Gross domestic product explained

The gross domestic product (GDP) or gross domestic income (GDI) is one of the measures of national income and output for a given country's economy. It is the total value of all final goods and services produced in a particular economy; the dollar value of all goods and services produced within a country’s borders in a given year.[1] GDP can be defined in three ways, all of which are conceptually identical. First, it is equal to the total expenditures for all final goods and services produced within the country in a stipulated period of time (usually a 365-day year). Second, it is equal to the sum of the value added at every stage of production (the intermediate stages) by all the industries within a country, plus taxes less subsidies on products, in the period. Third, it is equal to the sum of the income generated by production in the country in the period—that is, compensation of employees, taxes on production and imports less subsidies, and gross operating surplus (or profits).[2] [3]

The most common approach to measuring and quantifying GDP is the expenditure method:

GDP = consumption + gross investment + government spending + (exports − imports), or,
GDP = C + I + G + (X − M)."Gross" means that depreciation of capital stock is not subtracted out of GDP. If net investment (which is gross investment minus depreciation) is substituted for gross investment in the equation above, then the formula for net domestic product is obtained. Consumption and investment in this equation are expenditure on final goods and services. The exports-minus-imports part of the equation (often called net exports) adjusts this by subtracting the part of this expenditure not produced domestically (the imports), and adding back in domestic area (the 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:

GDP vs GNP

GDP can be contrasted with gross national product (GNP, or gross national income, GNI), which the United States used in its national accounts until 1992. The difference is that GNP includes net foreign income (the current account) rather than net exports and imports (the balance of trade). Put simply, GNP adds net foreign investment income compared to GDP.United States GDP, GNP and GNI (Gross National Income) can be compared at EconStats http://www.econstats.com/gdp/gdp__q10.htm.

GDP is concerned with the region in which income is generated. It is the market value of all the output produced in a nation in one year. GDP focuses on where the output is produced rather than who produced it. GDP measures all domestic production, disregarding the producing entities' nationalities.

In contrast, GNP is a measure of the value of the output produced by the "nationals" of a region. GNP focuses on who owns the production. For example, in the United States, GNP measures the value of output produced by American firms, regardless of where the firms are located. Year-over-year real GNP growth in the year 2007 was 3.2%.

Measuring GDP

Components of GDP

Each of the variables C (Consumption), I (Investment), G (Government spending) and X − M (Net Exports) (where GDP = C + I + G + (X − M) as above)

(Note: * GDP is sometimes also referred to as Y in reference to a GDP graph)

Examples of GDP component variables

Examples of C, I, G, and NX: If you spend money to renovate your hotel so that occupancy rates increase, that is private investment, but if you buy shares in a consortium to do the same thing 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.

For example, if a hotel is a private home then renovation spending would be measured as Consumption, but if a government agency is converting the hotel into an office for civil servants the renovation spending would be measured as part of public sector spending (G).

If the renovation involves the purchase of a chandelier from abroad, that spending would also be counted as an increase in imports, so that NX would fall and the total GDP is affected by the purchase. (This highlights the fact that GDP is intended to measure domestic production rather than total consumption or spending. Spending is really a convenient means of estimating production.)

If a domestic producer is paid to make the chandelier for a foreign hotel, the situation would be reversed, and the payment would be counted in NX (positively, as an export). Again, GDP is attempting to measure production through the means of expenditure; if the chandelier produced had been bought domestically it would have been included in the GDP figures (in C or I) when purchased by a consumer or a business, but because it was exported it is necessary to 'correct' the amount consumed domestically to give the amount produced domestically. (As in GrossDomestic Product.)

Types of GDP and GDP growth

  1. Current GDP is GDP expressed in the current prices of the period being measured
  2. Nominal GDP growth is GDP growth in nominal prices (unadjusted for price changes).
  3. Real GDP growth is GDP growth adjusted for price changes.

Calculating the real GDP growth allows economists to determine if production increased or decreased, regardless of changes in the purchasing power of the currency.

GDP income account

Another way of measuring GDP is to measure the total income payable in the GDP income accounts. In this situation, Gross Domestic Income (GDI) is sometimes used rather than Gross Domestic Product. This should provide the same figure as the expenditure method described above. (By definition, GDI=GDP. In practice, however, measurement errors will make the two figures slightly off when reported by national statistical agencies.)

The formula for GDP measured using the income approach, called GDP(I), is:

GDP = Compensation of employees + Gross operating surplus + Gross mixed income + Taxes less subsidies on production and imports

The sum of COE, GOS and GMI is called total factor income, and 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).

