GROSS DOMESTIC PRODUCT (GDP)

DEFINITION

Gross domestic product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in a specific time period. Though GDP is usually calculated on an annual basis, it can be calculated on a quarterly basis as well (in the United States, for example, the government releases an annualized GDP estimate for each quarter and also for an entire year).

GDP includes all private and public consumption, government outlays, investments, private inventories, paid-in construction costs and the foreign balance of trade (exports are added, imports are subtracted). Put simply, GDP is a broad measurement of a nation’s overall economic activity – the godfather of the indicator world.

 

The Significance of GDP

GDP is commonly used as an indicator of the economic health of a country, as well as a gauge of a country's standard of living. Since the mode of measuring GDP is uniform from country to country, GDP can be used to compare the productivity of various countries with a high degree of accuracy. Adjusting for inflation from year to year allows for the seamless comparison of current GDP measurements with measurements from previous years or quarters. In this way, a nation’s GDP from any period can be measured as a percentage relative to previous periods. An important statistic that indicates whether an economy is expanding or contracting, GDP can be tracked over long spans of time and used in measuring a nation’s economic growth or decline, as well as in determining if an economy is in recession (generally defined as two consecutive quarters of negative GDP growth).

GDP’s popularity as an economic indicator in part stems from its measuring of value added through economic processes. For example, when a ship is built, GDP does not reflect the total value of the completed ship, but rather the difference in values of the completed ship and of the materials used in its construction. Measuring total value instead of value added would greatly reduce GDP’s functionality as an indicator of progress or decline, specifically within individual industries and sectors. Proponents of the use of GDP as an economic measure tout its ability to be broken down in this way and thereby serve as an indicator of the failure or success of economic policy as well.

How to Determine GDP

There are three primary methods by which GDP can be determined. All, when correctly calculated, should yield the same figure. These three approaches are often termed the expenditure approach, the output (or production) approach and the income approach.

GDP Based on Spending

The expenditure approach or spending approach, which is the most common method, calculates the monies spent by the different groups that participate in the economy. For instance, consumers spend money to buy various goods and services and businesses spend money as they invest in their business activities (buying machinery, for instance). And governments also spend money. All these activities contribute to the GDP of a country. In addition, some of the goods and services that an economy makes are exported overseas, their net exports. And some of the products and services that are consumed within the country are imports from overseas. The GDP calculation also accounts for spending on exports and imports.

 Q2 Figures. Total in $ billion.

Net Exports

Net Exports

Personal Consumption Expenditure69%

17%

Government Consumption Expenditure and Gross Investment

16%

Gross Private Domestic Investment

Net Exports (-3%)

Total:
19,227

GDP Based on Production

The production approach is something like the reverse of the expenditure approach. Instead of exclusively measuring input costs that feed economic activity, the production approach estimates the total value of economic output and deducts costs of intermediate goods that are consumed in the process, like those of materials and services. Whereas the expenditure approach projects forward beyond intermediate costs, the production approach looks backward from the vantage of a state of completed economic activity.

GDP Based on Income

Considering that the other side of the spending coin is income, and since what you spend is somebody else’s income, another approach to calculating GDP – something of an intermediary between the two aforementioned approaches – is based on a tally of the national income. Income earned by all the factors of production in an economy includes the wages paid to labor, the rent earned by land, the return on capital in the form of interest, as well as an entrepreneur’s profits. An entrepreneur’s profits could be invested in his own business or it could be an investment in any outside business. All this constitutes national income, which is used both as an indicator of implied productivity and of implied expenditure.

GDP and GNI

Another adjustment can be made for foreign payments made to Americans, which is income for Americans and U.S. payments made to foreigners, to arrive at the net foreign factor income. Subtracting the payments made to foreigners from the payments made to Americans provides a net foreign factor income.

With this approach, the GDP of a country is calculated as its national income plus its indirect business taxes and depreciation, as well as its net foreign factor income.  GDP calculated in this way – incorporating income received from overseas – is also referred to as gross domestic income (GDI), or as gross national income (GNI). In an increasingly global economy, GNI is increasingly being recognized as possibly a better metric for overall economic health than GDP because it measures national income, regardless of whether the income is earned by people within a country's borders or elsewhere in the world.

Nominal vs. Real GDP

Considering that GDP is based on a monetary value of an economy’s output, it is subject to inflationary pressure. Over a period of time, prices typically tend to go up in an economy and this is reflected in the GDP. Thus, just by looking at an economy’s unadjusted GDP, it is difficult to tell whether the GDP went up as a result of production expanding in the economy or because prices escalated.

That’s why economists have come up with an adjustment for inflation to arrive at an economy’s real GDP, rather than its nominal GDP, which ignores inflation and deflation. By adjusting the output in any given year for inflation so that it reflects the price levels that prevailed in a reference year, called “the base year,” economists adjust for the inflation effect. This way, it is possible to compare a country’s GDP from one year to another and see if there is any real growth.

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 inflationary forces (if the nominal is higher) or deflationary forces (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.

Overall, real GDP is a much better index for expressing long-term national economic performance. Take for example a hypothetical country which in the year 2000 had a nominal GDP of $100 billion, which grew to $150 billion by 2010 its nominal GDP. Over the same period of time, inflation reduced the relative value of the dollar by 50%. Looking at merely nominal GDP, the economy appears to be performing well, whereas the real GDP expressed in 2000 dollars would be $75 billion, revealing that in fact an overall decline in economic performance occurred.

Why GDP Fluctuates

GDP fluctuates because of the business cycle. When the economy is booming and GDP is rising, there comes a point when inflationary pressures build up rapidly as labor and productive capacity near full utilization. This leads the central bank to commence a cycle of tighter monetary policy to cool down the overheating economy and quell inflation.

As interest rates rise, companies and consumers cut back their spending, and the economy slows down. Slowing demand leads companies to lay off employees, which further affects consumer confidence and demand. To break this vicious circle, the central bank eases monetary policy to stimulate economic growth and employment until the economy is booming once again. Rinse and repeat.

Consumer spending is the biggest component of the economy, accounting for more than two-thirds of the U.S. economy. Consumer confidence, therefore, has a very significant bearing on economic growth. A high confidence level indicates that consumers are willing to spend, while a low confidence level reflects uncertainty about the future and an unwillingness to spend.

Business investment is another critical component of GDP, since it increases productive capacity and boosts employment. Government spending assumes particular importance as a component of GDP when consumer spending and business investment both decline sharply, as, for instance, after a recession. Finally, a current account surplus boosts a nation’s GDP, while a chronic deficit is a drag on GDP.

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