Gross domestic product explained

Gross domestic product (GDP) refers to the market value of all officially recognized final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living;[1] [2] GDP per capita is not a measure of personal income. See Standard of living and GDP.

It is not to be confused with Gross National Product (GNP) which allocates production based on ownership. Gross domestic product is related to national accounts, a subject in macroeconomics.

History

GDP was first developed by Simon Kuznets for a US Congress report in 1934,[3] who immediately said not to use it as a measure for welfare (see below under limitations).

Determining GDP

GDP can be determined in three ways, all of which should, in principle, give the same result. They are the product (or output) approach, the income approach, and the expenditure approach.

The most direct of the three is the product approach, which sums the outputs of every class of enterprise to arrive at the total. The expenditure approach works on the principle that all of the product must be bought by somebody, therefore the value of the total product must be equal to people's total expenditures in buying things. The income approach works on the principle that the incomes of the productive factors ("producers," colloquially) must be equal to the value of their product, and determines GDP by finding the sum of all producers' incomes.[4]

Example: the expenditure method:

GDP = private consumption + gross investment + government spending + (exports − imports), or

GDP= C+I+G+\left(X-M\right)

Note: "Gross" means that GDP measures production regardless of the various uses to which that production can be put. Production can be used for immediate consumption, for investment in new fixed assets or inventories, or for replacing depreciated fixed assets.

"Domestic" means that GDP measures production that takes place within the country's borders. In the expenditure-method equation given above, the exports-minus-imports term is necessary in order to null out expenditures on things not produced in the country (imports) and add in things produced but not sold in the country (exports).

Economists (since Keynes) have preferred to split the general consumption term into two parts; private consumption, and public sector (or government) spending. Two advantages of dividing total consumption this way in theoretical macroeconomics are:

Production approach

" Market value of all final goods and services calculated during 1 year . "

The production approach is also called as Net Product or Value added method. This method consists of three stages:

  1. Estimating the Gross Value of domestic Output in various economic activities;
  2. Determining the intermediate consumption, i.e., the cost of material, supplies and services used to produce final goods or services; and finally
  3. Deducting intermediate consumption from Gross Value to obtain the Net Value of Domestic Output.

Symbolically,

Gross Value Added = Value of output – Value of Intermediate Consumption. Value of Output = Value of the total sales of goods and services + Value of changes in the inventories.

The sum of Gross Value Added in various economic activities is known as GDP at factor cost.

GDP at factor cost plus indirect taxes less subsidies on products is GDP at Producer Price.

For measuring gross output of domestic product, economic activities (i.e. industries) are classified into various sectors. After classifying economic activities, the gross output of each sector is calculated by any of the following two method

  1. By multiplying the output of each sector by their respective market price and adding them together and
  2. By collecting data on gross sales and inventories from the records of companies and adding them together.

Subtracting each sector's intermediate consumption from gross output, we get sectoral Gross Value Added (GVA) at factor cost. We, then add gross value of all sectors to get GDP at factor cost. Adding indirect tax less subsidies in GDP at factor cost, we get GDP at Producer Prices.

Income approach

" sum total of incomes of individual living in a country during 1 year ."

Another way of measuring GDP is to measure total income. If GDP is calculated this way it is sometimes called Gross Domestic Income (GDI), or GDP(I).GDI should provide the same amount as the expenditure method described below. (By definition, GDI = GDP. In practice, however, measurement errors will make the two figures slightly off when reported by national statistical agencies.)

This method measures GDP by adding incomes that firms pay households for factors of production they hire- wages for labour, interest for capital, rent for land and profits for entrepreneurship.

The US "National Income and Expenditure Accounts" divide incomes into five categories:

  1. Wages, salaries, and supplementary labour income
  2. Corporate profits
  3. Interest and miscellaneous investment income
  4. Farmers’ income
  5. Income from non-farm unincorporated businesses

These five income components sum to net domestic income at factor cost.

Two adjustments must be made to get GDP:

  1. Indirect taxes minus subsidies are added to get from factor cost to market prices.
  2. Depreciation (or Capital Consumption Allowance) is added to get from net domestic product to gross domestic product.

