Whenever we study the financial condition of our country, or when we see someone comparing the financial state of two countries, we often hear the term GDP. So, what's GDP?
Today, we'll explore this GDP, and how do we calculate it.
Before jumping right onto the topic, let's learn about few important terminologies.
Aggregate Output and Income
The aggregate output of an economy: the value of all goods and services in a period. Typically, is a one-year period
The aggregate income of an economy: the value of all payments earned by the suppliers of factors used in the production of goods and services. Few examples include the compensation of employees, interests, and profits.
Aggregate expenditure: it’s the total amount spent on goods and services produced in an economy during a given period
For a given period, Aggregate expenditure = Aggregate output = Aggregate Income
To illustrate it, let's see an example:
You can see this picture as,
Business firms provide income sources to households and, then the same households spend that income on business firms as expenditures.
The households provide labor and capital (can be thought of as a form of expenditure) to Business firms, and in return, firms provide goods and services (output) to them.
Gross domestic product or GDP
There are mainly two definitions of it –
with respect to the output and expenditure: GDP is the market value of all final goods and services produced within an economy over a given period.
with respect to income: GDP is the aggregate income earned by all households, companies, and governments over a given period.
We often compare the GDPs of two different countries. However, to ensure the comparisons sound legit and are justifiable, the following criteria are used:
Only count goods and services produced during the measurement period.
Count goods and services whose value can be determined by being sold in the market. For instance, government services like the police are not included because you can’t put a price on them.
Use the market value of final goods and services: To understand this, say BMW buys its glass windows from Company X and uses that to build its cars. Now, the final value of those glass windows sold by Company X will not be taken into consideration as they are being reused. Instead, the final value of the BMW car will be considered.
Calculating GDP
There are again two approaches here:
The income approach: computes GDP as the total income earned by households, businesses, and the government in a given period.
The expenditure approach: this approach is based on calculating the total amount spent on goods and services. This again divides into two parts
2.a: GDP computed through the sum of value added approach where we sum up the value created at each stage of production and distribution.
2.b: GDP computed through the value of final output approach where we add the values of all final goods and services produced during the period.
To illustrate both the parts, we will take an example here. Consider this chain of production here:
Farmer is selling wheat to the miller who then grinds it and sends it to the baker. Baker bakes a loaf of bread and sells it to the retailer, and finally, the customer buys the bread from the retailer.
Now, if we look at this table of receipts sent and the value-added at each stage by each component, we can calculate the GDP
2.a is calculated by adding the values added by the farmer, miller, baker, and retailer. Whereas, 2.b is simply the final/total product value created by all the individual components
Components of GDP
GDP components based on the expenditure approach
Consumer spending on final goods and services, denoted as C.
Gross private domestic investment, denoted as I.
Government spending on final goods and services, denoted as G.
Net exports (exports - imports), denoted as X – M.
Now, let's see how the different parts of the economy use these components?
Household: They either consume (C) the income or save (S) it
Business Sectors: They borrow the money from the financial markets and invest (I) that money.
Government sector: They collect taxes (T) and spend on goods and services (G).
External sector: refers to trade and capital flows from a given economy (E) to the rest of the world.
Let's have a look at how they add up together here –
GDP (based on the expenditure approach) is the area inside the dotted line
= C + I + G + (X – M).
This is the same as the sum of components mentioned above.
GDP components based on the income approach
GDP based on the income approach =
National income + Capital consumption allowance + Statistical discrepancy
Each part is briefly explained below -
National income = Compensation of employees + Corporate profits before taxes + Interest income + unincorporated business net income + Rent + Indirect business taxes less subsidies
Capital consumption allowance (CAA) = can be thought of as a measure of depreciation.
Statistical discrepancy = few errors that we face when we use different data sources to plug in values. We use this part in the formula to make GDP based on both approaches equal.
Personal income and Personal disposable income
We have added this part to understand few terms used in the blog till now.
1. Personal income: it's a broad measure of household income and measures the ability of consumers to make purchases.
Personal income = national income – indirect business taxes (eg. taxes that are often built into the price of a good or service like service tax, excise duty, value-added tax) – corporate income taxes (eg. Taxes to govt) – undistributed corporate profits (not paid to the investors as dividends but rather reinvested in the company) + transfer payments (eg. unemployment benefits)
2. Personal disposable income: Personal income – personal taxes
Nominal and Real GDP
For comparing the GDPs of multiple years, we would want to consider the output (in terms of revenue) in both the years and then compare it right?
The output formula we would be using is = price of one item * total volume
However, if the item price increases drastically in the future year keeping the volume produced the same, the overall output would differ. But we know that the price increase doesn't mean that the GDP is also increased. This is where Nominal and Real GDP come into play.
Nominal GDP: it values goods and services at their current prices. It doesn’t strip out inflation or the pace of rising prices, which can inflate the growth figure (the issue we discussed above). Hence, it is only used when comparing different quarters of output within the same year.
Real GDP: it measures current year output using prices from a base year, hence eliminating the inflation effect. For comparing the GDP of two or more years, the 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.
Eg: India is the second-largest producer of Rice. Say for simplicity, India only produces rice.
In 2019, one million kilograms of rice were produced at 50 bucks per kilogram.
In 2021, again one million kilograms of rice were produced at 100 bucks per kilogram.
Assuming 2019 as our base year. Let's calculate the nominal and the real GDP in 2021.
Nominal GDP = current price * output = 100 * 1mil = 100 mil
Real GDP = price at base year * output = 50 * 1mil = 50 mil
Note: To determine if the output has gone up or not, we use the real GDP.
GDP deflator: it’s a price index that can be used to convert nominal GDP into real by removing the effects of changes in prices. It can be calculated as:
GDP deflator = (Nominal GDP/Real GDP) * 100
Inflation rate: it can be measured by the change in the price level in the deflator. For instance, say in 2019, the price index was 125.53, and in 2020, the price index was 131.58.
The inflation rate can be calculated as = (131.58/125.53) – 1 = 4.8%
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