The Gross domestic product (GDP) is a monetary measure that represents the market value of all the finished goods and services produced in a specific time period, normally a year, within the geographic boundaries of a country. It is the number that is looked at when talking about the “size” of an economy.
As stated in the definition, the GDP is calculated by looking only at the final value of the product or service produced, it does not take into consideration, for example, the value of the parts that are included in the construction of a car, but just the market value of the final product. It is important to not take into consideration the other intermediate steps of production because it leads to double-counting.
From the GDP value, it is possible to calculate other derived measures that can help to better understand specific economic phenomena. Examples of these measures are the GDP per capita, the GDP per capita at purchasing power parity, or even other ratios like the debt-to-GDP ratio, the ratio between a country’s government debt and its gross domestic product.
In other cases, the value of the total GDP can be broken known into the contribution of each economic sector or industry and can be useful for the decision making of authorities, because with more detailed data they are able to understand which are the most crucial sectors in their economy, which are the strongest and which the weakest.
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Determining the GDP
There is no one single and unique way to determine the value of the GDP. In fact, there are three main approaches which in theory, if correctly calculated, should yield the same figure.
These three ways to determine the GDP are the production approach, the expenditure approach, and the income approach.
The production approach is the most direct among the three. It estimates the value of the entire economic output, and deducts the costs related to all the intermediate goods that are consumed in the production process.
In other words, GDP = gross value of output — value of intermediate consumption
The expenditure approach is based on the calculation of the spending of the actors that participate in the economy. It means that GDP is seen as the sum of consumption (C), investment (I), government spending (G) and net exports (NX, exports-imports).
- Consumption, C: represents the spending of private consumers and is usually the largest component in the GDP. Personal expenditures are grouped into 3 categories depending on the entity of their purchase: services, durable goods, and non-durable goods.
- Investment, I: it includes for the most part investments by businesses, for example, to buy new pieces of machinery to increase production. It is important to remember that into this category exchanges of existing assets are not included, as well as the buying of financial products, that are classed as saving. Investments are an important component of the economy because usually, greater investments lead to an increase in productivity and an increase in employment.
- Government spending, G: represents the sum of government expenditures on final goods and services. The expenditures of the government tend to be of a relevant magnitude given that they spend money on infrastructure, salaries of public servants, purchases of weapons for the military, etc. However, this measure does not take into consideration transfer payments such as social security.
- Net exports, NX: this factor is the result of a subtraction of the total amount of imports from the total amount of exports. Exports (gross exports) are goods and services produced by an economy and that are exported in other countries, while on the other hand, imports (gross imports), are the opposite, products and services produced in other countries that are sold in the domestic economy.
Finally, the income approach uses the sum of primary incomes distributed by resident producer units to estimate the GDP.
This approach is based on the idea that if you spend a certain amount of money to buy a specific good or service, that amount of money from your point of view is seen as an expense, from the point of view of the seller it can be considered as income.
Therefore it includes compensation of employees, corporate profits, interests and other income from investment, farmers’ income, and income from non-farm unincorporated businesses.
Nominal vs Real GDP
When talking about the gross domestic product is important to distinguish clearly Nominal GDP from Real GDP, and to understand which are the main factors that differentiate them. It is important because in various cases it is not uncommon to hear about one or the other, which are used in different contexts to explain phenomenons or economic issues, and therefore we need to have clear in our minds what they represent.
Nominal GDP, which is generally used when comparing the GDP of different quarters or different years, represents the GDP evaluated at current market prices. It does not strip out inflation or other factors that can alter the figure.
On the other hand, the real GDP, which is generally considered a much better index for expressing long-term national economic performance, is the measure of the value of economic output adjusted for inflation (or deflation). Thanks to this adjustment to the nominal GDP, it is possible for economists to compare the GDP of a country or economic area in time and see if there has been real growth or if the greater value of this year’s GDP has been caused solely by an increase in inflation.
For example, if the nominal GDP goes from a value of 100 in year 1, to 105 in year 2, we may think that the total output of our country is increased by 5% right? Wrong.
In fact, even though the nominal GDP is increased by 5%, if there has been an increase in inflation of 5%, which means that products and services cost 5% more than last year, the real GDP is the same as last year, therefore the real growth has been 0.
Of course, this is a simplistic example, but it is helpful to understand why the real GDP is much better in this kind of analysis.
Criticism and problems with GDP
Even though the GDP is widely used by economists, governments and other authorities, it has also received many critics that point out the drawbacks to using GDP as a measure of social and economic progress, due to different limitations that it has.
The main criticism is that does not consider the overall well-being of the population of a country. In fact, unfortunately, it is not uncommon that people refer to a positive level in GDP growth as if the standard of living in that country is automatically increased by that amount. One reason for the fact that an increase in GDP does not automatically reflect into an increase in people’s well being, which is also another common criticism to the use of GDP, is that it does not take into consideration the environmental costs related to the GDP growth. In fact, especially in developing countries, this could be a very determinant factor, where a higher economic growth can be favored with respect to the preservation of the environment, damaging the overall well-being of the population.