Total income can be subdivided according to various schemes, leading to various formulae for GDP measured by the income approach. A common one is:

GDP = compensation of employees + gross operating surplus + gross mixed income + taxes less subsidies on production and imports

GDP = COE + GOS + GMI + TP & MSP & M

The sum of COE, GOS and GMI is called total factor income; it is the income of all of the factors of production in society. It measures the value of GDP at factor (basic) prices. The difference between basic prices and final prices (those used in the expenditure calculation) is the total taxes and subsidies that the government has levied or paid on that production. So adding taxes less subsidies on production and imports converts GDP at factor cost to GDP(I).

Total factor income is also sometimes expressed as:

Total factor income = Employee compensation + Corporate profits + Proprietor's income + Rental income + Net interest[5]

Yet another formula for GDP by the income method is:

GDP=R+I+P+SA+W

where R : rents
I : interests
P : profits
SA : statistical adjustments (corporate income taxes, dividends, undistributed corporate profits)
W : wages
Note the mnemonic, "ripsaw".

Expenditure approach

" All expenditure incurred by individual during 1 year . "

In economics, most things produced are produced for sale, and sold. Therefore, measuring the total expenditure of money used to buy things is a way of measuring production. This is known as the expenditure method of calculating GDP. Note that if you knit yourself a sweater, it is production but does not get counted as GDP because it is never sold. Sweater-knitting is a small part of the economy, but if one counts some major activities such as child-rearing (generally unpaid) as production, GDP ceases to be an accurate indicator of production. Similarly, if there is a long term shift from non-market provision of services (for example cooking, cleaning, child rearing, do-it yourself repairs) to market provision of services, then this trend toward increasedmarket provision of services may mask a dramatic decrease in actual domestic production, resulting in overly optimisticand inflated reported GDP. This is particularly a problem for economies which have shifted from production economies toservice economies.

Components of GDP by expenditure

GDP (Y) is a sum of Consumption (C), Investment (I), Government Spending (G) and Net Exports (X – M).

Y = C + I + G + (X − M)

Here is a description of each GDP component:

A fully equivalent definition is that GDP (Y) is the sum of final consumption expenditure (FCE), gross capital formation (GCF), and net exports (X – M).

Y = FCE + GCF+ (X − M)FCE can then be further broken down by three sectors (households, governments and non-profit institutions serving households) and GCF by five sectors (non-financial corporations, financial corporations, households, governments and non-profit institutions serving households). The advantage of this second definition is that expenditure is systematically broken down, firstly, by type of final use (final consumption or capital formation) and, secondly, by sectors making the expenditure, whereas the first definition partly follows a mixed delimitation concept by type of final use and sector.

Note that C, G, and I are expenditures on final goods and services; expenditures on intermediate goods and services do not count. (Intermediate goods and services are those used by businesses to produce other goods and services within the accounting year.[6])

According to the U.S. Bureau of Economic Analysis, which is responsible for calculating the national accounts in the United States, "In general, the source data for the expenditures components are considered more reliable than those for the income components [see income method, below]."[7]

Examples of GDP component variables

C, I, G, and NX(net exports): If a person spends money to renovate a hotel to increase occupancy rates, the spending represents private investment, but if he buys shares in a consortium to execute the renovation, it is saving. The former is included when measuring GDP (in I), the latter is not. However, when the consortium conducted its own expenditure on renovation, that expenditure would be included in GDP.

If a hotel is a private home, spending for renovation would be measured as consumption, but if a government agency converts the hotel into an office for civil servants, the spending would be included in the public sector spending, or G.

If the renovation involves the purchase of a chandelier from abroad, that spending would becounted as C, G, or I (depending on whether a private individual, the government, or a business is doing the renovation), but then counted again as an import and subtracted from the GDP so that GDP counts only goods produced within the country.

If a domestic producer is paid to make the chandelier for a foreign hotel, the payment would not be counted as C, G, or I, but would be counted as an export.

A "production boundary" that delimits what will be counted as GDP.

"One of the fundamental questions that must be addressed in preparing the national economic accounts is how to define the production boundary–that is, what parts of the myriad human activities are to be included in or excluded from the measure of the economic production."[8]
All output for market is at least in theory included within the boundary. Market output is defined as that which is sold for "economically significant" prices; economically significantprices are "prices which have a significant influence on the amounts producers are willing to supply and purchasers wish to buy."[9] An exception is that illegal goods and services are often excluded even if they are sold at economically significant prices (Australia and the United States exclude them).

