Gross Domestic Product (GDP) - Explained
What is GDP?
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Table of ContentsWhat is Gross Domestic Product (GDP)?How Gross Domestic Product is Measured?Nominal vs. Real GDPSources of GDP DataAcademic Research on Gross Domestic Product (GDP)
What is Gross Domestic Product (GDP)?
Gross domestic product (GDP) is the total monetary value of goods and services produced and offered within a country for a specific year. GDP is estimated annually, it is the monetary value of finished products (commodities) and services rendered within a country. GDP does not include imported goods and services, it focuses on those manufactured within the premises of a country. Unlike gross national product (GNP) that includes productions of citizens living out of the country. GDP can also be calculated quarterly, it is a broad concept that captures the overall economic activities such as production and distribution of goods and services in a country for a year.
How Gross Domestic Product is Measured?
GDP is a monetary measurement of the total value of goods and services produced within the borders of a country in a year. This is essential for the estimation of a country's financial and economic health over a period of time. It serves as a gauge for the standard of living of people in a country. The GDP for a particular period can also be compared with those of previous periods to determine economic growth or retardation. Certain economic decisions and policies that the government make are premised on the result of GDP for a particular period. GDP is also vital to analysts, investors and business owners. Economic analysts use GDP results in comparison of the economic development exhibited by different countries in different geographical regions. There are three major methods that are used in the calculation of gross domestic product (GDP) of a country in a period of time (usually quarterly or annually). These are;
- Expenditure or spending approach,
- Income approach, and
- Product or output approach.
When all these three methods are used and are calculated accurately, they yield the same results. Spending method for calculating GDP is also known as the expenditure method, it takes in account all activities needed in producing a finished output or product for sale. The expenditure approach for calculating GDP has the following formula; GDP = C + G + I + NX. This means; GDP = Consumer +Government expenditure + Investment + export - import. The expenditure approach is the most common method which involves the calculation of money spent by consumers, government and production and distribution processes. The spending of expenditure approach takes into account all the activities that contribute to the GDP of a country. This calculation however excludes imported products and services, this is because imports do not count when calculating the GDP of a country. Another method for calculating the GDP of a country for a specific year is the production approach. This is also referred to as output approach , net product or value added approach. This method is in contrast to the spending (expenditure) method that takes all spendings involved in the production of goods and services in account. GDP based on production calculates the total value of economic output for a particular period excluding the cost of goods that are consumed in the process of production. The output approach for measuring GDP considers the processes involved in the production of a completed economic activity. GDP can also be calculated using the income approach. The income approach is a sum of all the factors involved in the production of goods and services. It includes the estimation of the earnings of all factors of production in a particular economy, such as money (rent) earned by land, return on capital in cases of investments, profits made from a product and other factors. Furthermore, incomes that are not accounted for in the above payment such bas depreciation taxes, indirect business taxes and other forms of income are added to the national income when calculating the GDP of an economy. GNI is the total income realized by the citizens of a country including those outside the borders of the country. GDP measures the total income of people within the boundaries of a country excluding those residing in foreign countries. Indirect business taxes, depreciation taxes and other forms of income are also added when calculating GDP. However, when income received from overseas (net foreign factor income) is added to the calculation of GDP, it then becomes GDI or GNI. In recent times, countries have realized that GNI is a better metric over GDP because it measures overall economic health of a nation taking into account income earned by people within a country and those outside the countrys borders. The balance of trade is a key element in calculating the GDP of an economy. It is the difference between the values of imports and exports in a country at a particular time. A decline in GDP will occur when consumers spend more on imported products than on domestic product. GDP will increase if buy domestic products more than they buy foreign products. Since the balance of trade measures the difference between imports and exports, it then becomes a vital ingredient in calculating GDP. Contrary to the widely-held belief that protectionism increase GDP, in the actual sense, it reduces GDP of both domestic and foreign nations, this is why there is advocacy for trade liberalization globally. The Bureau of Economic Analysis (BEA) is the United States agency that is saddled with the task of estimating the U.S GDP annually. The expenditure approach is used in calculating the GDP, (GDP = C + G + I + NX) which means GDP = Consumer +Government expenditure + Investment + export - import. Included in the GDP calculation are outputs of all corporations including foreign companies located in the United States. Hence, in this context, GDP and GNI have no substantial difference.
Nominal vs. Real GDP
Increase in prices are captured in the GDP of an economy and it is mostly difficult to tell whether the increase is caused by expanded production or by inflation. In order to measure the real GDP of an economy and distinguish it from nominal GDP, economists devised adjustment for inflation. Nominal GDP refers to the measurement of economic output without inflation adjustment while real GDP is subject to inflation and deflation. Real GDP helps economists detect whether there is any real growth in the economy of a country over a given period. Nominal GDP is often higher but real GDP expresses long-term economic performance and accounts for change in market value. When the GDP of a country is adjusted for inflation, it means that it takes into account the period of inflation rate in the economy. GDP figures that Investors get access to are those adjusted for inflation (real GDP). Adjustment for Inflation is key in GDP calculations, not only does it amount for changes in market value, it gives a highlight of the overall economic performance of a given country. Adjustment for inflation reflect the real growth of an economy after removing the effects of inflation. By this, economists and investors detect decline, increase and stability in the economic growth of a country. Today, economists have come to an agreement that a rate of 2.5-3.5% GDP growth per year is what most economies can effectively maintain. When a GDP is unadjusted for inflation, there are five scenarios that will occur in the economy, they are;
- Increase in production (more goods are produced at the same prices) - in this scenario, increase in production translates to increased wages, it also increase employment rate in a country. Since more goods are produced to meet demands, GDP growth and inflation increase will occur in this scenario.
