Gross Domestic Product (GDP): Meaning, Formula & Calculation

Gross domestic product (GDP) in economics is the monetary value of all the finished products and services produced during a specific time period. It is a broad measure of a country’s domestic production. Therefore, it serves as a gauge of a given country’s health. In other words, GDP measures the value of a country’s economic activities. It is a vital concept of national income (review my previous article on national income)

Even though government calculates GDP annually, they can also calculate it quarterly. It gives a picture of a countries economy, helping to estimate the size of an economy and its growth rate. It is a vital tool that guides policymakers, investors, and businesses in taking strategic decisions.

What is gross domestic product (GDP)

As we all know, GDP is the total monetary value of all goods and services that residents of a country produce within one year.  Irrespective of whether these residents are citizens or foreigners, these finished products in the country are included.

We can explain the gross domestic product in the following simplified ways;

  • The figures of GDP show the value of a country’s output in its local currency.
  • GDP tries to capture all the final goods and services which a country produces within a specific period of time. It gives assurance that the final monetary value of everything that a country produces is represented in GDP.
  • We can calculate it either annually or quarterly

Components for Analyzing GDP

In calculating a country’s gross domestic product, we involve all the private and public consumptions, government cash transactions, investments, construction costs, etc. In essence, we have to calculate the market value of all finished products and services in order to determine the GDP. It is the sum of consumer spending, investment, government purchases, and net exports. We can express these components in a formula (the expenditure approach).

Y = C + I +G NX     Where

Y = GDP

C = Consumer spending

I = Investment

G = Government spending/purchases

NX = Net exports.

There are basically five components of the gross domestic product as expressed in the formula above. They include;

  • Private consumption
  • Fixed investment
  • Government purchases
  • Net exports
  • Change in inventories

Consumer spending (C)

Also known as Consumption is the total expenditure by individuals and households on both durable and nondurable goods and services. It is anything individuals or households would use their money to buy. It does not include purchasing a property. Examples include food, clothing, shelter, and healthcare. It makes up the largest part of the gross domestic product calculation.

Investment (I) (Fixed investment)

This is the total expenditure on inventories, capital equipment, and structures. This includes investments in equipment and materials by a business. We do include properties that households purchase since individuals purchase houses on loan, that is, most households do not pay all cash for property beforehand. Purchasing stocks does not count in this description of income, they are considered savings. Examples include housing, plants and machinery, unsold products, and businesses buying new computers for their employees.

Government spending (G)

Otherwise known as government purchases or government consumption. It is the total expenditure that all government bodies make on goods and services. In other words, it is the total goods government has spent money on, any physical product. Examples include salaries to government employees, naval ships, construction costs, and panes. It does not include payments on programs like social welfare and social security.

Net exports (NX)

Net export describes the difference between foreigners’ spending on domestic goods (exports) and residents’  spending on foreign goods (imports). Exports are goods produced within a country and sold to other countries. Imports are goods produced in other countries and sold into a country, that is a country’s purchases from other countries. We have to subtract the imports from the exports in order to arrive at the net exports, otherwise, foreign production will be counted as domestic supply.

Change in inventories

Inventory change is the difference between the previous inventory total and the current inventory total, usually yearly. We use the concept to calculate the cost of goods sold and to review proper inventory management.

Types of gross domestic products (GDP)

There are three basic types of gross domestic product which include the real GDP, the nominal GDP  books, and the per capita GDP. Others added the Net GDP to the types of GDP which constitutes the fourth type. We shall explain them in detail.

A) Nominal GDP

Nominal GDP is a country’s production which includes current prices in the calculation. We record goods counted under nominal GDP based on the actual sales price of that year. Economists value GDP either in local currency or at foreign exchange rates. The aim of evaluating it at a foreign exchange rate is to compare the GDP of different countries in financial terms. We use nominal GDP when comparing the GDP between different quarters of output in the same year. While comparing it between different years, real GDP is used.