This leaves non-market output. It is partly excluded and partly included. First, "natural processes without human involvement or direction" are excluded.[10] Also, there must be a person or institution that owns or is entitled to compensation for the product. An example of what is included and excluded by these criteria is given by the United States' national accounts agency: "the growth of trees in an uncultivated forest is not included in production, but the harvesting of the trees from that forest is included."[11]

Within the limits so far described, the boundary is further constricted by "functional considerations."[12] The Australian Bureau for Statistics explains this:"The national accounts are primarily constructed to assist governments and others to make market-based macroeconomic policy decisions, including analysis of markets and factors affecting market performance, such as inflation and unemployment."Consequently, production that is, according to them, "relatively independent and isolated from markets," or "difficult to value in an economically meaningful way" [i.e., difficult to put a price on] is excluded.[13] Thus excluded are services provided by people to members of their own families free of charge, such as child rearing, meal preparation, cleaning, transportation, entertainment of family members, emotional support, care of the elderly.[14] Most other production for own (or one's family's) use is also excluded, with two notable exceptions which are given in the list later in this section.

Nonmarket outputs that are included within the boundary are listed below. Since, by definition, they do not have a market price, the compilers of GDP must impute a value to them, usually either the cost of the goods and services used to produce them, or the value of a similar item that is sold on the market.

GDP vs GNP

GDP can be contrasted with gross national product (GNP) or gross national income (GNI). The difference is that GDP defines its scope according to location, while GNP defines its scope according to ownership. In a global context, world GDP and world GNP are, therefore, equivalent terms.

GDP is product produced within a country's borders; GNP is product produced by enterprises owned by a country's citizens. The two would be the same if all of the productive enterprises in a country were owned by its own citizens, and those citizens did not own productive enterprises in any other countries. In practice, however, foreign ownership makes GDP and GNP non-identical. Production within a country's borders, but by an enterprise owned by somebody outside the country, counts as part of its GDP but not its GNP; on the other hand, production by an enterprise located outside the country, but owned by one of its citizens, counts as part of its GNP but not its GDP.

To take the United States as an example, the U.S.'s GNP is the value of output produced by American-owned firms, regardless of where the firms are located. Similarly, if a country becomes increasingly in debt, and spends large amounts of income servicing this debt this will be reflected in a decreased GNI but not a decreased GDP. Similarly, if a country sells off its resources to entities outside their country this will also be reflected over time in decreased GNI, but not decreased GDP. This would make theuse of GDP more attractive for politicians in countries with increasing national debt and decreasing assets.

Gross national income (GNI) equals GDP plus income receipts from the rest of the world minus income payments to the rest of the world.[17]

In 1991, the United States switched from using GNP to using GDP as its primary measure of production.[18] The relationship between United States GDP and GNP is shown in table 1.7.5 of the National Income and Product Accounts.[19]

International standards

The international standard for measuring GDP is contained in the book System of National Accounts (1993), which was prepared by representatives of the International Monetary Fund, European Union, Organization for Economic Co-operation and Development, United Nations and World Bank. The publication is normally referred to as SNA93 to distinguish it from the previous edition published in 1968 (called SNA68) [20]

SNA93 provides a set of rules and procedures for the measurement of national accounts. The standards are designed to be flexible, to allow for differences in local statistical needs and conditions.

National measurement

Within each country GDP is normally measured by a national government statistical agency, as private sector organizations normally do not have access to the information required (especially information on expenditure and production by governments).

See main article: National agencies responsible for GDP measurement.

Interest rates

Net interest expense is a transfer payment in all sectors except the financial sector. Net interest expenses in the financial sector are seen as production and value added and are added to GDP.

Nominal GDP and Adjustments to GDP

The raw GDP figure as given by the equations above is called the Nominal, or Historical, or Current, GDP. When comparing GDP figures from one year to another, it is desirable to compensate for changes in the value of money – i.e., for the effects of inflation or deflation. To make it more meaningful for year-to-year comparisons, it may be multiplied by the ratio between the value of money in the year the GDP was measured and the value of money in some base year. For example, suppose a country's GDP in 1990 was $100 million and its GDP in 2000 was $300 million; but suppose that inflation had halved the value of its currency over that period. To meaningfully compare its 2000 GDP to its 1990 GDP we could multiply the 2000 GDP by one-half, to make it relative to 1990 as a base year. The result would be that the 2000 GDP equals $300 million × one-half = $150 million, in 1990 monetary terms. We would see that the country's GDP had, realistically, increased 50 percent over that period, not 200 percent, as it might appear from the raw GDP data. The GDP adjusted for changes in money-value in this way is called the Real, or Constant, GDP.

