Gross domestic product

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In economics, gross domestic product (GDP) is a measure of the value of economic production of a particular territory in financial capital terms during a specified period. It is one of the measures of national income and output. It is often seen as an indicator of the standard of living in a country, but there may be problems with this view. GDP is often abbreviated as Y.

Definition

GDP is defined as the total value of final goods and services produced within a territory during a specified period (or, if not specified, annually, so that "the UK GDP" is the UK's annual product). GDP differs from gross national product (GNP) in excluding inter-country income transfers, in effect attributing to a territory the product generated within it rather than the incomes received in it.

Whereas nominal GDP refers to the total amount of money spent on GDP, real GDP adjusts this value for the effects of inflation in order to estimate the actual quantity of goods and services making up GDP. The former is sometimes called "money GDP," while the latter is termed "constant-price" or "inflation-corrected" GDP -- or "GDP in base-year prices" (where the base year is the reference year of the index used). See real vs. nominal in economics.

GDP measures only final goods and services, that is those goods and services that are consumed by their final user, and not used as an input into other goods. Measuring intermediate goods and services would lead to double counting of economic activity within a country. This distinction also removes transfers between individuals and companies from GDP. For instance, buying a Renoir doesn't boost GDP by $20m. (If it did, buying and selling the same painting repeatedly to a gallery would imply great wealth rather than penury.) Note that the Renoir purchase would affect the GDP figure, but not as a $20m receipt, the auctioneer's fees would appear in GDP as consumption expenditure, because this is a final service.

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

GDP = consumption + investment + exportsimports

Consumption and investment in this equation are the expenditure on final goods and services. The exports minus imports part of the equation (often called net exports) then adjusts this by subtracting the part of this expenditure not produced domestically (the imports), and adding back in domestic production not consumed at home (the exports).

Economists (since Keynes) have preferred to split the general consumption term into two parts; private consumption, and public sector spending. Two advantages of dividing total consumption this way in theoretical macroeconomics are:

  • Private consumption is a central concern of welfare economics. The private investment and trade portions of the economy are ultimately directed (in mainstream economic models) to increases in long-term private consumption.
  • If separated from endogenous private consumption, Government consumption can be treated as exogenous, so that different government spending levels can be considered within a meaningful macroeconomic framework.

Therefore GDP can be expressed as:

GDP = private consumption + government + investment + net exports
(or simply GDP = C + G + I + NX)

The components of GDP

Each of the variables C, I, G, and NX :

  • C is private consumption (or Consumer expenditures) in the economy. This includes most expenditures of households such as food, rent, medical expenses and so on.
  • I is defined as business investments in capital. Examples of investment by a business include construction of a new mine, purchase of software, or purchase of machinery and equipment for a factory. 'Investment' in GDP is meant very specifically as non-financial product purchases. Buying financial products is classed as saving in macroeconomics, as opposed to investment (which, in the GDP formula is a form of spending). The distinction is (in theory) clear: if money is converted into goods or services, without a repayment liability it is investment. For example, if you buy a bond or share the ownership of the money has only nominally changed hands, and this transfer payment is excluded from the GDP sum. Although such purchases would be called investments in normal speech, from the total-economy point of view, this is simply swapping of deeds, and not part of the real economy or the GDP formula.
  • G is the sum of government expenditures on final goods and services. It includes salaries of public servants, purchase of weapons for the millitary, and any investment expenditure by a government. It does not include any transfer payments, such as social security or unemployment benefits. The relative size of government expenditure compared to GDP as a whole is critical in the theory of crowding out, and the Keynesian cross.
  • NX are "net exports" in the economy (gross exports - gross imports). GDP captures the amount a country produces, including goods and services produced for overseas consumption, therefore exports are added. Imports are subtracted since imported goods will be included in the terms G, I, or C, and must be deducted to avoid counting foreign supply as domestic.

It is important to understand the meaning of each variable precisely in order to:

Examples of GDP component variables

Examples of C, I, G, & 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.

If the hotel is your private home your 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 unaffected 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 you are paid to manufacture the chandelier to hang in a foreign hotel the situation would be reversed, and the payment you receive would be counted in NX (positively, as an export). Again, we see that GDP is attempting to measure production through the means of expenditure; if the chandelier you 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 Gross Domestic Product.).

Difference from Aggregate expenditure

An alternative measure of the economy to GDP is the Aggregate expenditure measure, which is identical to GDP except that it excludes items produced but not purchased (net inventory/stock level growth). If the economy produces more goods than are sold, the increase in inventory would generally be included in the GDP figure (as "Investment"). GDP counts these changes in inventory levels as investment.

The GDP Income account

Another way of measuring GDP is to measure the total income payable in the GDP income accounts. This should provide the same figure as the expenditure method described above.

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
  • Compensation of employees (COE) measures the total remuneration to employees for work done. It includes wages and salaries, as well as employer contributions to social security and other such programs.
  • Gross operating surplus (GOS) is the surplus due to owners of incorporated businesses. Often called profits, although only a subset of total costs are subtracted from gross output to calculate GOS.
  • Gross mixed income (GMI) is the same measure as GOS, but for unincorporated businesses. This often includes most small businesses.