Another formula can be written as this:

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

Measurement

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).

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.

Cross-border comparison

The level of GDP in different countries may be compared by converting their value in national currency according to either

The relative ranking of countries may differ dramatically between the two approaches.

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.

Standard of living and GDP

GDP per capita is often used as an indicator of standard of living in an economy, the rationale being that all citizens would benefit from their country's increased economic production.

The major advantages to using GDP per capita as an indicator of standard of living are that it is measured frequently, widely and consistently; frequently in that most countries provide information on GDP on a quarterly basis (which allows a user to spot trends more quickly), widely in that some measure of GDP is available for practically every country in the world (allowing crude comparisons between the standard of living in different countries), and consistently in that the technical definitions used within GDP are relatively consistent between countries, and so there can be confidence that the same thing is being measured in each country.

The major disadvantage of using GDP as an indicator of standard of living is that it is not, strictly speaking, a measure of standard of living. GDP is intended to be a measure of particular types of economic activity within a country. Nothing about the definition of GDP suggests that it is necessarily a measure of standard of living. For instance, in an extreme example, a country which exported 100 per cent of its production and imported nothing would still have a high GDP, but a very poor standard of living.

The argument in favour of using GDP is not that it is a good indicator of standard of living, but rather that (all other things being equal) standard of living tends to increase when GDP per capita increases. This makes GDP a proxy for standard of living, rather than a direct measure of it. GDP per capita can also be seen as a proxy of labour productivity. As the productivity of the workers increases, employers must compete for them by paying higher wages. Conversely, if productivity is low, then wages must be low or the businesses will not be able to make a profit.

There are a number of controversies about this use of GDP.

Limitations of GDP to judge the health of an economy

GDP is widely used by economists to gauge the health of an economy, as its variations are relatively quickly identified. However, its value as an indicator for the standard of living is considered to be limited. Criticisms of how the GDP is used include:

Simon Kuznets in his very first report to the US Congress in 1934 said:[5]

...the welfare of a nation [can] scarcely be inferred from a measure of national income...
In 1962, Kuznets stated:[6]
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.

Alternatives to GDP

HDI uses GDP as a part of its calculation and then factors in indicators of life expectancy and education levels.

The GPI and the similar ISEW attempt to address many of the above criticisms by taking the same raw information supplied for GDP and then adjust for income distribution, add for the value of household and volunteer work, and subtract for crime and pollution.

The World Bank has developed a system for combining monetary wealth with intangible wealth (institutions and human capital) and environmental capital.[7]

Some people have looked beyond standard of living at a broader sense of quality of life or well-being.It also states that GDP is a statistic crucial to the success of a specified country

This survey, the first wave of which was published in 2005, assessed quality of life across European countries through a series of questions on overall subjective life satisfaction, satisfaction with different aspects of life, and sets of questions used to calculate deficits of time, loving, being and having.[8]

The Centre for Bhutanese Studies in Bhutan is currently working on a complex set of subjective and objective indicators to measure 'national happiness' in various domains (living standards, health, education, eco-system diversity and resilience, cultural vitality and diversity, time use and balance, good governance, community vitality and psychological well-being). This set of indicators would be used to assess progress towards Gross National Happiness, which they have already identified as being the nation's priority, above GDP.

The Happy Planet Index (HPI) is an index of human well-being and environmental impact, introduced by the New Economics Foundation (NEF), in July 2006. It measures the environmental efficiency with which human well-being is achieved within a given country or group. Human well-being is defined in terms of subjective life satisfaction and life expectancy.

Lists of countries by their GDP

See also

External links

Global

Data

Articles and books

Notes and References

  1. Book: Sullivan, arthur. Arthur O' Sullivan

    . Arthur O' Sullivan. Steven M. Sheffrin. Economics: Principles in action. Pearson Prentice Hall. 2003. Upper Saddle River, New Jersey 07458. 57, 301. 0-13-063085-3.

  2. Web site: User's guide: Background information on GDP and GDP deflator. HM Treasury.
  3. Web site: Measuring the Economy: A Primer on GDP and the National Income and Product Accounts. Bureau of Economic Analysis. PDF.
  4. http://mises.org/story/770
  5. Simon Kuznets, 1934. "National Income, 1929-1932". 73rd US Congress, 2d session, Senate document no. 124, page 7. http://library.bea.gov/u?/SOD,888
  6. Simon Kuznets. "How To Judge Quality". The New Republic, October 20, 1962
  7. Web site: World Bank wealth estimates.
  8. Web site: First European Quality of Life Survey.