Every business organization wants to know about the economic growth so as to determine the fate of the product or services rendered by the organizations. It is a very important part of doing a business. Knowing the economy helps deduct the factors like the demand of a product, increase or decrease in demand, etc. Every big company makes big decisions based on these kinds of factors. Measuring GDP gives the stats about economic growth and the current economy of the country.
Various countries have various economic structures, which is generally measured by the Bureau of Economic Analysis. The analysts here measure the growth rate and GDP of an economy. This helps business organizations to recognize the potential of an investment if the economy will grow or how to contain the issues if an economy is predicted to go downwards. Here you will learn all about the Economic Growth and GDP along with its various usages and why measuring GDP of a country is so important.
Gross Domestic Product or GDP
In this portion, you will find GDP’s definition and the definition will be clearly described for you to understand it clearly along with calculating it and why it is so important for a country.
Gross domestic product or GDP is market value of services and goods which are manufactured in a country within a given amount of time. It can be classified into four divisions:
1. Market Value of services and goods.
2. Final services and goods
3. Production of services and goods within a country.
4. Time Period.
Now each of this part is explained below in detail.
Market Value of services and goods
Market value is the cost at which goods or services are sold in a market. For example, if cost of a banana is 10 cents, the market value of the banana is that. Now to measure the total production in a country, we need to be able to count the total production of goods that is produced. Like for example, corn, banana, mobiles, laptops, apples, etc. But only counting goods will not get us a clear picture. This will not tell us about the greater or lesser produced goods.
This is solved by measuring GDP. GDP values the items at the price they are sold in a market. For example, if 1 banana is sold at 10 cents then 100 bananas market price is 10 dollars and if 1 apple cost 5 cents then 100 apples will cost 50 dollars. So we can now add the total price of both the items and value the production.
Final services and goods
Final services or goods are the finished product that is used by a user. It is different than the intermediate goods which mainly is used in the finished final product. Intermediate goods are thing or parts which are used to complete the final products or services. An intermediate product example is tyres used in cars and motorcycles. The tyres are fitted in a motorcycle or vehicle which then becomes a finished product or goods. Similarly, bricks and cement are intermediate goods which are used in the completion of a building which is the final products.
There are products which can be finished or intermediate goods depending on its usage. This means a good can be classified and used as both a finished goods and an intermediate good. For example Wine, if wine is used in cooking a dish it will be regarded as intermediate goods. But if the same wine is served as a drink for people to consume, it will be regarded as a final product.
If we want to calculate GDP, then we do it on the final services and goods produced. We don’t calculate GDP on intermediate services and goods as this will give us a wrong information cause then we will be counting twice once for the intermediate commodities and services and then again for the finished final services and goods. For example, the worth of a bicycle already includes the price of intermediate goods like the tires, so counting it twice will give us extra reading when the production amount is same.
Apart from final or intermediate goods, there are products which are not final or intermediate in nature. Examples of goods like this are: shares, stocks, used products that is second hand products like vehicles, phones, laptops, etc. These second-hand goods were calculated in GDP of the year they were made and sold in the market.
Production of services and goods within a country
The final services and goods can be counted as GDP if the production of those commodities and services were manufactured in that country. It might happen that a company is of USA but its products are made in Japan, so this company’s products will be counted as Japan’s GDP and not USA. For example, Volkswagen is a German company but the cars which are produced in India will be calculated in India’s GDP and not Germany’s.
Time period is referred to the time with which final goods are produced. Here. The GDP measures value of a product in a given period. The data in a year maybe quarterly observed, and calculated or done annually. These are called quarterly or annual GDP data. Other than the worth of production, GDP also measures the total amount of expenditure and total earning. It is very important to calculate total expenditure and earning as this gives us a detailed report of the productivity and the standard of living of a place or country. The standard of living, income, etc. are all connected to each other. It means that the standard of living of a country can only rise if the income of that country raises which in turn helps to buy more goods and services. And since the demand for commodities and services rises, the supply to meet the needs should rise which means more production of services and goods.
To understand this we will study the chart below which shows circular flow of income and expenditure.
Circular Flow of Income and Expenditure
Circular flow of income and expenditure is linked to each other. The economy consists of several parties, the Government, Households, Firms and rest of the world also in a way is linked to the economy of a country which in turn creates circular flow of income and expenditure.
Let’s start with the Government part of economy and then we will go through the rest.
