Changes in the amount of investment tend to be quite volatile from quarter to quarter. This is often because capital expenditure tends to occur in large 'lumps'. For example, an airline might purchase a number of aircraft in one quarter but then nothing else over the rest of the year. Investment data are also prone to large revisions as new information becomes available, often from annual statistical inquiries.

It is also useful to look at other data to assess current and future trends in investment, including information about company profitability and borrowing. Surveys also provide information about firms' investment intentions and capacity utilisation, as well as business confidence.

what drives investment?

Firms invest so that they have the capital equipment they need to allow them to produce goods and services in a profitable way. How much they invest will be affected by a variety of factors, such as their use of existing capacity - their capacity utilisation - and expected future demand and profits. Firms are more likely to install new equipment and add to their capacity when they are optimistic that they can increase sales profitably. Investment takes time so firms need to be confident about future demand. Rising investment tends to be associated with favourable economic conditions, when the prospects for demand are good and a high proportion of companies are operating at, or close to, full capacity.

Changes in technology are also likely to influence the amount that firms invest. New technology might enable more efficient, lower-cost production. And the availability of finance within a company and the cost of borrowing or raising external finance will also affect investment. High levels of company debt and high interest rates will tend to constrain investment.

Changes in investment tend to be more strongly cyclical than GDP as a whole. Firms tend to cut back their investment plans when economic activity is weak - investment can fall sharply in recessions - and increase spending when the economy is more buoyant.

inventories (stocks)        

Inventories are stocks of goods held by companies, either as materials and components for future production or as finished goods for future sales. They can be seen as a form of investment - spending today for revenue tomorrow. Output can be thought of as sales plus or minus the change in stocks. Changes in the level of stocks have important implications for the pattern of both current and future economic growth.

Firms will have some desired level of stock that they want to hold relative to their output or sales. Better management and control of both stocks and production has meant that stocks as a proportion of output - what is called the stock-output ratio - have been falling over recent decades. But changes in stock levels from quarter to quarter can be volatile and large. Such changes often reflect temporary imbalances between demand and output.

Data on changes in the level of stocks for the economy as a whole and the main sectors are included in the second release of GDP. Rather than expressing these changes as a growth rate, they are recorded in terms of millions of pounds, from which the contribution of the change in stocks to the change in overall GDP is calculated. This contribution can be positive or negative. It is often difficult to explain changes in the level of stocks in any particular quarter and to judge the likely implications for future demand and output.

What can cause the level of stocks to change?

A rise or fall in stocks might reflect unexpected changes in demand. If demand is higher than expected, companies might run down stocks ahead of increasing their output. If demand is lower than expected, firms might see their stock levels rise. Alternatively, firms might deliberately build up stock levels by increasing output in anticipation of higher future demand, or reduce stocks if they expect demand to fall. In a recession, reductions in the level of stocks can exacerbate falls in output.

If companies have reduced what they are holding in stock to excessively low levels, it is likely they will want to increase stock levels in the future. This will add to the future growth in output. Alternatively, if stocks have risen to high levels, firms are likely to want to reduce them at some point.

A large proportion of all the stocks in the economy is held by manufacturers and distributors. Distributors - retailers and wholesalers - hold stock ahead of sales to customers, either as goods on the shelves in shops or in warehouses. Manufacturers hold stocks of materials and finished goods, and will also have unfinished goods at different stages of the production process - what is called work-in-progress. They might want to hold stocks of raw materials in case of shortages or disruptions to future supply, or in case they need to increase production at short notice. They might hold stocks of finished goods to meet short-term or temporary fluctuations in demand rather than keep changing output.

The cost of holding stocks will also be a consideration. For example, if interest rates are high companies might prefer to lower stock levels to reduce their borrowing or increase their bank deposits.

public spending        

Government and other public sector spending on goods and services is an important component of total demand. Like any other part of demand, how much the government is spending and plans to spend on goods and services will affect the overall balance between demand and supply in the economy.

MPC projections of public spending are based on the government's published spending plans, and the MPC monitors how actual spending compares with these plans over time.