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).

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, Organisation 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 sets out 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 organisations normally do not have access to the information required (especially information on expenditure and production by governments).

GDP can measure spending on all goods and services. GDP can also measure all income earned.

Interest rates

Net interest expense is a transfer payment in all sectors except the financial sector. Net interest expenses in the financial sector is seen as production and value added and is 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.

  • The current exchange rate method converts the value of goods and services using global currency exchange rates. This can offer better indications of a country's international purchasing power and relative economic strength. For instance, if 10% of GDP is being spent on buying hi-tech foreign arms, the number of weapons purchased is entirely governed by current exchange rates, since arms are a traded product bought on the international market (there is no meaningful 'local' price distinct from the international price for high technology goods).
  • The purchasing power parity method accounts for the relative effective domestic purchasing power of the average producer or consumer within an economy. This can be a better indicator of the living standards of less-developed countries because it compensates for the weakness of local currencies in world markets. The PPP method of GDP conversion is most relevant to non-traded goods and services.

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.

GDP and standard of living

GDP per capita is often used as an indicator of standard of living in an economy. While this approach has advantages, many criticisms of GDP focus on its use as an indicator of standard of living.

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, which allow crude comparisons between the standard of living in different countries to be compared. 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 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.

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

Controversies

Although GDP is widely used by economists, its value as an indicator has also been the subject of controversy. Criticisms of GDP include:

  • GDP doesn't take into account the black economy, where the money spent isn't registered, and the non-monetary economy, where no money comes into play at all, resulting in inaccurate or abnormally low GDP figures. For example, in countries with major business transactions occurring informally, portions of local economy are not easily registered. Bartering may be more prominent than the use of money, even extending to services (I helped you build your house ten years ago, so now you help me).
  • Very often different calculations of GDP are confused among each other. For cross-border comparisons one should especially regard whether it is calculated by purchasing power parity method or current exchange rate method.
  • Quality of life is determined by many other things than physical goods (economic or not).
  • In 'poor' countries, it may just be that everything is cheap, except for a few western goodies. So one may have little money, but if everything is cheap that evens out nicely. Thus, the standard of living may be quite reasonable, it's just that there are, say, fewer TV-sets, meaning people have to share them (which may actually increase the quality of life in a social sense).
  • If many products are of low quality in terms of durability then people will have to (unnecessarily) buy them again and again, thus boosting GDP without increasing their satisfaction. (On the other hand, if products were very durable then that would hamper innovation because people would be less inclined to buy new products, giving producers less of an incentive to develop them.) Similarly, if many products are of low quality in terms of usability and people don't know beforehand which products are the best choice for them, then they will either have to make do with an inferior product or buy again and again until they find something more satisfying. Furthermore, if products have a short lifespan in the market (eg because of fast innovation or fashion) then this process starts all over again when people need a replacement. Note that in a capitalist society these factors working together can easily cause a very high GDP combined with low customer satisfaction.
  • GDP doesn't measure the sustainability of growth. A country may achieve a temporary high GDP by over-exploiting natural resources or by misallocating investment. Oil rich states can sustain high GDPs without industrializing, but this high level will not be sustainable past the point that the oil runs out. Economies experiencing a housing bubble or a low private saving rate tend to grow faster due to higher consumption, at the expense of reduced pensions in future.
  • GDP counts work that produces no net change. For instance, a hurricane destroying thousands of homes would not be counted by GDP, but the rebuilding of those homes would be. A good recent example would be the aftermath of 2005 Katrina hurricane, which is poised to become the most expensive hurricane in history. GDP would capture the rebuilding activity and suggest a rising living standard, but we're only working toward restoring what was lost for the most part. Therefore, GDP growth would over-estimate the increase in the standard of living. See Negative externalities.
  • As a measure of actual sale prices, GDP does not capture the economic surplus between the price paid and subjective value received.
  • the annual growth of real GDP is adjusted by using the "GDP deflator", which tends to underestimate the objective differences in the quality of manufactured output over time. (The deflator is explicitly based on subjective experience when measuring such things as the consumer benefit received from computer-power improvements since the early 1980s). Therefore the GDP figure may underestimate the degree to which improving technology and quality-level are increasing the real standard of living.
  • Some economists such as Hermann E. Daly consider GDP to be a poor measure even of material well being, especially in developed countries. They argue that GDP only measures production and consumption, not however the level of utility people gain from producing and consuming. This idea is expressed in the theory of uneconomic growth, which states that GDP growth above a certain "economic limit" actually decreases material well being. An extreme example of this is a major war. Historically, GDP growth was often boosted in war time while material living standards fell considerably.
  • GDP does not take inequality into account.

Some economists have attempted to create a replacement for GDP called the Genuine Progress Indicator (GPI), which attempts to address many of the above criticisms.

Lists of countries by their GDP

See also

Calculation

External links

Data


Articles

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