1. The Government
Government has government expenditure that is buying services and goods from the firms. The taxes are not part of circular flow of expenditure but expenditures of government is financed with taxes. A lot of financial expenditure is done on households too, in the form of benefits like if unemployed, social security, paying subsidies, etc. But like taxes, these are not counted in circular flow of income and expenditure. This is how the government contributes to the economy of a country.
2. Firms and Households
Households sell the services of labour, land and capital in the market. And the firms buy these factors from the household and pay the households for using these factors of production, like wages for the labour involved, interests on capital they use and rent it for usage of land. Profit goes to another factor that’s the business organization who used all factors of production in order to gain profit.
A portion of the earning is kept by firms that is the profit, this is not distributed by the firms to the household is kept under the household sectors earning. Firms sell consumer services and goods to the households and the households buy these services and goods for consumption like food, grooming products, etc. The total payment that is made by the households to the firms for using these services and goods is called consumption expenditure.
Capital equipment is traded in a market by the firms like vehicles, electronics, etc. but not all products are sold by the firm. Some stay in the inventory of the firm. For instance, if a firm produces 100 laptops and sells 80, the unsold 20 goes to its inventory which increases the number of products in the inventory of the firm. This is in the case of finished products. The products like a new place, or a new piece of machinery, etc. which will be used and is an addition to the inventory is regarded as investment.
3. Rest of the World
Companies sell and buy a lot of products from all over the world. It’s called import and export. Import is when services and goods are bought from rest of the world and export is when services and goods are sold to rest of the world. To get net exports, value of exports has to be subtracted from the value of imports. Net exports can be positive or negative. For example, net export is positive if the net flow of services and goods is from the firms in USA to rest of the world. And it is negative if the net flow of services and goods is from the firms of rest of the world to USA.
All the above factors are linked and affect in one way or another in circular flow of expenditure and income.
GDP measured in 2 ways (Expenditure and Income)
Here Gross domestic product or GDP can be measured in 2 ways:
A. By calculating total expenditure on services and goods, or
B. By calculating the total income which is earned by the production of services and goods.
The total expenditure is also known as the aggregate expenditure. It can be stated that Aggregate expenditure is the amount of expenditure by households when consumed services and goods plus the net exports plus the government expenditure plus investment by firms. The total amount which is paid for the factors of productions’ services (rent, wages, etc.) for the final products is the total aggregate income.
See the example below to understand the aggregate income equals aggregate expenditure:
A= Firms pay income to household
B= Households’ consumption expenditure
C= Firms’ Investments
D= services and Goods bought by the government
E-F= Net exports bought by rest of the world
Companies pay out as incomes because what they receive from the sale of services and goods the aggregate income equals aggregate expenditure.
A= B + C + D + E – F
Below in the table, you can see the USA’s data for the year 2010 of income and expenditure:
Billions of dollars in 2010 B= 10,285
This shows aggregate expenditure is equivalent to aggregate income.
Why GDP is called ‘Gross’ domestic product?
Domestic product is called ‘gross’ because it is the amount of the capital before deducting its loss of value or depreciation. It’s same as the gross salary, it is the amount before the deduction of taxes, PF, etc. Net domestic product stands for the capital which is used over the year. The NDP is GDP minus the depreciation on a country’s capital goods.
Depreciation is the deduction in the value of services and goods over a period of time due to some kind of degradation in the services and goods. Net investment is the amount spent by a firm or a country on capital services and goods which we can get by subtracting depreciation from gross investment.
Net Investment= Gross Investment – Depreciation of Capital assets
For example if you buy 3 Nutella Jars, throw 1 old Nutella Jar because it went bad then you’re ‘Gross Investment’ is the price of the 3 new Nutella Jars you bought, your Depreciation would be the value of the 1 Nutella Jar you threw away and your Net Investment would be the price of the 2 Nutella Jar.
In the expenditure method to measuring GDP gross investment is added so the total output is the gross measure. And in the income method of measuring GDP gross profit is included and again it gives us a gross measure. This is why it is called Gross Domestic Product.
Measuring USA GDP
You already know that gross domestic product is measured by two way:
A. The Expenditure method
B. The Income Method
Both these methods are used as total production equals total income and expenditure. Below, how to measure GDP with this two methods are explained in detail.
The Expenditure Method
In this method GDP is measured as expenditure through consumption(B), Investment (C), services and goods bought by the government(D), net exports(E-F) and it will be equal to the GDP. Below in the table as an example, the Expenditure method will be given.
