Module 5

GDP
What Is Gross Domestic Product (GDP)?

Gross domestic product (GDP) is the total monetary or market value of all the
finished goods and services produced within a country’s borders in a specific time
period. As a broad measure of overall domestic production, it functions as a
comprehensive scorecard of a given country’s economic health.

Though GDP is typically calculated on an annual basis, it is sometimes calculated

on a quarterly basis as well. In the U.S., for example, the government releases an
annualized GDP estimate for each fiscal quarter and also for the calendar year. The
individual data sets included in this report are given in real terms, so the data is
adjusted for price changes and is, therefore, net of inflation.

• Gross domestic product is the monetary value of all finished goods and
services made within a country during a specific period.
• GDP provides an economic snapshot of a country, used to estimate the size of
an economy and its growth rate.
 • GDP can be calculated in three ways, using expenditures, production, or
incomes and it can be adjusted for inflation and population to provide deeper
insights.
• Real GDP takes into account the effects of inflation while nominal GDP does
not.
• Though it has limitations, GDP is a key tool to guide policymakers, investors,
and businesses in strategic decision-making.

History of GDP

The concept of GDP was first proposed in 1937 in a report to the U.S. Congress in
response to the Great Depression, conceived of and presented by an economist at the
National Bureau of Economic Research (NBER), Simon Kuznets.

At the time, the preeminent system of measurement was GNP. After the Bretton
Woods conference in 1944, GDP was widely adopted as the standard means for
measuring national economies; however, the U.S. continued to use GNP as its
official measure of economic welfare until 1991, after which it switched to GDP.

Beginning in the 1950s, however, some economists and policymakers began to

question GDP. Some observed, for example, a tendency to accept GDP as an
absolute indicator of a nation’s failure or success, despite its failure to account for
health, happiness, (in)equality, and other constituent factors of public welfare. In
other words, these critics drew attention to a distinction between economic progress
and social progress.

Understanding Gross Domestic Product (GDP)

The calculation of a country’s GDP encompasses all private and public consumption,
government outlays, investments, additions to private inventories, paid-in
construction costs, and the foreign balance of trade. (Exports are added to the value
and imports are subtracted).
Of all the components that make up a country’s GDP, the foreign balance of trade is
especially important. The GDP of a country tends to increase when the total value
of goods and services that domestic producers sell to foreign countries exceeds the
total value of foreign goods and services that domestic consumers buy. When this
situation occurs, a country is said to have a trade surplus.

If the opposite situation occurs—if the amount that domestic consumers spend on
foreign products is greater than the total sum of what domestic producers are able to
sell to foreign consumers—it is called a trade deficit. In this situation, the GDP of a
country tends to decrease.

GDP can be computed on a nominal basis or a real basis, the latter accounting for
inflation. Overall, real GDP is a better method for expressing long-term national
economic performance since it uses constant dollars.

Let's say one country had a nominal GDP of $100 billion in 2012. By 2022, its
nominal GDP grew to $150 billion. Prices also rose by 100% over the same period.
In this example, if you looked solely at its nominal GDP, the country's economy
appears to be performing well. However, the real GDP (expressed in 2012 dollars)
would only be $75 billion, revealing that an overall decline in real economic
performance actually occurred during this time.
Types of Gross Domestic Product

GDP can be reported in several ways, each of which provides slightly different
information.

Nominal GDP

Nominal GDP is an assessment of economic production in an economy that includes

current prices in its calculation. In other words, it doesn’t strip out inflation or the
pace of rising prices, which can inflate the growth figure.

All goods and services counted in nominal GDP are valued at the prices that those
goods and services are actually sold for in that year. Nominal GDP is evaluated in
either the local currency or U.S. dollars at currency market exchange rates to
compare countries’ GDPs in purely financial terms. 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. This is because, in effect, the removal
of the influence of inflation allows the comparison of the different years to focus
solely on volume.

Real GDP

Real GDP is an inflation-adjusted measure that reflects the number of goods and
services produced by an economy in a given year, with prices held constant from
year to year to separate out the impact of inflation or deflation from the trend in
output over time. Since GDP is based on the monetary value of goods and services,
it is subject to inflation.

Rising prices tend to increase a country’s GDP, but this does not necessarily reflect
any change in the quantity or quality of goods and services produced. Thus, by
looking just at an economy’s nominal GDP, it can be difficult to tell whether the
figure has risen because of a real expansion in production or simply because prices
rose.

Economists use a process that adjusts for inflation to arrive at an economy’s real
GDP. By adjusting the output in any given year for the price levels that prevailed in
a reference year, called the base year, economists can adjust for inflation’s impact.
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, then 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 changes in market value and thus narrows the difference
between output figures from year to year. If there is a large discrepancy between a
nation’s real GDP and nominal GDP, this may be an indicator of significant inflation
or deflation in its economy.
GDP Per Capita

GDP per capita is a measurement of the GDP per person in a country’s population.
It indicates that the amount of output or income per person in an economy can
indicate average productivity or average living standards. GDP per capita can be
stated in nominal, real (inflation-adjusted), or purchasing power parity (PPP) terms.
At a basic interpretation, per-capita GDP shows how much economic production
value can be attributed to each individual citizen. This also translates to a measure
of overall national wealth since GDP market value per person also readily serves as
a prosperity measure.

Per-capita GDP is often analyzed alongside more traditional measures of GDP.