This is because removing the impact of inflation allows the comparison between different years to focus purely on the volume. Nominal GDP includes every change in market prices that occurs in the current year as a result of inflation and deflation. That means there is an adjustment for changes in the price level to reflect the real output. We derive the results after multiplying the quantity output of the current year by the current market price.

B) Real GDP

This is a calculation that is adjusted for inflation. It reflects the number of goods and services which an economy produces in a given year with prices held constant from year to year. This is to separate the influence of inflation and deflation from the output trend over time. It is the measurement of economic output that accounts for the effects of inflation and deflation. We calculate the prices of goods and services at a constant price level. Because GDP emphasizes the monetary value of goods and services, inflation is inevitable. The rise in prices may seem to increase a countries GDP, but this may not reflect any change in the quality or quantity of products and services produced.

Nominal GDP does not give a clear picture of whether a figure has risen due to real expansion in production or due to a price rise. The real GDP provides a more accurate economic growth assessment than the nominal GDP. A nominal GDP will make it look as if a country is producing more only when prices have risen. As earlier stated, a real GDP takes into account changes in the price level. It provides an avenue for the comparison of GDP by year because it takes into account inflation. It indicates where an economy is in the business cycle. To ascertain the trend of real GDP helps an economy to prepare for recessions and make good financial decisions. We calculate the real GDP by dividing the nominal GDP by the deflator, thus;

R = N/D    Where

R = Real GDP

N = Nominal GDP

D = Deflator

What is the Gross Domestic Product Price Deflator

The GDP deflator, also known as implicit price deflator or GDP price deflator measures the changes in the price of all products and services in an economy. It helps to compare the performance of an economy yearly, that is from one year to another. It is a more detailed measure of inflation than the Consumer Price Index (CPI).

The US Bureau of Economic Analysis (BEA) stated that the GDP price deflator is “a measure of inflation in the prices of goods and services produced in the United States, including exports. The GDP price deflator mirrors the GDP price index, although they are calculated differently”. They also pointed out that “the GDP deflator is used by some firms to adjust payment in their contracts”.

It is therefore the average of the prices of all goods and services included in GDP. It is a price index used to convert nominal GDP into real GDP. Most economists prefer the price deflator because it is the widest measure of inflation. It helps to show how much prices have risen over a specific period of time. Therefore it measures price inflation or deflation with respect to a particular base year.

The formula for calculating GDP price deflator is;

Deflator = Nominal GDP⁄Real GDP × 100

GDP Deflator Vs Consumer Price Index (CPI)

GDP deflator measures the price value of a country’s aggregate economic output while CPI measures only the value of goods and services which consumers bought. Deflator measures only the goods produced within the country with the exception of import, while the CPI includes goods which consumers Import. In measuring inflation, the GDP deflator is more comprehensive than the CPI.

Real GDP Vs Nominal GDP

While the effects of inflation distort nominal GDP, real GDP corrects the distortion by removing the effects of inflation. Nominal GDP compares the GDP between different quarters of output in the same year. While comparing it between different years, real GDP is used. Economists evaluate real GDP at the market price of some base year, while nominal GDP is evaluated at current market prices.

 

C) Per capita GDP (GDP per capita)

When we talk about per capita, it means measuring GDP per person in the population of a country. It shows the estimated amount of output per person. This means that it shows the average living standard in an economy. We can state GDP per capita in form of either real or nominal terms. It shows how much the value of economic output can be assigned to each individual. GDP per capita seems to be a more traditional measure of GDP, it measures a country’s GDP with respect to its population. It is important in analyzing how each factor contributes to the overall output of the economy. A country that has a small population but a high per capita GDP shows that there is a self-sufficient economy. In other words, such a country has abundant special resources and uses them more efficiently.

D) Net GDP

Net GDP  is also known as the net domestic product (NDP). It is the yearly measure of a country’s economic output which comes about after subtracting depreciation. In other words, it shows the net book value of all products within a country during a specific period. A widened gap between GDP and NDP is an indicator of economic stagnation.

How to calculate gross domestic product

There are different ways in which economists calculate a country’s GDP, theoretically, they should produce the same result. In the course of explaining what is GDP, I stated the GDP formula. We shall look intensively at the various ways of calculating GDP.