The overall total for public spending on goods and services is the most important consideration, rather than the particular ways in which the money is spent, although this can also be of significance. Estimates are provided with the second GDP release. In addition, monthly figures are also available on the public finances.

public finances

Each month, figures are published showing how much the government has received in revenue - for example, from income tax and VAT - and how much has been spent by the different areas of government - such as health and education. These data provide a check on the extent to which government spending plans are being achieved. The difference between expenditure and revenue will determine the amount of borrowing the government has to undertake. This is called the Public Sector Net Cash Requirement (PSNCR). This will be negative, ie in surplus, when revenue is greater than expenditure.

Monthly movements in public spending and revenue can be volatile, reflecting the timing of spending by government departments and the receipt of revenue. Low spending in one month might be reversed the following month. Over time, however, the monthly public finance data do provide an indication of trends in government spending and whether it is growing more or less than envisaged by the MPC.

external demand        

the balance of trade

The balance of trade in goods and services - the difference between exports and imports - is an important indicator of economic activity. Total spending in the economy will include what is spent on imports; and total output will include what is produced for export. So the balance of trade measures the difference between domestic production and domestic spending.

When the balance of trade is negative, ie imports are greater than exports, the UK is purchasing more from other countries than it is selling to them. A more negative or less positive trade balance could indicate that domestic demand is too high relative to supply, which draws in more imports. But it could indicate that growth prospects in the UK are considered to be good and so investment spending is high, drawing in imports of machinery and other capital goods. If the balance of trade is becoming less negative or more positive, that could indicate that demand overseas is strong, enabling UK exports to rise. Changes in the balance of trade therefore reflect both domestic and external demand conditions.

the world economy

The prospects for growth in the world economy are an important consideration for monetary policy, particularly growth in the UK's main export markets. Demand for UK exports is an important component of overall demand.

The MPC looks particularly closely at the economies of the United States, Japan and the euro area. These are the world's largest economies. The MPC has to be alert to any developments in the world economy that influence demand for UK goods and services and the prospects for the wider world economy.

The MPC considers a range of data on the main overseas economies to provide indications about current and future growth in demand for UK exports. A key indicator in many countries is the growth in GDP. But, additionally, labour market indicators are also useful, and prices in overseas markets will be the main determinant of UK export prices.

the exchange rate and competitiveness

The level of UK exports and imports will also be affected by the exchange rate. It will influence the competitiveness of UK exports and foreign imports - a depreciation of the pound tends to make UK goods cheaper abroad and imports more expensive; an appreciation has the opposite effect.

Changes in the exchange rate are likely to take time to influence prices and, in turn, exports and imports. And the reasons for a change in the exchange rate and whether it is likely to be a temporary or sustained change will also influence the impact on prices and demand. Of course, many other factors will affect the competitiveness of UK exporters and firms that compete in the domestic market with imports, including wage costs and product quality. But the exchange rate is certainly important, as exporters will tell you. The exchange rate is discussed under 'Money and financial markets'.

exports and imports

Although the balance of trade is a useful summary measure, it is often more informative to look at trends in exports and imports separately. They may provide clues about different aspects of the economy. For example, strong growth in export volumes might reflect growth in the world economy, whereas strong growth in import volumes might signal strong domestic demand growth. Growth in exports and imports might also reveal something about the competitiveness of UK producers, both in domestic and overseas markets.

Data on the volume of exports and imports are available on a monthly and quarterly basis. The monthly data releases focus on exports and imports of goods. These data are broken down into trade with EU and non-EU countries. Trade with EU countries accounts for a large part of the UK's total trade - almost 60% of UK exports. The second GDP release provides details of total trade in goods and services.

Key data: expenditure

GDP
retail sales volumes
CBI Distributive Trades Survey
housing market turnover
house prices
GfK consumer confidence
PSNCR
import volumes
export volumes

total income from goods and services - GDP(I)        

The income measure of GDP - GDP(I) - measures the incomes paid in the process of producing goods and services. This includes incomes paid to employees and profits retained by firms. It does not include incomes such as unemployment benefits or interest payments because these are transfers between different parts of the economy, ie they are not additional income.

wages and salaries

The main source of income is that paid to employees. This is referred to as 'employee compensation', estimates of which are available with the second release of GDP. The data are based on the monthly earnings data that are discussed under 'The labour market'. The largest part of employee compensation is in the form of wages and salaries. These data are published with the third release of GDP along with estimates of post-tax disposable income and the saving ratio. The relationship between income, spending and saving was discussed earlier under 'consumer spending'.

Key data: income

GDP
household post-tax income
wages and salaries
personal disposable income
saving ratio

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