The factor used to convert GDP from current to constant values in this way is called the GDP deflator. Unlike the Consumer price index, which measures inflation or deflation in the price of household consumer goods, the GDP deflator measures changes in the prices of all domestically produced goods and services in an economy–including investment goods and government services, as well as household consumption goods.[21]

Constant-GDP figures allow us to calculate a GDP growth rate, which tells us how much a country's production has increased (or decreased, if the growth rate is negative) compared to the previous year.

Real GDP growth rate for year n = [(Real GDP in year ''n'') − (Real GDP in year ''n'' − 1)] / (Real GDP in year n − 1)

Another thing that it may be desirable to compensate for is population growth. If a country's GDP doubled over some period but its population tripled, the increase in GDP may not be deemed such a great accomplishment: the average person in the country is producing less than they were before. Per-capita GDP is the measure compensated for population growth.

Cross-border comparison and PPP

The level of GDP in different countries may be compared by converting their value in national currency according to either the current currency exchange rate, or the purchase power parity exchange rate.

The ranking of countries may differ significantly based on which method is used.

There is a clear pattern of the purchasing power parity method decreasing the disparity in GDP between high and low income (GDP) countries, as compared to the current exchange rate method. This finding is called the Penn effect.

For more information, see Measures of national income and output.

Per unit GDP

GDP is an aggregate figure which does not consider differing sizes of nations. Therefore, GDP can be stated as GDP per capita (per person) in which total GDP is divided by the resident population on a given date, GDP per citizen where total GDP is divided by the numbers of citizens residing in the country on a given date, and less commonly GDP per unit of a resource input, such as GDP per GJ of energy or Gross domestic product per barrel.GDP per citizen in the above case is pretty similar to GDP per capita in most nations, however, in nations with very high proportions of temporary foreign workers like in Persian Gulf nations, the two figures can be vastly different.

Standard of living and GDP

GDP per capita is not a measurement of the standard of living in an economy. However, it is often used as such an indicator, on the rationale that all citizens would benefit from their country's increased economic production. Similarly, GDP per capita is not a measure of personal income. GDP may increase while real incomes for the majority decline. The major advantage of GDP per capita as an indicator of standard of living is that it is measured frequently, widely, and consistently. It is measured frequently in that most countries provide information on GDP on a quarterly basis, allowing trends to be seen quickly. It is measured widely in that some measure of GDP is available for almost every country in the world, allowing inter-country comparisons. It is measured consistently in that the technical definition of GDP is relatively consistent among countries.

The major disadvantage is that it is not a measure of standard of living. GDP is intended to be a measure of total national economic activity—a separate concept.

The argument for using GDP as a standard-of-living proxy is not that it is a good indicator of the absolute level of standard of living, but that living standards tend to move with per-capita GDP, so that changes in living standards are readily detected through changes in GDP.

Externalities

GDP is widely used by economists to gauge economic recession and recovery and an economy's general monetary ability to address externalites. It is not meant to measure externalities. It serves as a general metric for a nominal monetary standard of living and is not adjusted for costs of living within a region. GDP is a neutral measure which merely shows an economy's general ability to pay for externalities such as social and environmental concerns.[22] Examples of externalities include:

Simon Kuznets in his very first report to the US Congress in 1934 said:[3]

...the welfare of a nation can, therefore, scarcely be inferred from a measure of national income...
In 1962, Kuznets stated:[23]
Distinctions must be kept in mind between quantity and quality of growth, between costs and returns, and between the short and long run. Goals for more growth should specify more growth of what and for what.

Lists of countries by their GDP

List of newer approaches to the measurement of (economic) progress

Criticisms

Austrian School economist Frank Shostak has argued that GDP is an empty abstraction devoid of any link to the real world, and, therefore, has little or no value in economic analysis. In his own words:[26]

The GDP framework cannot tell us whether final goods and services that were produced during a particular period of time are a reflection of real wealth expansion, or a reflection of capital consumption.

For instance, if a government embarks on the building of a pyramid, which adds absolutely nothing to the well-being of individuals, the GDP framework will regard this as economic growth. In reality, however, the building of the pyramid will divert real funding from wealth-generating activities, thereby stifling the production of wealth.