Expenditure: This is the value of everything purchased within a country including the country’s net exports to other countries.

Income: Also called domestic income, is the income of all individuals and businesses within the country.

Production: This is the market value of all country’s products, that is the economic output.

Calculating Gross Domestic Product using the expenditure approach

The formula says thus;

GDP = Consumption (C) + Investment (I) + Government Spending (G) + [Exports (E) – Imports (I)]   Otherwise stated as;

Y = C + I + G + NX (as earlier stated in the beginning)

NX = X − M

NX = Net exports

X = Exports

M = Imports

This approach is based on the ideology that all finished goods within an economy have to be purchased by someone. The approach concludes that the producer is the buyer of unsold goods.

The above components have been explained earlier.

Calculating Gross Domestic Products using the income approach

Using the income approach, the formula for calculating GDP is expressed as;

GDP = Compensation of employees + Gross operating surplus + Gross mixed income + (Taxes − Subsidies on production and imports).

Compensation of employees

This is the total payment made to all employees and laborers, it also includes welfare payments such as social security.

Cross operating surplus

These are the profits of incorporated businesses. Most large businesses with many employees are incorporated.

Gross mixed income

These are the profits of unincorporated businesses. Most small businesses with few employees are unincorporated.

Calculating Gross Domestic Product using the product approach

This approach accounts for the value of the aggregate domestic output (the value-added to the entire domestic output). We obtain our value-added by taking the price which the seller is selling the products and subtracting it from the price which the seller purchased from the supplier.

In measuring Gross Domestic Product, the three methods mentioned above should arrive at the same result. However, there are slight differences between them. The discrepancies (inconsistency) in the raw statistics used in the calculation are the reasons for these slight differences.

Making adjustments to Gross Domestic Product

Economists make adjustments to Gross Domestic Products in order to improve the importance/usefulness of the figures. GDP discloses an economy’s size but provides less information about the standard of living of that country according to economists. One of the reasons is that the size of the population and the cost of living in the world are not stable. For example, comparing the GDP of the USA and that of Russia will provide less meaningful information about their real standards of living. This is because their populations differ, one definitely has more information than the other.

In order to solve this problem, economists decide to use the GDP per capita instead, to compare the sizes of the economy. Dividing the country’s total GDP by the population makes it easier to check the performances of each economy. These figures then help to assess the standard of living in that economy.

GDP per capita does not account for the cost of living in a country. For example, if the nominal GDP in Iceland is $1000 while that of Russia is $10000. This does not necessarily show that the GDP per capita (average GDP) is ten times that of Iceland.

The purchasing power parity (PPP) tries to fill up this gap. This is through comparing the number of goods money can buy after adjusting the exchange rate of different countries to the same currency.

A real GDP per capita which is adjusted for PPP is a well-refined statistic figure which is capable of measuring true income. This is a very important tool for an economy’s wellbeing.

Giving the example above between Iceland and Russia, Russia is better off than Iceland in nominal terms. If the worth of food, clothing, etc., of Iceland, is trice that of Russia, then Iceland has a higher real income.

What is Purchasing Power Parity (PPP)?

Purchasing power parity (PPP) is a metric in the macroeconomic analysis used to compare economic performance/productivity and standards of living between countries. The economic theory compares the currencies of different countries through an approach called the “basket of goods” approach. Macroeconomic analysts popularly use the purchasing power parity (PPP) to compare the currencies of different countries through a “basket of goods” approach. It allows economists to compare economic performances/productivity and standards of living between countries. This forms the reason why some countries prefer to adjust their gross domestic product (GDP) figures to reflect Purchasing Power Parity (PPP).

The formula for calculating PPP is;

S =P1⁄P2   where

S = Exchange rate of currency 1 to currency 2

P1 = Cost of goods X in currency 1

P2 = Cost of goods X in currency 2

Uses of Gross Domestic Product

GDP is a measure of economic well-being, it serves as a tool that measures the overall size and health of an economy. This is because it measures the total monetary value of all domestic goods and services which a country produces in a given year. Comparing the figures with previous years whether an economy is expanding or contracting. When an economy produces more goods and services, it shows a sign of expansion, but less output signifies contraction.

