Gross Domestic Product

Gross domestic product (GDP) is a measure of national income which equals the market value of all final goods and services produced in the geographical boundaries of a country in a given time period.

GDP is the single most important number in finance which is sliced and diced to measure a whole range of economic statistics such as GDP per capita (i.e. total GDP divided by population), gross national product (also called gross national income), growth rate (i.e. percentage change in real GDP), labor productivity, total factor productivity, income per capita, etc.

There are three key words in the above definition: market value, final, geographical boundaries.

  • The GDP is a measure of market values of goods and services produced. If something is not traded in market such as leisure, self-service, etc. it is not counted as part of GDP. An important exception is the government services which even though not tradeable are included in GDP. Since there is no market and hence no market value, such items are included at costs.
  • The GDP is a measure of all final goods and services. Final goods are goods which are ready for their intended consumption. It means that intermediate goods, i.e. goods which are themselves an input in some other production process, are not included. It is because including both intermediate goods and final goods would double-count production and income.
  • The GDP measures income generated within the geographical boundaries of a country. GDP includes income earned and expenditure made by all people residing or visiting a country regardless of their nationality. This is how GDP differs from gross national product (also called gross national income).
  • Other considerations in calculating and interpreting GDP includes: (a) GDP ignores financial/paper transactions that do not involve any production i.e. purchase of a share of common stock by an investor from another investor is not counted in GDP; (b) GDP ignores transfer payments i.e. social security benefits, etc.; (c) GDP ignores second-hand purchases and sales: (d) GDP ignores work people do for themselves

Approaches

GDP can be calculated in three different ways and each gives us the same answer. These three methods are (a) the product approach, (b) the expenditure approach, and (c) the income approach.

The mutual comparability of the three approach can be expressed mathematically as follows:

$$ Total\ Production=Total\ Expenditure=Total\ Income $$

The formula for calculation of GDP using expenditure approach is as follows:

$$ Y=C+I+G+X-M $$

Where C is personal consumption, I is private investment, G is government spending, X is exports and M is imports.

The convergence at a single GDP number using either approach results from the circular flow nature of production in income. The circular flow means that if properly accounted for, an economy’s total production must equal its total expenditure and total income. It is so because what consumers spend in product market (i.e. total expenditure) they earn in factor markets (i.e. through wages, interest, dividends, etc.). Hence, whether we start counting expenditure or income, we must arrive at the same figure.

Nominal GDP vs Real GDP and Growth Rate

The GDP compiled by statistical agencies is based on the prices prevailing in the market during the period. This number is called nominal GDP. In order to compare GDP number across time, it is important to remove the effect of changes in purchasing power from historical time series. The real GDP is the gross domestic product which is worked using current year quantities and the base year prices. In a time series of real GDP, GDP numbers for all periods are restated based on the prices that prevailed in the base year.

When we talk about an economy’s growth in a given period, we measure it by percentage change in its real GDP.

Short-comings in GDP

Even though GDP is quite useful, it doesn't give a complete picture of an economy becuase:

  • GDP and GDP per capita doesn’t provide any information about distribution of income in an economy. In the increasing disparity of income and wealth, this drawback is a very serious one.
  • GDP doesn’t count self-service and leisure and a number of other categories of productive activities.
  • GDP doesn’t count the underground economy (also called informal sector). Since the size of the underground economy is relatively quite large in developing countries, GDP understates total production.
  • GDP ignores the physical depreciation of capital goods i.e. roads, buildings, factories, etc. that’s consumed in generating the income/expenditure. Hence, it overstates the net production of an economy.

Written by Obaidullah Jan, ACA, CFA and last revised on