So what are we to make out of the periodical pronouncements that the economy, as depicted by real GDP, grew by a particular percentage? All we can say is that this percentage has nothing to do with real economic growth and that it most likely mirrors the pace of monetary pumping.

We can thus conclude that the GDP framework is an empty abstraction devoid of any link to the real world. Notwithstanding this, the GDP framework is in big demand by governments and central bank officials since it provides justification for their interference with businesses. It also provides an illusory frame of reference to assess the performance of government officials.

Many environmentalists argue that GDP is a poor measure of social progress because it does not take into account harm to the environment.

See also

Bibliography

External links

Global

Data

Articles and books

Notes and References

  1. Book: O'Sullivan, Arthur.
  2. http://www.guardian.co.uk/business/2009/sep/14/sarkozy-attacks-gdp-focus French President seeks alternatives to GDP
  3. Congress commishened Kuznets to create a system that would measure the nation's productivity in order to better understand how to tackle the Great DepressionSimon Kuznets, 1934. "National Income, 1929–1932". 73rd US Congress, 2d session, Senate document no. 124, page 7. http://library.bea.gov/u?/SOD,888
  4. World Bank, Statistical Manual >> National Accounts >> GDP–final output, retrieved October 2009.
    Web site: User's guide: Background information on GDP and GDP deflator. HM Treasury.
    Web site: Measuring the Economy: A Primer on GDP and the National Income and Product Accounts. Bureau of Economic Analysis. PDF.
  5. United States Bureau of Economic Analysis,, page 5; retrieved November 2009. Another term, "business current transfer payments," may be added. Also, the document indicates that Capital Consumption Adjustment (CCAdj) and Inventory Valuation Adjustment (IVA) are applied to the proprietor's income and corporate profits terms; and CCAdj is applied to rental income.
  6. Thayer Watkins, San José State University Department of Economics, "Gross Domestic Product from the Transactions Table for an Economy", commentary to first table, " Transactions Table for an Economy". (Page retrieved November 2009.)
  7. Concepts and Methods of the United States National Income and Product Accounts, chap. 2.
  8. BEA, Concepts and Methods of the United States National Income and Product Accounts, p 12.
  9. Australian National Accounts: Concepts, Sources and Methods, 2000, sections 3.5 and 4.15.
  10. This and the following statement on entitlement to compensation are from Australian National Accounts: Concepts, Sources and Methods, 2000, section 4.6.
  11. Concepts and Methods of the United States National Income and Product Accounts, page 2-2.
  12. Concepts and Methods of the United States National Income and Product Accounts, page 2-2.
  13. Australian National Accounts: Concepts, Sources and Methods, 2000, section 4.4.
  14. Concepts and Methods of the United States National Income and Product Accounts, page 2-2; and Australian National Accounts: Concepts, Sources and Methods, 2000, section 4.4.
  15. Concepts and Methods of the United States National Income and Product Accounts, page 2-4.
  16. Concepts and Methods of the United States National Income and Product Accounts, page 2-5.
  17. Book: Lequiller, François. Derek Blades. Understanding National Accounts. OECD. 2006. 18. 978-92-64-02566-0. To convert GDP into GNI, it is necessary to add the income received by resident units from abroad and deduct the income created by production in the country but transferred to units residing abroad..
  18. United States, Bureau of Economic Analysis, Glossary, "GDP". Retrieved November 2009.
  19. Web site: U.S. Department of Commerce. Bureau of Economic Analysis. Bea.gov. 2009-10-21. 2010-07-31.
  20. Web site: National Accounts. Central Bureau of Statistics. 2011-06-29.
  21. HM Treasury, Background information on GDP and GDP deflator
    Some of the complications involved in comparing national accounts from different years are suggested in this World Bank document.
  22. News: Eric Zencey-G.D.P. R.I.P.. Nytimes.com. August 2009. 2011-01-31.
  23. Simon Kuznets. "How To Judge Quality". The New Republic, October 20, 1962
  24. Web site: First European Quality of Life Survey.
  25. See Emanuele Felice, Neither dashboard nor 'mashup' indices: an empirical wealth approach as a pathway to a comprehensive measure of development, http://www.h-economica.uab.es/wps/2012_01.pdf
  26. Web site: What is up with the GDP?. Frank Shostak.