Guide to Gross Domestic Product (GDP)

Gross Domestic Product is the monetary or market value of all goods and services produced by a country during a particular period. As a measure of domestic production, it is a comprehensive scorecard of the country’s economic health.

However, it does not take into consideration the variations in living costs and inflation rates in different nations. Nonetheless, it is a beneficial method to compare different economies on the international market.

What is Gross Domestic Product (GDP)?

According to the Organization for Economic Co-operation and Development (OECD), GDP is the aggregate measure of production. It is the amount of gross value added by all individuals and institutions involved in the production of goods and services.

This economic measure considers the taxes and also reduces any subsidies while valuing the outputs.

The total can be broken down based on the contribution of every sector within the industry or economy. This economic measure is considered one of the most important indicators of national development in countries across the world.

Methods of calculating GDP

GDP calculation is done using three methods, which if done accurately, provide the same result. The three methods are as follows:

Expenditure method

Also known as the spending method, it calculates the spending by different participating groups in the country. The GDP formula using this method is

GDP = C + G + I +NX

Where C is consumption (private consumption or consumer spending)

G is Government spending

I is the investment and

NX indicates the net exports

Consumer spending is the largest component and has a significant impact on the country’s overall growth.

Higher consumer confidence reflects more spending and lower confidence in the future results in lesser spending.

Government incurs expenses for infrastructure, buying equipment, and payroll. It gains importance when business investment and consumer spending may be lower, for example, during a recession.

The investment comprises domestic investing or capital expenditure. Companies spend money for their operations and it is an important component as it enhances the country’s production capability and employment.

Net exports are the difference between exports and imports. It includes all expenditures for all companies in the country whether domestic or foreign businesses.

Production method

Instead of measuring the inputs contributing to the economic activities, the production method estimates the value of the output.

It deducts the costs of intermediate goods like materials or services used during the process. This method considers the state of completed economic activities to measure the growth.

Income method

This is somewhere between the spending and the production methods. It considers the earnings of all the different factors of production within an economy.

These include labor wages, rental income from land ownership, return on investments via interest, and business profits.

The method makes the necessary adjustments for items that are not payments incurred for various factors of production (FOP). Some of these include sales and property taxes categorised as indirect business expenses.

Depreciation is added to the national income to calculate the total economic income.

Types of Gross Domestic Product (GDP)

There are primarily two types of GDP, which are discussed below:

Real GDP

It is an inflation-adjusted measure reflecting the total goods and services produced by the country during a particular period. The prices are held constant to separate the effects of inflation or deflation in the output over a period.

Since this economic indicator calculates the monetary value of goods and services, it is impacted by inflation.

Rising prices may increase the measure but it may not change the quality and quantity of actual production of goods and services. Therefore, economists adjust inflation to determine the real GDP.

This is done by adjusting the output in a particular year for prices prevalent to the base year. This allows a comparison of the country's growth on a year-on-year (YoY) basis and determines if there is any real economic rise.

It is calculated using the price deflator, which is the difference between the prices in the current and base years. It accounts for the changes in the market value thereby narrowing the difference between the outputs on a YoY basis.

Nominal Growth Domestic Product (GDP)

Nominal GDP is the economic production in the country at current prices. It doesn't consider the impact of inflation or the rate of increasing prices.

The prices for the goods and services are considered at which they are sold in the particular year. The economic indicator may either be shown in the country's local currency or American Dollars at the prevailing exchange rates.

This type is generally used while comparing the increase in outputs in different quarters during the same year. To compare the growth over two different years, it is adjusted for inflation.

GDP Growth Rate

The GDP growth rate compares the year-on-year or quarterly changes in the country’s economic output. It helps to understand how quickly a country is economically growing.

The growth rate is depicted as a percent and is popular among economic policy-makers. This rate is closely linked to various key targets like unemployment rates and inflation.

GDP Per Capita

The GDP per capita income indicates the amount of income or output per person to determine average living standard and productivity. It can be stated in nominal, real (adjusted for inflation), and purchasing power parity (PPP).

GDP Purchasing Power Parity (PPP)

Although it is not a direct measure of this economic indicator, several economists use PPP to determine how a country’s growth measures in international currencies.

They use a method to adjust the differences between local prices and living costs for making inter-country comparisons of real income, living standards, and real output.

How does Gross Domestic Product (GDP) affect you?

Personal finance, job growth, and investments are affected by this economic indicator. Investors look at the growth rate to decide if they want to invest in a country and compare various nations to find the best opportunities.

Interest rates

The Central Bank determines the monetary policies based on the economic growth of the country. If the growth rate is accelerating, it may indicate “overheating” and the central bank may increase interest rates.

On the other hand, if the growth rate is declining, the interest rate may be reduced to stimulate the recessionary trend.

These changes in interest rates affect the population. The interest rates on various loans are impacted by these changes. If the rates increase, variable loan rates may rise and vice versa.

Unemployment

If the growth rate declines, there may be higher unemployment due to job cuts. However, it may be a lagging indicator since there may be a gap between the time taken for companies to compile layoff lists and exit packages and its implementation.

Gross Domestic Product (GDP) in India

In India, contributions to this economic indicator are divided into three sectors, which include industries, agriculture and allied services, and other services.

It is measured as the market prices and the base year is Financial Year (FY) 2011-2012. The formula is

GDP at market prices = GDP at factor costs + indirect taxes – subsidies

For FY 2019–2020, the growth in the real Indian GDP rate is estimated at approximately 5%. This was estimated to be 6% for FY 2018–2019. Moreover, for the third quarter of 2019, it was around 4.7%.

The annual estimate for 2018 was $2,718,732 million. And according to the International Monetary Fund (IMF), the estimate was $2,935,570 million. Moreover, the economic indicator in the third quarter of 2019 was estimated at $578,691 million.

Problems with GDP measurement

This economic indicator measures the total market value of all goods and services in a country. Since it uses market value, several factors are not included in the calculation.

Firstly, it does not consider the environmental costs and their impact on the overall well-being of the population. Secondly, the calculation does not consider unpaid services like volunteer work, which can have a significant impact on the quality of life.

Finally, the economic indicator does not account for the black economy as such activities are not taxed and not available in the government records.
To sum it up, this indicator is a measurement that captures a country’s total output. Generally, countries with higher growth have more availability of goods and services and enjoy better living standards.

However, due to its limitations, some economists argue about its use in determining the overall economic health of a country in general.