Particulars Signs Amount in Billions(2010) GDP Percentage
Expenditures through consumption B 10,285 70.5
Gross domestic investment C 1,842 12.6
Services and Goods
Bought by Government D 2,991 20.5
Net exports E–F –539 –3.7
Gross domestic product A 14,579 100.0
In 2010, GDP measured by this method was 14,579 billion dollars.
1. Expenditure through consumption is the amount spent by American households on services and goods. These include everything from material goods that is things like furniture, alcohol, guns, books, toys, etc. and services like medical and legal advice, banking, etc.
2. Generally, gross domestic investment refers to the addition to the existing inventories of new equipment, machineries or buildings, etc. by firms. Investment on new homes also comes under this column.
3. Services and Goods bought by the government which means the expenditure the government makes on medical benefits, military, infrastructure, etc.
4. Net exports are the ultimate net value which we get after deducting value of imports from value of exports. For example, USA sold weapons to a different country which is an export, buying electronics from China is an import.
The Income Method
In this method, the GDP is measured by totaling the incomes that is paid by the firms to the households for services they offer. The households offer the services of factors of production and firms pay for that like wages for laborers, rent for land, interest on capital and profit for the entrepreneurship. Income can be divided into two major categories by The National Income and Product Accounts:
1. Employees compensation
2. Net operating surplus
Employees Compensation is the way through which a laborer gets paid for his or her services. This consists of net salary or net wages which are known as take home salary. This is what a laborer is able to take home after tax deduction, medical benefit, pension fund, etc.
Net operating surplus is a profit like measure that shows total incomes from all the factors after deduction. This is divided into four categories:
1. Net interest
2. Rental income
3. Corporate profit
4. Proprietor or owner’s revenue
Net interest is the amount of money received by the households due to the loans after deducting interest that households pay on their own borrowed loans.
Any amount of money generated and received as a payment for renting lands, equipment, etc. are classified as Rental income.
Income in the form of profits by the corporations, some of which is not distributed and some of which is paid as dividends to households are called Corporate profits.
Proprietor or owner’s income is the amount earned by owner of a business organization. This includes the profit, capital and any kind of labour he has given.
Particulars Amount in billions of dollar (2010) GDP Percentage
Employees’ compensation 7,929 54.4
Net interest 924 6.3
Rental income 299 2.1
Corporate profits 1,210 8.3
Owners’ income 1,050 7.2
Net domestic income at factor cost 11,412 78.3
Indirect taxes(less subsidies) 1,127 7.7
Net domestic income at market prices 12,539 86.0
Depreciation 1,860 12.8
GDP (income method) 14,399 98.8
Statistical discrepancy 180 1.2
GDP (expenditure method) 14,579 100.0
In 2010, the total GDP calculated was 14,399 billion. This amount is less than the GDP calculated by expenditure method. 1.2 percent of discrepancy is seen in calculating GDP. At factor cost GDP is same as Net domestic income at factor cost and we need to add indirect taxes subtracting subsidies and adding depreciation. Employee compensation is seen to be the most in aggregate income.
In the table above you can see that employee compensation is the largest part of the income source. It is much more than what other factors of income contribute in net operating surplus. All the factor incomes are calculated together to get the net domestic income at factor cost. The factor cost is used as different factors of production land, labour, capital, etc. are needed and used to create final products and services. We get domestic product at market price when we add the total sum of final goods.
An indirect tax is a tax imposed on services and goods rather than the income or the profits. For example tax on gasoline, food, etc. Due to this consumers pay more than the producers receive sometimes. Market price is always more than the factors cost. For instance, if a Popsicle cost $1 and the sales tax is 10 percent, then you will pay $1.10 for the popsicles. So market price is $1.10 while the item cost including profit and factor cost is $1.
A subsidy is a sum of money granted by the government to help an industry or business to keep the price of commodity or service low. Subsidies are amount paid to farmers and dairy farmers in order to keep the prices of the commodities low and due to this the consumers pay less for these merchandises and services. In this case, the factor cost more than the market price. There are five parts of income which sum to net domestic income at factor cost. Two modifications are made to get the GDP. Indirect taxes less subsidies are added to get factor cost from market prices.
The amount of total expenditure is gross as the investment added is also gross. Corporate profits are measured after the subtraction of depreciation and this shows net domestic income at the market price is a net measure of income. If we have net income and we need the gross income amount all we have to do is add the depreciation to the net income.
