Introduction to Gross Domestic Product (GDP)

  • Ayush Singh Rawat
  • Apr 03, 2021
  • Financial Analytics
Introduction to Gross Domestic Product (GDP) title banner

You might have heard the news that the current pandemic has caused the GDP of India to take a serious hit and not just only India, there was a 24% shrink in India’s GDP, even though the economic activities have been disturbed everywhere.

 

Many times GDP is referred to as a country’s growth and as a measurement of a country’s advancement. While it may convey the economic growth and development  of a certain area but the quality of life is hard to suggest through these measures. It is also the most used measurement across the globe which makes it a universal indicator for development. 

 

Let’s delve into the topic of GDP!! 

 

 

History of GDP

 

According to Wikipedia, the modern concept of GDP was first brought up and developed by Simon Kuznets for a US Congress report in 1934. 

 

  • In this report, Kuznets warned against the use of GDP as a measure of welfare however after the iconic Bretton Woods conference in 1944, it became the prime tool for measuring a country's economy. 

  • Gross national product (GNP) was the preferred estimate at that time, which differed from GDP as it measured production by a citizen in his home country and abroad rather than his resident institutional units.

 

 

What is GDP?

 

GDP is the final monetary value of all the goods and services produced within the geographic location such as a country during a specified period of time, could be a year or even a quarter. As a broad measure of overall domestic production of a country, it functions as a tentative scorecard of a given country’s current economic well-being.

 

Though GDP is commonly calculated on an annual basis, it is sometimes also calculated on a quarterly time frame as well. In India, the government releases an annual report of the GDP estimate for each fiscal quarter and also for the economic  calendar year. The individual data sets included in this report are given in raw and real terms, so the data is adjusted by keeping inflation in mind. 

 

(Most related: What is Expansionary Fiscal Policy?)

 

In India, the Central Statistical Office(CSO) and in the United states, Bureau of Economic Analysis (BEA) are responsible for calculating the GDP using data ascertained through surveys of retailers, manufacturers, and builders, and by looking at trade flows.

 

A country's GDP is calculated by including all government spending, private and public consumption of goods and services, investments, additions to private inventories, paid-in construction costs, and the very important foreign balance of trade. (Exports are added to this value and imports are subtracted from it).

 

The GDP of a country tends to increase when the total value of goods and services that domestic producers trade to foreign countries outsells the total value of foreign goods and services that domestic consumers buy. This phenomena is known as having a trade surplus.


 

Importance of GDP

 

  1. GDP accurately predicts the size of an economy and the GDP growth rate is one of the best single indicators of economic growth, while GDP per capita is the most precise in relating money with the living standards over time.

  1. GDP allows central banks and policymakers to judge whether the economy is contracting or expanding, whether it needs an uplift or needs to be restrained, and if the possible threats such as a recession or rampant inflation are anywhere near to be found.

  2. The national income and product accounts (NIPA), which lay out rules in order to measure GDP, allow policymakers, economists, and businesses to analyze the impact of variables such as the monetary and fiscal policy, economic blunders, such as a spike in the oil price, and tax and spending budgets on specific sectors of an economy, as well as on the overall economy itself.

  3. Along with better-introspective policies and institutions, national accounts have had a major contribution in significantly reducing the harsh business cycles since the end of World War II.


 

How to Calculate GDP?

 

GDP can be calculated using three primary methods. All three methods should produce the same figures when calculated separately. These three approaches are known as the expenditure approach, the output (or production) approach, and the income approach.


 

the photo portrays the 3 methods used to calculate the GDP of an economy namely: the expenditure approach, the production approach and the income approach.

GDP Calculation Approaches


  1. The Expenditure Approach

 

The expenditure approach, also known as the spending approach, firstly calculates the spending carried out by the different groups that actively participate in the economy. The Indian GDP is primarily measured based on the expenditure approach. 

The GDP can be calculated using this approach by the following formula:

 

 GDP = C + G + I + NX 

 

where C=consumption; G=government spending; I=Investment; and NX=net exports, all these activities are attributed to the GDP of a country.

 

  • Consumption in the above formula refers to consumer spending or private consumption expenditure. Consumers spend money to monopolize goods and services, such as groceries and beauty treatment. Consumer spending is the biggest contributing component of GDP, accounting for more than two-thirds of the Indian GDP. Consumer confidence, therefore, has a very significant effect on economic growth. 

 

On a scale a high confidence level indicates that consumers are willing to splurge money on goods and services, while a low confidence level reflects reluctancy about the future and an unwillingness to spend.

 

  • Government spending mentioned in the formula represents government consumption expenditure and gross investment carried out under government’s name. 

 

Governments need to spend money on equipment, infrastructure, and payroll. Sometimes government spending may become more prominent in a country's GDP when consumer spending and business investment both are taking a hit.

 

  • Investment refers to capital expenditures or private domestic investments. Businesses need to spend money in order to invest in their business activities and hence grow their business. 

 

Business investment critically contributes to a nation’s GDP since it helps in increasing the productive capacity of an economy and also generate more employment opportunities.

 

  • Net exports is the calculation that involves subtracting total exports taken place from total imports taken place (NX = Exports - Imports). 

 

The goods and services that an economy produces and is exported to other countries, less the number of imports that are purchased by domestic consumers of an economy, represents a country's net exports. 

 

All expenditures used by companies located in a certain country, even if the companies are foreign, are included in this calculation.

 

 

  1. The Production (Output) Approach


The production approach is actually the reverse of the expenditure approach as it measures the input costs that contribute to economic activity while the production approach estimates the total value of economic output and deducts the cost of goods that are consumed during the process (like those of materials and services) from it. 

 

Whereas the expenditure approach extends forward from costs, the production approach retracts steps from the point of a state of completed economic activity.

 

 

  1. The Income Approach


The income approach represents a kind of middle landmark between the above two approaches for calculating GDP. 

 

  • The income approach involves calculating the income earned by all the leading factors of production in an economy, including the wages received by labor, the rent earned by land mortgaging, the return on capital in the form of interest, and corporate profits. 

  • The income approach tends to make some adjustments for those items that do not contribute as payments made to factors of production. For an instance, there are some taxes—such as sales taxes and property taxes—that are regarded as indirect business taxes. 

  • In addition, depreciation–a buffer that businesses keep aside to account for the replacement of equipment that tends to wear down due to rigorous usage, is also added to the national income. All of these payments and finances together constitutes a given nation's income.

 

 

Advantages of GDP

 

  • It is easily the best indicator of development in terms of how broad it’s reach is and also the expenditures that it covers.

  • It is very easy to measure GDP in terms of percentage and it also forms a very reliable source of information when comparing with one's previous years GDP and with other countries.

  • As the calculations methods are used all over the world by countries to calculate their economies, so it can be regarded as a universal safe indicator.

  • It is a good way for governments to know whether economic policies have been successful or not, and to what extent they have or have not been.

  • It is a cheap method in comparison and also the process of collection of data is easy which makes it working smoothly and non-troublesome.

 

 

Conclusion

 

The various advantages tell us why GDP is the better method for calculating economic development. Despite these laurels under the method’s belt, it has been criticised for not being able to measure quality of life, standard of living and even political freedom among many others.

 

(Recommended blog: 4 types of Elasticity)

 

This just proves that no method comes with a cent percent guarantee of being accurate but still GDP is a very effective method and in terms of finance and economic growth it might even be the best.

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