GDP helps to closely monitor the growth rate of an economy. With this, economists report it in form of a percentage. Reporting of GDP is usually based on the real GDP in order to reduce or eliminate the effects of inflation.

Policymakers, government sectors, businesses, individuals, and economists lean on GDP to assess the well-being of an economy and make viable decisions. In making decisions on tax, trade, and interest rates, policymakers look to GDP. The rate of its growth affects investment decisions and business decisions and also determines the ease of employment. GDP statistics help governments and policymakers in shaping their policies and determining how much public spending is affordable. It helps economists in the course of their research.

The relationship between Gross Domestic Product and investment

A company needs to have sufficient funds for it to be economically viable. Economic viability enables a business to improve its capital structure. Normally, businesses will get these funds by issuing stocks. Capital investments are long-term investments that help companies generate revenue for several years. They improve their efficiency in operations and their production facilities. Investment in capital goods does not yield an immediate increase in revenue. Companies engage in research whenever they want to take new products to the market. This innovation leading to an increase in production boosts an economy’s GDP.

Improved capital goods help to increase productivity in labor because companies become more efficient and productive. The existence of new factories leads to higher and faster production. For instance, most new production facilities consume less energy and they probably house their equipment in a more energy-efficient environment. This leads to a lower cost of production at a faster rate higher profits.
When labor becomes more efficient in different companies all over the nation, it leads to accelerated economic growth. We definitely cannot separate growth in GDP and economic growth. An increase and efficiency in production lead to GDP growth. In essence, the emergence of new factories, lower cost of production, and faster growth in profit boost an economy’s GDP.

Because GDP provides a framework for a financial decision, investors take a close watch at GDP. On the other hand, foreign investors get attracted to countries with a high GDP because a high GDP is a parameter for economic growth. They invest in such countries due to the benefits they stand to get on the returns on investment. Investors have confidence in investing in countries experiencing economic growth and less confidence in low growth economies.

The limitations of Gross Domestic Product statistics

One of the greatest limitations of GDP is that it does not count environmental costs. That is the negative effects of industrial activities on the environment. A more accurate gauge of a country’s standard of living may include its environmental conditions. It does not reveal the externalities that can arise from producing or consuming a nation’s output.

Another limitation is that it does not include paid services such as social welfare and volunteer work which have a great impact on society. In other words, it does not include non-market transactions.

GDP fails to disclose the level of income inequality in an economy, that is, it does not clearly state who is poor and who is rich in the society. It also does not reveal the sustainability of economic growth.

It does not show the differences between the replacement of depreciated capital and the creation of new ones.

Conclusion

Gross Domestic Product as a gauge used to measure the health of an economy is vital to a country’s economic growth. That is, the economic output of a country can give you a picture of the economic state of that economy.

Currently, the GDP of the United States happens to be the highest with a nominal GDP at $20.81 trillion, per capita GDP at $63,051, and GDP (PPP) at  $20.81 trillion as of 2020. The US is the world’s richest country because it has the largest economy. It is an entrepreneurial environment that encourages hard work and has a favorable regulatory environment.

The GDP of China shows that the nation plays an influential role in the global economy with a nominal GDP of $14.86 trillion, per capita GDP at $10,389, and GDP (PPP) at $24.16 trillion.

Japan, Germany, and the United Kingdom followed suit. India happened to be the sixth-largest economy that has advanced technology and manufacturing mechanisms. The foreign direct investment flow to India has grown steadily. Some key government policies are favorable to the economy and these factors have facilitated GDP growth.

We will there see that the economic positions of these countries have little or no changes, even though they are bound to change in later years. Currently, the top 15 richest countries globally are the USA, china, japan, Germany, UK, India, France, Canada, South Korea, Russia, Brazil, Australia, Spain, and Indonesia.

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