The GDP in the income method may not always match the GDP in the expenditure method. For example a bartender earns in wages and tips from the customers. So if he doesn’t show all the tips he received in his income and spends that money on something else, it will not show up in the income method to calculate GDP but will show up in the expenditure method to calculate GDP. So the numbers might not match when calculated GDP in both the methods. Estimation is another reason that contributes to the difference when calculated as some expenditure items are guessed and not directly estimated.
Statistical discrepancy is the gap in the numbers when GDP is calculated through both the methods. This statistical discrepancy which we can see in the above chart shows that it is never large. And to get it we have to subtract total GDP of income method from total GDP of expenditure method.
Real GDP and Nominal GDP
Sometimes we need to compare GDP of different years to check the increased GDP and the combined factor of raised prices and production increased leads to increased GDP. So to know the actual increased part we need to separate increased price and production from each other and this is where we distinguish real GDP and nominal GDP.
Nominal GDP is the gross domestic product evaluated at current market price that is the commodities and services produced in a given year and are priced according to that year.
Real GDP is the macroeconomic measure with the value of economic output adjusted for price changes. Through this if we compare the value of GDP of two separate years at the same pricing we will get the difference In GDP in two different years.
Below in the table it will be shown how we get the difference in GDP of two different years and the two years being 2005 and 2010.
Particulars Quantity (millions) Amount in dollars Expenditure(millions of dollar)
A T-shirts 10 5 50
B Computer chips 3 10 30
C Security services 1 20 20
D Real and Nominal GDP in 2005 100
A T-shirts 4 5 20
B Computer chips 2 20 40
C Security services 6 40 240
D Nominal GDP in 2010 300
Quantities of 2010 valued at prices of 2005
A T-shirts 4 5 20
B Computer chips 2 10 20
C Security services 6 20 120
D Real GDP in 2010 160
In reference to this chart, we can get the fact that in 2005 Real and Nominal GDP was 100 million and in 2010 nominal GDP was 300 million. But the Real GDP was 160 million which was the result of calculating the 2005 prices in part and the quantities of 2010 in part. So therefore the increase in GDP in 2010 from 2005n was 60%
Calculation of Real GDP
To get an idea of the calculation, we will take into account one of each component like one consumption goods, one capital goods and one government service for an economy. In the table above you can see the quantities which were produced at 2005 and 2010. For 2005 we calculate the nominal and real GDP. The quantity produced for each particular will be multiplied by its price in 2005 and we will get the total expenditure of that particular item. Then totaling the expenditure we will get the amount of GDP in 2005. Since it is used on the table as a base year the nominal and real GDP will be the same which in this case is 100 million.
If you check the 2010 table, you will see that the nominal GDP is 300 million which is much more than that of 2005. But real GDP shows us how much exactly has the production has increased in total. The last part of the above table shows that the quantities of the particulars are taken from the 2010 table and the prices are taken from the 2005 table in order to calculate real GDP in 2010. All the quantities of each product which is produced in 2010 is multiplied by the price of 2005 of that item. By totaling it the real GDP of 2010 comes to 160 million. This number shows us that if these number of quantities sold in 2010 was priced same as 2005 the total expenditure would come to 160 million which is 60%
Usage and Limitation of Real GDP
The estimation of real GDP is used for two main functions by the Economists:
1. Comparison of standard of living over a certain period of time
2. Comparison of standard of living across different countries
Comparing Standard of Living Over Time
Comparison of standard of living over time is an approach to calculate the real GDP of a person over various years. To get real GDP of a single person you need to divide real GDP by the country’s population. Through this approach we come to know the standard of living of per person in a country that is what an average person can afford to buy in terms of services and goods. By using this method we remove every obstacle which comes while comparing like rising prices, rising cost of living, etc. This also gives long and short term trend of the standard of living.
Let us understand this with an example:
In the year 1960 real GDP per person was $15,850 and in 2010 was $42,800.So dividing it gives us 2.7 times the GDP per person of 2010 from 1960’s ($42,800/$15,850). This shows the standard of living of people in 2010 is 2.7 times better than that of people in 1960s. There are two features of expanding living standard of people:
1. The potential growth of GDP per person
2. Variation or Fluctuation of real GDP per person
The potential growth of GDP per person
It is the maximum a real GDP can be produced in a country while avoiding certain factors like labour, land, capital shortage, etc. which would bring rising inflation. If the quantities of factors of production grow at a constant pace then the potential GDP per person will grow at a constant pace too. But this never goes at a constant pace. For exam in the 1960s it increased at 2.8% per year but in the 1970s it dropped down to 2.3% which brings about a lot of big consequences in the economy.
