Gross Domestic Product

Definition

Gross domestic product is a monetary measure of the market value of all the final goods and services produced in a specific time period.GDP per capita does not, however, reflect differences in the cost of living and the inflation rates of the countries; therefore using a basis of GDP per capita at purchasing power parity is arguably more useful when comparing living standards between nations, while nominal GDP is more useful comparing national economies on the international market. The OECD defines GDP as “an aggregate measure of production equal to the sum of the gross values added of all resident and institutional units engaged in production and services.” An IMF publication states that, “GDP measures the monetary value of final goods and services—that are bought by the final user—produced in a country in a given period of time.” Total GDP can also be broken down into the contribution of each industry or sector of the economy.

Gross Domestic Product

Gross Domestic Product, or GDP, is a monetary measure of the market vlue of all final goods and services produced over a period of time. GDP provides a broad measure of overall domestic production, functioning as a comprehensive scorecard for a countrys economic health. Typically Gross Domestic Product is calculated on an annual basis. However, it is possible to calculate GDP quarterly. In the United States, the government releases an annualized GDP estimate for each quarter, as well as for the entire year. Most of the individual data sets will also be given in real terms, meaning that the data is adjusted for fluctuations in price, and is therefore, a net of inflation.

The History of Gross Domestic Product

GDP has a long history and was first introduced as a concept by William Petty, who used it to attack landlords against unfair taxation during warfare between the Dutch and English between 1654 and 1676. Gross Domestic Product as we know it today was developed by Simon Kuznets for a US Congress report in 1934. In 1944, GDP became the main tool in which a countrys economy was measured. The history of the concept of GDP should be distinguished from the history of changes in ways of estimating it. The value added by firms is relatively easy to calculate from their accounts, but the value added by the public sector, by financial industries, and by intangible asset creation is more complex. These activities are increasingly important in developed economies, and the international conventions governing their estimation and their inclusion or exclusion in GDP regularly change in an attempt to keep up with industrial advances. In the words of one academic economist “The actual number for GDP is therefore the product of a vast patchwork of statistics and a complicated set of processes carried out on the raw data to fit them to the conceptual framework.”

How to Determine Gross Domestic Product

GDP can be determined in three ways. Theoretically, each should provide the same result. The three methods used to calculate GDP are the production (i.e. output/value added), approach, the income approach, or the speculated expenditure approach.

GDP Calculated Using the Expenditure Approach

The expenditure approach calculates the spending by the different groups that participate in the economy. This approach can be calculated using the following formula: GDP = C + G + I + NX (Gross Domestic Product = Consumption + Government Spending + Investment + Net Exports) Each of these activities contribute to the GDP of a county. The United States primarily uses the expenditure approach to measure its GDP.

GDP Calculated Based on the Production Approach

The production approach is nearly the reverse of the expenditure approach. Instead of measuring input costs that feed economic activity, this approach estates the value of economic output and deducts costs of intermediate goods that are consumed in the process (such as materials and services). The Production Approach looks backward from the vantage of a state of completed economic activity whereas the Expenditure Approach projects forwards from costs.

GDP Using the Income Approach

Another approach to calculating GDP is the Income Approach. This method of calculating GDP is something of an intermediary between the Production Approach and the Expenditure Approach. Income earned by all factors of production in an economy includes the wages paid to labor, rent collected by land, capital gains (aka interest), as well as corporate profit. The income approach factors in some adjustments for some items that dont show up in these payments made to factors of production. For one, there are some taxessuch as sales taxes and property taxesthat are classified as indirect business taxes. In addition, depreciation, which is a reserve that businesses set aside to account for the replacement of equipment that tends to wear down with use, is also added to the national income. All this constitutes national income, which is used both as an indicator of implied production and of implied expenditure.

GDP vs GNP vs GNI

While GDP is the most widely used metric, there are alternative means in measuring a countrys economy. Many of these methods are based on nationality instead of physical borders. One of those measures is Gross National Product, or GNP. GNP measures the overall production of a native person or corporation including those based abroad while excluding domestic production by foreigners. GNP is an older measurement system that uses the production approach. Another measure is Gross National Income, or GNI. GNI is the sum of all income earned by citizens of a country, regardless of their physical location. GNI is a more modern approach compared to GNP, and uses the income approach to make its estimates. As the worlds economy becomes more global, Gross National Income is starting to be recognized as a possible better metric for a nations overall economic health than Gross Domestic Product. This is due to the fact that certain countries have most of their income withdrawn abroad by foreign corporations and individuals, which inflates GDP figures.

Nominal GDP vs Real GDP

Since GDP is based on the monetary value of goods and services, it is subject to inflation. Rising prices will tend to increase GDP and falling prices will make GDP look smaller, without necessarily reflecting any change in the quantity or quality of goods and services produced. Therefore, simply looking at a nations un-adjusted economic GDP, it is difficult to determine if the GDP went up as a result of production increases or if because prices of products increased. To solve this issue, economists have created an adjustment metric known as Real GDP. Real GDP adjusts the output in any given year for the price levels that prevailed in a reference year, called the base year, allowing economists to adjust for the impact of inflation. Overall, this gives a truer sense whether or not a countrys GDP experienced any growth year over year. Real GDP is calculated using a GDP price deflator, which is the difference in prices between the current year and the base year. For example, if prices rose by 5% since the base year, the deflator would be 1.05. Nominal GDP is divided by this deflator, yielding real GDP. Nominal GDP is usually higher than real GDP because inflation is typically a positive number. Real GDP accounts for the change in market value, which narrows the difference between output figures from year to year. A large discrepancy between a nation’s real and nominal GDP signifies significant inflation (if the nominal is higher) or deflation (if the real is higher) in its economy. Nominal GDP is used when comparing different quarters of output within the same year. When comparing the GDP of two or more years, real GDP is used because, by removing the effects of inflation, the comparison of the different years focuses solely on volume.

In Summary of Gross Domestic Product

Gross Domestic Product ultimately tracks the health of a countrys economy. It represents the value of all gods and services produced during a specific time period with a countrys borders. GDP is used to determine whether an economy is growing, experiencing a recession, or stagnating. Investors use GDP figures to make investment decisions; i.e. a good economy will mean higher earnings and higher stock prices. Overall, GDP is important on a number of levels and reflects a countrys year over year production and growth.

Gross Domestic Product

Definition