Definition
Gross Domestic Product (GDP) is the sum total of the value of all the final goods and services produced in an economy in a given period of time . The accounting period of GDP is one fiscal year. That is, we account the goods and services produced in a year in our GDP calculations.
Real and Nominal GDP
We have stated GDP as the ‘value’ of goods and services. This value is the money value. That means we multiply each quantity with its price to get the GDP. This is done because all goods and services have different units of measurement. To compute them in a common unit we convert them to money values through the price. When we compute the GDP taking the current prices of goods and services the GDP figure is known as nominal GDP .
Now it should be noted that when we compare the GDP for different years we can observe that the GDP has increased. But this increase can be more due to the rise in prices rather than the rise in the quantity of goods and services produced. Thus, from the nominal GDP we cannot understand by how much actual production has increased or decreased. To get the idea about actual changes in the output in the economy we use the real GDP figures. The Real GDP is the vale of goods and services computed at constant prices. We take a year as a base period. We then compute the GDP of every year taking that base year prices. Now we can compare the GDPs of different years to understand how production has changed in the economy as the GDP for every year is measured in the common base year prices.
Three Methods of Computing GDP
GDP can be measured in three different ways: Product method, Income method and Expenditure method. These three methods arise from the concept of GDP. The value of goods and services is the total of the value of all goods and services produced, Thus it is the total production in an economy. But this production gives rise to income of the people involved in production. Thus sum total of the income also gives us the GDP. This is income method. Again the income is spent on the goods and services. Thus the expenditures also give us the GDP. Let us discuss the three methods of measuring GDP.
Product Method of Measuring GDP: In the product method we identify the different producing units. Then we take the sum total of the goods produced by each unit. We convert them to money value by multiplying them with the price. But some of the goods are used by other producers to produce their goods. For example, wheat flour is purchased by us for cooking purposes but it is also purchased by the baker to produce bread. Thus it is an intermediate good to the baker and not a final product. If we compute the value of both wheat flour and bread there will be the problem of double counting as we have counted wheat flour twice. To avoid double counting we use the value-added method of computing GDP . In the value added method we deduct the value of the inputs from final value of each good and service. The first step in the value added or product method is to identify the producing units. We divide the economy into three sectors, primary secondary and tertiary. The primary sector produces goods directly from nature like agriculture and mining. The tertiary sector takes the materials from the primary sector to produce goods. These are the industries. The tertiary sector mainly includes services like banking and insurance. It also includes infrastructure. The next step is to calculate the value added for each production unit. The sum total of the value added for all production units in the economy gives us the GDP.
Income Method: The factors involved in the production of goods and services receive income. Thus this income involves the value of production as each factor has to be paid for its contribution to production. This payment is the cost of production which is reflected in its price. Thus the income of the factors of production is equivalent to the value of goods and services produced. The factors of production are land, labor, capital and entrepreneur. The four factors earn four types of income. Land or property owner earns rent, laborers and white collar employees earn wages and salaries, the investor earns interest and the entrepreneur earns profit. Thus income method is the sum of rent, wage, interest and profit. In the US economy five categories of income are identified :
Compensation to employees
Proprietor’s Income
Rental Income
Corporate profits
Net Interest
Thus the sum of these incomes gives us the GDP.
Expenditure Method: The total production or income can also be viewed as the expenditure on goods and services. The final production is used by the economy and the people in the economy incur expenditure in purchasing these goods and services. Thus if we add the expenditures we arrive at the value of goods and services. The four components of expenditures are :
Consumption Expenditure ( C )
Investment Expenditure ( I )
Government Expenditure that is government purchases of goods and services ( G )
Net exports of goods and services ( Exports-Imports) NX
Thus we can write GDP ( Y ) as:
Y = C+I+G+NX
Money Transactions not included In GDP
In the GDP accounts we only consider currently produced goods and services and final goods and services. We only include those transactions that involve productive activity or that which contributes to the total production in the economy in the current accounting year. Thus some money transactions are excluded from the accounts. These are:
Purchase of used/second-hand goods.
Transfer payments like government compensation for social security, unemployment benefits etc.
Purchase of intermediate goods
GDP as a measure of Standard of Living
GDP tells us the total amount of goods and services produced in an economy or the total income earned by the people in the economy. Thus a country with a higher GDP has a higher amount of goods and services or output produced. Thus the people of the economy earn higher income than the country with a lower GDP. Thus the country with a higher GDP enjoys a higher standard of living. It should be remembered in this context that the standard of living depends on the population as well. Thus per capita GDP is a better measure of standard of living as it considers the population of the country.
Problems of Using GDP as an index of Standard of Living
A country with high GDP but huge population will not enjoy a higher standard of living compared to a country with slightly lower GDP but low population. Thus per capita income or GDP divided by population is the better measure.
We should also note that GDP is only a quantitative measure. It does not consider the well being of the people in terms of health, education and environmental standards. Thus real GDP is not an ideal measure of standard of living. A country with high GDP can have widespread poverty, large inequality in income, malnutrition among the masses and lack of education. Thus to compare the standard of living or well being of a nation we should use other qualitative and comprehensive measures.
References
Banerjee, A., & Mazumdar, D. (2010). Principles of Economics. Kolkata: ABS Publishing House.
Mankiw, G. (2013). Macroeconomics. Macmillan.