Variation or Fluctuation of real GDP per person
Real GDP is seen to fluctuate around the potential GDP growth, and this sometimes leads to the downgrade or decrease in real GDP of an economy.
Slowdown of productivity growth
The cost of slowdown in productivity after 1970s can be seen by the Lucas Wedge cost of slower growth. This shows value of the gap between the rate of dollar is and what it would have been if the real GDP per person growth would have been constant. This was low on 1970s but by 2010 it was seen that the real GDP per person was $28,400 per year lower that it would have been if there was no growth slowdown and the value of the accumulated gap was huge which $380,000 per person is.
Real GDP fluctuations – the business cycle
The fluctuations in the pace of the real GDP growth are called the business cycle. The business cycle points out the irregular increased and decreased movements of the total production in an economy and other measures of economic action. Every economic business cycle has two phases through which it might go, expansion and recession and has two turning points peak and trough.
An expansion as you can understand by the name that it is a period when real GDP will increase. During this phase, the real GDP returns to potential GDP, and when this expansion progresses the potential GDP will grow and the real GDP will cross the potential GDP.
Recession is a period of temporary economic decline during which business and trading activities reduce generally, by a fall in GDP in back to back two or more quarters. The growth rate is -ve here.
In the peak turning point an expansion end and recession begins where the highest level a real GDP have attained. And recession ends at trough when the real GDP has hit the lowest point from where the expansion will begin again. In 2008 American economy was at the lowest point and was in recession but again in mid of 2009 the expansion again started.
Standard of living which is across different countries
It is often seen that two different problems arise when we associate living standards across different countries using real GDP one is the different currency. The currency has to be converted in the currency unit of the other country to compare. And another one is that the commodities and services produced has to be valued at similar price. Comparing USA and China will help you understand these two problems which will arise if compared.
The currency unit of China and USA
The currency unit of China is Yuan and the USA is dollars. It was seen that in 2010 in USA real GDP person was $42,800. Alongside in China, the price was 23,400 Yuan. The currency rate exchange was 8.2 Yuan equaled 1 US dollar. According to this exchange rate it was seen that real GDP per person in China was when converted to dollar was $2,850. This shows real GDP per person in USA was 15b times more than that of China.
Purchasing Power Parity between these two countries
PPP or the purchasing power parity of the both countries should be same. Prices of some merchandise in China are lower than that of USA so it will add more value in the USA real GDP than it will add to China’s real GDP. For example if a food item price in China is more but when converted to US dollar it becomes half, this adds only half to China’s real GDP. Though some prices are higher in China than USA but most prices are lesser so the prices in China puts a lower value to their GDP that the USA. According to PPP comparison real GDP in USA was 6.5 times than that of China (which is not 15 times).
Limitations in case of Real GDP
There are a lot of limitations in case of real GDP. It measures the commodities and services which are brought to the markets. Some factors which are part of standard of living nonetheless are not a component of GDP is:
1. Household production
2. Underground economic activity
3. Health and life expectancy
4. Leisure time
5. Environmental quality
6. Political freedom and social justice
A large number of productions is seemed to take place in our domestic homes. Examples of household productions are cleaning the house, cooking, washing a car, mowing the lawn, etc. These are not included in the GDP as these are not offered for selling and buying in the markets. Since this does not get included in the GDP it undervalues the total production. But at the same time the growth rate is overestimated of the total production. There is a reason for this. Some things which are in the growth rate of market production is a replacement to the home productions. So it is understood that some part of the market production which arises GDP actually arises from the reduction in home production.
This is further divided into two trends one is women who have occupations which improved from 38% in 1960 to 58% in 2010. And the second is market purchase of produced merchandises and services. For instance, a number of people eat at restaurants rather than at home and number of day care facilities also increased. Previously these were household production but now it is more of a business which contributes to the real GDP. This way real GDP raises more quickly.
Underground Economic Activity
Underground economic activity means that the number of economic activity that takes place in some hidden way to avoid paying taxes and avoid following regulations set forth by the government and are generally illegal in some way. Measuring underground economy is hard but one can describe it very easily. The underground economy generally consists of production of drugs, forcing people to work without paying them minimum wage rate set by the government, cash paying jobs to avoid taxes, etc. This is a long list and even people getting tips for their work also fall under this.
It is estimated that underground economy is somewhere between 9 to 30 percent of USA GDP which ranges from $1,300 billion to $4,333 billion. It is a constant and in a stable proportion and is still useful in the real GDP for standard of living. Underground economy expands relatively if taxes become high and regulation becomes strict.