- Both GDP and inflation increase will also occur if there is no increase in demand but goods are produced at higher prices. Increase in prices can be linked to a decline in supply of materials used for production.
- In scenario 3, more goods are produced at higher prices- this is as a result of increase in demand and shortage in supply.
- In this scenario, much more gods are produced at lower prices, this is not common.
- Lesser goods are produced at higher prices.
Fluctuation in economic activities also results in fluctuation of the GDP of an economy. When economic activities are booming, GDP also increases, but when there is decline in economic activities, the GDP also decreases. For instance, when the economy is booming, employment rate increases, wages for labor also increase but in cases of increase in interest rate (which is an attribute of poor economy), there is low demand and companies tend to decrease their production level. Usually, the total demand placed on goods and service produced in an economy determines its GDP. When the economy is not booming, consumers spend less which also affect production in the economy. Consumers play a significant role in the calculation of GDP, so, when demands fluctuate, GDP also fluctuates. Simon Kuznets, a Russian economist developed GDP in 1934, GDP however came into force when it was used to report the Great Depression to the United States Congress in 1937. Its use expanded to being a major tool in measuring a countrys economy after the Bretton Woods conference in 1944. Before the U.S started using GDP, GNP has been used in measuring economic health in the U.S before 1991. However, in the 1950s, some criticisms arose regarding the effects of GDP in measuring the economic growth of a country. Some of the limitations of GDP that economists observe is that some countries tend to use GDP as an absolute measurement of the countrys economic success and failure. However, new means of calculating GDP have been developed. There are attempts by economists to modify the calculation of GDP, in order to increase its accuracy, specificity and effectiveness. Larger percentage of economists maintain that nominal GDP is a poor measurement of a countrys economic wellness, real GDP is used instead. One of the major refinements of GDP is the introduction of GDP per capita, when comparing economic growth between two countries. GDP per capita is realized by dividing the GDP os a country by its population. However, GDP per capita does not seem to be effective because it does not take into consideration the standard of living in a country. Hence an adjustment was made, real per capita GDP was introduced to accurately measure the true income and other factors of the economy. GNP includes the net income of citizens living abroad abroad as against GDP that only measures the net income of citizens living in a particular country. GNP measures the levels of production and net income of citizens both home and abroad, this means that for United States as example, GNP measures the net income of corporations owned by Americans even if they are not located in America. The ratio of domestic producers to foreign manufacturers that a country has determines the whether GNP will be higher or lower than GDP. GDP has however been a widely acceptable tool for measuring the economic success of a country due to certain accounting issues that generate from GNP calculations. The GDP of a country can be calculated quarterly and annual, although come nations do annual calculations, this is not rampant. In the United States, the Bureau of Economic Analysis (BEA) releases GDP data which are made accessible to the public quarterly and annually. Economists and investors draw insights from GDP data when making investment decisions but the insights that can be drawn are limited because GDP data reflect the net income for a past year and not the present time. Despite this fact, GDP still has some level of influence in the investment market generally as GDP can be compared to the ratio of total market capitalization before investment decisions are made. Using GDP as a measure of the economic growth of a nation has attracted some criticisms. Its major criticisms are the following;
- GDP is an inaccurate measure of economic growth since it does not account for the profit a nation earns through companies of its citizens that are located abroad.
- GDP only relies on official documents, it then fails to account for unofficial sources of income, such as the black market that generates a lot of income.
- GDP measure the growth of an economy but excludes population which is an integral part of the economy.
- GDP does not capture the total value of income realized through volunteer work or the services of stay-at-home parents.
Sources of GDP Data
There are many reliable sources through which the data for calculating the GDP of an economy is collected. The most reliable sources for GDP are; The World Bank, the International Monetary Fund (IMF), Statistical Agencies owned by countries, Organization for Economic Cooperation and Development (OECD), and few others. The World Bank is a reliable source that provides a detailed list of countries through which analysts can track their GDP data. IMF also provides data such as the World Economic Outlook and International Financial Statistics. OECD however provides historical GDP data as well as future forecasts of GDP of its members countries and just a few non-members. GDP is an essential metric in the evaluation of a country's economic growth over a period of time. According to Paul Samuelson and William Nordhaus, GDP of crucial is economic decisions as it helps policymakers to determine whether the economy of a country is deteriorating or expanding. GDP also gives investors and economists insights on the economic well-being of diverse nations across the continent. The GDP of a nation depicts the overall economic and well-being of the nation. Furthermore, through the GDP data, the analysis of economic variables such as inflation, recession, economic shocks, spikes in prices and other variables is made possible.
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