Gross domestic product
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Gross Domestic Product (GDP) is a macroeconomic concept used to measure the total values of all goods and services produced by a country. Despite limitations, it is a fundamental tool in understanding economics.
Estimating the total output of a nation or region is not new. In the 1600s Sir William Petty made early attempts to aggregate different aspects of the British economy. Over the centuries as economics and statistics became more disciplined and formalized better measures were developed. In the 1930's economist Simon Kuznets made several estimates of the national income of the United States for Congress to ascertain the depth of the Great Depression. In the mid 1940s Gross National Product(GNP) was developed and used as an important tool in managing, understanding, and harnessing national resources for the war effort. Over the rest of the 20th century measuring national income become more standardized and has been adopted by most nations and a number of international bodies. In 1991 the United States switched from measuring GNP to GDP.
Calculations and Components
Where C refers to consumption, I to investment, G to government, X-M to foreign trade, and Y to final output.
There are some important aspects of what is not included in most measures of national output.
- Some financial goods: GDP does not include the buying and selling of certain financial products like stocks and bonds. These represent transfers of ownership, not the creation of new value.
- Resales: Selling a used car does not count towards GDP, it is seen more as transferring ownership, not the creation of any new value. Additionally, the value of most resale items are lower than at initial purchase.
- Transfer payments: Government transfers like Social Security are also not included. Taking money from one person and giving it to another doesn't impact total spending. When the Social Security recipient does spend their money, this does add to GDP. Some slightly more complex formulations of GDP include taxes and transfers.
- Bads: Bads(as opposed to goods) refer to black and grey market items associated with crime and destruction. Drugs, prostitution, gambling, and illegal weapons are not counted. In part because they are hard to keep track of, but also because of their often destructive impacts of human health and society.
- Intermediate goods: In order to avoid double counting, GDP only measures final sales. Intermediate goods in a supply chain are not counted towards it. In each step towards the final sale, they represent value added.
Consumption, or "C", refers to the type of normal household spending most people engage in. Clothing, food, electronics, and medicine are all parts of consumption. In developed nations like the United States consumption often comprises the largest share of GDP.
Investment(I) refers to spending undertaken by firms. Investment can be thought of as spending intended to produce more output later, or deferred consumption. A factory owner may forgo his or her current consumption and install new equipment that produces more output, yielding a higher income for even more personnel consumption later. In addition to new equipment, inventory is also included. In developing nations like China investment often takes up an enormous share of national income.
Government spending in an economy is referred to as "G" and represents purchases made by the state. Government spending is typically a mixture of consumption and investment. During recessions Keynesian economists often advocate increasing G to offset declines in C and I.
The foreign trade of an economy, or "X-M", measures the impact of international trade. X, meaning exports, are thought of as supporting domestic employment. M, or imports, are seen as supporting foreign employment. If a nation has a trade deficit, the effect of X-M on GDP will be negative.
There are some slight, but important modifications often made to GDP.
- Inflation: In order to make comparisons meaningful over time, national income accounts are adjusted for changes in the price level. These measures of national income are known as Real GDP. Unadjusted series are referred to as Nominal GDP. If the price level rises by 10%, nominal income will rise, even if real output falls by 5%. Real GDP adjusts for this and shows that the economy actually contracted. The equation for real GDP is as follows
Where NGDP is nominal GDP, P is the price level, and RGDP is real GDP.
- Population: Because population growth often coincides with economic growth, economists like to adjust total output by measuring it against the population. If an economy grows by 5% but the population by 10%, GDP per person has shrunk. GDP per Capita is the commonly used phrase and is calculated by simply diving total GDP(Y) by the population(P).
- Hours Worked: Occasionally GDP will be measured in terms of hours worked. This is done as a means to measure productivity. If two nations have populations that work the same number of hours but differ in total output one probably suffers from lower labor productivity.[note 2]
- Purchasing Power Parity(PPP): A commonly used technique to compare GDP between nations using the prices of similar goods in different locations. In theory the price of a good in two locations should be the same, assuming no transportation costs or tariffs. Suppose the UK has a per capita income of £100 compared to the USA where it is only $80. If the same shirt is $5 in the USA and £7 in the UK then the exchange rate would be 1.4 British £ per US dollar. Americans actually have greater purchasing power, at least for this shirt. Regarding shirts, the UK only has about 71% of the purchasing power as the USA, and a PPP adjusted GDP of about $71.43. PPP adjustments in the real world use much larger baskets of goods to avoid potential biases.
Some Useful Equations
GDP levels are important but so are growth rates. There are two main ways to calculate GDP growth.
- Year to Year: Subtract the initial period(p1) in which GDP was measured from the current period(p2). Divide this by the initial period(p1) to find the rate. Multiply the rate(r) by 100.
- Compounding: Divide GDP in the later period(Y1) by the earlier period(Y2). Take this to the power of the number of periods(n) in question. Subtract 1 and then multiply this by 100.