Economists use this metric for insight into their own country’s domestic productivity
and the productivity of other countries. Per-capita GDP considers both a country’s
GDP and its population. Therefore, it can be important to understand how each factor
contributes to the overall result and is affecting per-capita GDP growth.

If a country’s per-capita GDP is growing with a stable population level, for example,
it could be the result of technological progressions that are producing more with the
same population level. Some countries may have a high per-capita GDP but a small
population, which usually means they have built up a self-sufficient economy based
on an abundance of special resources.
GDP Growth Rate

The GDP growth rate compares the year-over-year (or quarterly) change in a
country’s economic output to measure how fast an economy is growing. Usually
expressed as a percentage rate, this measure is popular for economic policymakers
because GDP growth is thought to be closely connected to key policy targets such
as inflation and unemployment rates.

If GDP growth rates accelerate, it may be a signal that the economy is overheating
and the central bank may seek to raise interest rates. Conversely, central banks see a
shrinking (or negative) GDP growth rate (i.e., a recession) as a signal that rates
should be lowered and that stimulus may be necessary.

GDP Purchasing Power Parity (PPP)

While not directly a measure of GDP, economists look at PPP to see how one
country’s GDP measures up in international dollars using a method that adjusts for
differences in local prices and costs of living to make cross-country comparisons of
real output, real income, and living standards.

GDP Formula

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

The expenditure approach, also known as the spending approach, calculates

spending by the different groups that participate in the economy. The U.S. GDP is
primarily measured based on the expenditure approach. This approach can be
calculated using the following formula:

GDP=C+G+I+NX
where:
C=Consumption
G=Government spending
I=Investment
NX=Net exports

All of these activities contribute to the GDP of a country. Consumption refers to

private consumption expenditures or consumer spending. Consumers spend money
to acquire goods and services, such as groceries and haircuts. Consumer spending is
the biggest component of GDP, accounting for more than two-thirds of the U.S.
GDP.

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.
Government spending represents government consumption expenditure and gross
investment. Governments spend money on equipment, infrastructure, and payroll.
Government spending may become more important relative to other components of
a country’s GDP when consumer spending and business investment both decline
sharply. (This may occur in the wake of a recession, for example.)

Investment refers to private domestic investment or capital expenditures. Businesses

spend money to invest in their business activities. For example, a business may buy
machinery. Business investment is a critical component of GDP since it increases
the productive capacity of an economy and boosts employment levels.
The net exports formula subtracts total exports from total imports (NX = Exports -
Imports). The goods and services that an economy makes that are exported to other
countries, less the imports that are purchased by domestic consumers, represent a
country’s net exports. All expenditures by companies located in a given country,
even if they are foreign companies, are included in this calculation.

The Production (Output) Approach

The production approach is essentially the reverse of the expenditure approach.

Instead of measuring the input costs that contribute to economic activity, the
production approach estimates the total value of economic output and deducts the
cost of intermediate goods that are consumed in the process (like those of materials
and services). Whereas the expenditure approach projects forward from costs, the
production approach looks backward from the vantage point of a state of completed
economic activity.

The Income Approach

The income approach represents a kind of middle ground between the two other
approaches to calculating GDP. The income approach calculates the income earned
by all the factors of production in an economy, including the wages paid to labor,
the rent earned by land, the return on capital in the form of interest, and corporate
profits.
The income approach factors in some adjustments for those items that are not
considered payments made to factors of production. For one, there are some taxes—
such as sales taxes and property taxes—that are classified as indirect business taxes.
In addition, depreciation—a reserve that businesses set aside to account for the
replacement of equipment that tends to wear down with use—is also added to the
national income. All of this together constitutes a nation’s income.

Global Sources for Country GDP Data

The World Bank hosts one of the most reliable web-based databases. It has one of
the best and most comprehensive lists of countries for which it tracks GDP data. The
International Money Fund (IMF) also provides GDP data through its multiple
databases, such as World Economic Outlook and International Financial Statistics.

In the U.S., the Fed collects data from multiple sources, including a country’s
statistical agencies and The World Bank. The only drawback to using a Fed database
is a lack of updating in GDP data and an absence of data for certain countries.
The BEA is a division of the U.S. Department of Commerce. It issues its own
analysis document with each GDP release, which is a great investor tool for
analyzing figures and trends and reading highlights of the very lengthy full release.
Why GDP is used to measure the growth?

GDP serves as a gauge of our economy’s overall size and health. GDP measures the
total market value (gross) of all U.S. (domestic) goods and services produced
(product) in a given year.

When compared with prior periods, GDP tells us whether the economy is expanding
by producing more goods and services or contracting due to less output. It also tells
us how the U.S. is performing relative to other economies around the world.
Economic growth rates are monitored closely, which is why GDP is often reported
as a percentage. Reported rates are typically based on “real GDP,” which is adjusted
to eliminate the effects of inflation.

Why GDP Matters?

Policymakers, government officials, businesses, economists and the public alike rely
on GDP and related statistics to help assess the economy’s well-being and to make
informed decisions.

Policymakers will look to GDP when contemplating decisions on interest rates, tax
and trade policies.

The pace at which our economy is growing affects business conditions and
investment decisions, as well as whether workers can find jobs.

State and local governments rely on GDP and similar statistics to help shape policy
or decide how much public spending is affordable.

Economists study GDP and related statistics to help inform their research.
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