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Budget explainer: What do key economic indicators tell us about the state of the economy?

The key indicators of the health of the economy are the unemployment rate, inflation rate and economic growth. AAP Image/Julian Smith

By cutting through the buzz and spin surrounding the federal budget, The Conversation’s budget explainers arm you with the key terms and facts needed to understand the budget and what it means for you.

Certain policy objectives in macroeconomic policy are almost universally accepted by economists:

1. A stable and strong rate of economic growth;

2. Low unemployment; and

3. Stable and low inflation.

Perhaps less universally accepted are:

4. A manageable current account deficit in the balance of payments; and

5. Structural fiscal budget balance and a low (or zero) level of debt.

Number four of these objectives receives little attention in Australia these days. However, the fifth of these objectives appears to have taken over economic and political debate in Australia.

Certain key indicators are used to judge the health of the economy and to evaluate government or Reserve Bank policies in terms of their ability to reach these objectives.

A stable and strong rate of economic growth

Economic growth refers to the expansion of society’s productive potential. It is usually measured by the annual percentage change in real gross domestic product (GDP).

Real GDP is a measure of the value of production of all goods and services produced in Australia, after the effects of inflation have been removed.

Therefore, if economic growth is 3% this year, then 3% more goods and services were produced this year than in the previous year.

Real GDP and economic growth are not perfect measures of what’s happening to a society’s wellbeing. Nevertheless, more jobs, increased standards of living and providing for the most disadvantaged depend on having a strong rate of growth.

Low unemployment

Unemployment is the greatest contributing factor to poverty. High unemployment also represents a waste of economic resources as less is produced (lower GDP) if workers are not being fully utilised.

There are other costs associated with high unemployment including a loss of individual self esteem, loss of skills, retraining costs and social problems. Governments also face consequences such as having to reallocate scarce taxation revenue from productive projects to social security payments, as well as the electoral unpopularity often associated with high unemployment.

The widely quoted indicator of unemployment is the unemployment rate derived from the Australian Bureau of Statistics (ABS) Labour Force Survey.

The unemployment rate is the percentage of the labour force that is unemployed. The labour force is the sum of the employed and the unemployed. You only have to work for one hour in paid employment per week to be classified as employed! To be classified as unemployed you have to be ready to start work and have actively looked for work in the past four weeks before the survey.

About 1.5 million people of working age rely almost entirely on social security for a living but only a third are unemployed.

While an important aim is to reduce the unemployment rate, being too successful or reducing it too quickly can itself be a problem as this can be interpreted as evidence of a potential increase in inflation. In economics jargon, unemployment must not fall too near the “natural rate of unemployment”.

Stable and low inflation

The inflation rate is the percentage increase in the general price level in the economy from one year to the next.

The most common measure of the general price level is the consumer price index (CPI). Although its measurement and interpretation is subject to many caveats it is still generally recognised as a good indicator of the cost of living of the average household.

If the index rises from, say, 120 to 122 then the inflation rate is 100*(122-120)/120 = 1.7%.

Wages and social security payments would need to rise by 1.7% in order for standards of living not to fall.

A structural fiscal budget balance and a low (or zero) level of debt

If the federal government’s expenditures are greater than its revenue a budget deficit results. Budget deficits add to government debt.

It is generally accepted the actual government budget will (and should) fluctuate between deficit and surplus during, respectively, downswings and upswings in the economy.

Unlike the actual budget balance, the structural balance is basically the budget deficit or surplus after accounting for cyclical movements in the economy – the balance when conditions are normal or average.

Considerable political debate and media coverage of deficit and debt issues concerns have centred on the fear that Australia, on its current trajectory, is heading for (or well on the way to) an unsustainable structural deficit.

Other indicators

The above areas may be traditional indicators of the health of the economy, yet they say little about the underlying processes which give rise to them.

For instance, economic growth can only increase and unemployment can only be reduced by firms increasing output and jobs and investing in new projects. This is why business confidence is so important.

The National Australia Bank (NAB) publishes a quarterly index of business confidence based on a survey of Australian firms. These firms are asked to rate their expectations of a number of factors, such as employment and business profits. Indexes are calculated by taking the difference between the percentage of respondents nominating good or very good, or a rise and those nominating poor or very poor, or a fall. The business confidence index is an average of these individual indexes.

Businesses are unlikely to expand if they don’t think consumers are going to spend and this is where consumer confidence is important.

The Westpac-Melbourne Institute Consumer Sentiment index is based on surveys of households regarding their expectation of key economic variables affecting them, such as the family finances. On the basis of whether their conditions are expected to improve or get worse households are classified as optimists or pessimists. If optimists outnumber pessimists then the index exceeds 100 and obviously the higher the index, the higher, on average, is consumer confidence.

Despite a myriad of indicators and attempts to introduce many other measures of wellbeing into the policy debate, such as the Fairfax-Lateral Economics Index of Australia’s Wellbeing, the unemployment rate, inflation rate and the rate of economic growth will continue to be the key indicators of the health of the economy.

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