GDP is a crucial tool in assessing the economic health of a nation. Most references towards economic growth are referring to GDP. As an indicator of economic success, it plays a vital role for both monetarists and Keynesians in assessing the performance of macroeconomic policies. Falling GDP is often accompanied with unemployment, deflation, and declining consumption. In the United States the Congressional Budget Office measures if the economy is at, exceeding, or below capacity. Essentially they want to see if GDP is as high as it could be with all resources fully mobilized. The production possibilities curve is another way in which economists conceptualize if an economy is operating up to its potential. GDP has a number of postive attributes that make it popular.
- Simplicity: GDP is a fairly straightforward concept that addresses a simple variable, spending. Because of this, it is easy to compare across nations and over relatively long periods of time.[note 3]
- It measures value: As economies mature more consumption is devoted to things like services(surgery, piano lessons, massages, consultancy) and not easily recorded physical items. Simply measuring physical output may be misleading as productivity rises people may not to buy as much energy. As a rule of thumb people spend on things that give them value, so an increase in spending often means consumption of what gives people value.
- Correlations with other indicators: Though not perfectly, GDP does track things like life expectancy, employment, crime, and even happiness.
- As a comparative indicator: GDP is frequently compared with things like national debts and deficits to keep them in perspective. A high national debt or deficit may seem bad, but if the overall economy is large and projected to grow at a reasonable rate, this may make the debt more manageable. During WW2 national income was an important tool in recording, utilizing, and mobilizing resources. Understanding the components of GDP by industry are often useful(ie. what percent of the economy is going to healthcare).
A number of prominent institutions keep estimates on GDP for different nations.
Starting in the late 1980s and early 1990s economists and governments began moving away from GNP and towards GDP. GNP refers to Gross National Product, a concept similar to GDP.
GNP refers to the total output of a nation and its citizens, so output that takes place outside its borders is included while production associated with foreign firms within its borders is excluded. Using this measures a nation like the United States, with enormous amounts of foreign investment, has a higher GNP than GDP. A developing nation like Vietnam, which hosts a large amount of foreign investment, but with little of its own, would see that its GNP is smaller than GDP. Because of the rapid increases in globalism in the early 1990s with the fall of communism and opening of improved international supply chains, measuring domestic output is generally seen as a better measure of welfare. Some institutions still keep track of GNP, although it has largely fallen out of favor.
Criticisms and Limitations
GDP has been criticized by a number of people, including some economists. Criticisms often point to over reliance on GDP and aspects of human welfare it doesn't measure. Most economists recognize the deficient aspects of GDP and use a number of variables when grading economies.[note 4]
Things Not Measured By GDP
- Household production: The value added by homemakers and household work is not counted. Hiring the services of a nanny or maid is counted toward GDP, doing the same work yourself is not. The fruit you pick from a fruit tree on your own yard certainly gives value, but it is not counted either.
- Leisure: GDP does not measure leisure. Leisure may be of greater value than consumption, so a slight fall in consumption may reflect more vacationing. If the average worker puts in more hours, and average output goes up only marginally, this may not really be a major improvement in utility.
- Changes in quality: GDP on its own doesn't tell us what people are buying. Measuring the added value of new products like computers, insulin, or exotic pets is missed by the nominal data. This is somewhat offset by measuring real GDP because most price indexes try to adjust for the value of quality and new products.
- The environment: One of the most important "missed" aspects of GDP is the environment. Big gains in GDP may improve welfare in some areas, but environmental damage can have seriousness negative effects on human health. The damage done by pollution or garbage can be difficult to quantify. How much do people value a clean environment, and how do we account for that as a measure of well being? GDP has no obvious way to reconcile these issues.
- Fixing broken windows: This is something GDP does measure that is not obviously good. If your $500 tv falls of its stand and gets smashed in an earthquake and you buy a new one this adds to GDP. Both growth rates and income levels are up, but you are no better off than before. You spent $500 dollars to maintain your present welfare instead of using the money for something new to add to it.
Critics of GDP have argued for heavily modified versions of it or completely different measures of welfare. Amongst many, these include the Human Development Index, OECD Better Life Index, Genuine Progress Indicator, and Gross Sustainable Development Product. While these indexes may have certain advantages over GDP, most are much more complicated and require keeping track of many different variables to compute.
Some people have gone beyond pointing out GDP's limitations and accused it of being an essentially meaningless indicator. This often includes heterodox economists, such as those associated with the Austrian school. In general, because of its correlation with things like health, longevity, and education, most mainstream economists are hesitant to simply reject it.
- National Income Accounting
- Net Domestic Product
- Gross National Income
- Gross Domestic Income
- Net National Income
- Conversely, income approaches aggregate things like wages, salaries, rent, interest, and profits.
- It is also possible that other factors could impact differences in GDP per hours worked. If global oil prices are high commodity producers as diverse as Norway, Saudi Arabia, and Equatorial Guinea could see a big boost in GDP per hours worked not because of gains in productivity but because of high demand for energy.
- Comparing GDP over very long periods of time is however, more difficult, although economists like Angus Maddison have attempted it.
- Those variables being things like income equality, household income, health, education, and intergenerational economic mobility.
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