Gross domestic product

The gross domestic product (GDP) or gross domestic income (GDI) is the amount of
goods and services produced in a year, in a country. It is the market value of all final
goods and services made within the borders of a country in a year. It is often positively
correlated with the standard of living,[1] alternative measures to GDP for that purpose.[2]

Gross domestic product comes under the heading of national accounts, which is a
subject in macroeconomics.

Determining GDP
GDP can be determined in three ways, all of which should in principle give the same
result. They are the product (or output) approach, the income approach, and the
expenditure approach.

The most direct of the three is the product approach, which sums the outputs of every
class of enterprise to arrive at the total. The expenditure approach works on the principle
that all of the product must be bought by somebody, therefore the value of the total
product must be equal to people's total expenditures in buying things. The income
approach works on the principle that the incomes of the productive factors ("producers,"
colloquially) must be equal to the value of their product, and determines GDP by finding
the sum of all producers' incomes.[3]

Example: the expenditure method:

GDP = private consumption + gross investment +government spending +

(exports − imports), or

Note: "Gross" means that GDP measures production regardless of the various uses to
which that production can be put. Production can be used for immediate consumption,
for investment in new fixed assets or inventories, or for replacing depreciated fixed
assets. "Domestic" means that GDP measures production that takes place within the
country's borders. In the expenditure-method equation given above, the exports-minus-
imports term is necessary in order to null out expenditures on things not produced in the
country (imports) and add in things produced but not sold in the country (exports).

Economists (since Keynes) have preferred to split the general consumption term into two
parts; private consumption, and public sector (or government) spending. Two
advantages of dividing total consumption this way in theoretical macroeconomics are:

• Private consumption is a central concern of welfare economics. The private

investment and trade portions of the economy are ultimately directed (in
mainstream economic models) to increase in long-term private consumption.
• If separated from endogenous private consumption, government
consumption can be treated as exogenous, so that different government
 spending levels can be considered within a meaningful macroeconomic
framework.

Income Approach

This method measures GDP by adding incomes that firms pay households for the
factors of production they hire- wages for labor, interest for capital, rent for land and
profits for entrepreneurship.

The US "National Income and Expenditure Accounts" divide incomes into five
categories:

1. Wages, salaries, and supplementary labour income

2. Corporate profits
3. Interest and miscellaneous investment income
4. Farmers’ income
5. Income from non-farm unincorporated businesses

These five income components sum to net domestic income at factor cost.

Two adjustments must be made to get GDP:

1. Indirect taxes minus subsidies are added to get from factor cost to market prices.
2. Depreciation (or capital consumption) is added to get from net domestic product
to gross domestic product.

Expenditure approach

In economies, most things produced are produced for sale, and sold. Therefore,
measuring the total expenditure of money used to buy things is a way of measuring
production. This is known as the expenditure method of calculating GDP. Note that if you
knit yourself a sweater, it is production but does not get counted as GDP because it is
never sold. Sweater-knitting is a small part of the economy, but if one counts some
major activities such as child-rearing (generally unpaid) as production, GDP ceases to
be an accurate indicator of production. Similarly, if there is a long term shift from non-
market provision of services (for example cooking, cleaning, child rearing, do-it yourself
repairs) to market provision of services, then this trend toward increased market
provision of services may mask a dramatic decrease in actual domestic production,
resulting in overly optimistic and inflated reported GDP. This is particularly a problem for
economies which have shifted from production economies to service economies.

Components of GDP by expenditure

Components of U.S. GDP

GDP (Y) is a sum of Consumption (C), Investment (I), Government Spending (G)
and Net Exports (X - M).

Y = C + I + G + (X − M)

Here is a description of each GDP component:

• C (consumption) is normally the largest GDP component in the economy,

consisting of private (household final consumption expenditure) in the economy.
These personal expenditures fall under one of the following categories: durable
goods, non-durable goods, and services. Examples include food, rent, jewelry,
gasoline, and medical expenses but does not include the purchase of new
housing.
• I (investment) includes business investment in equipments for example and
does not include exchanges of existing assets. Examples include construction of
a new mine, purchase of software, or purchase of machinery and equipment for a
factory. Spending by households (not government) on new houses is also
included in Investment. In contrast to its colloquial meaning, 'Investment' in GDP
does not mean purchases of financial products. Buying financial products is
classed as 'saving', as opposed to investment. This avoids double-counting: if
one buys shares in a company, and the company uses the money received to
buy plant, equipment, etc., the amount will be counted toward GDP when the
company spends the money on those things; to also count it when one gives it to
the company would be to count two times an amount that only corresponds to
one group of products. Buying bonds or stocks is a swapping of deeds, a transfer
of claims on future production, not directly an expenditure on products.
 • G (government spending) is the sum of government expenditures on final
goods and services. It includes salaries of public servants, purchase of weapons
for the military, and any investment expenditure by a government. It does not
include any transfer payments, such as social security or unemployment benefits.
• X (exports) represents gross exports. GDP captures the amount a country
produces, including goods and services produced for other nations' consumption,
therefore exports are added.
• M (imports) represents gross imports. Imports are subtracted since imported
goods will be included in the terms G, I, or C, and must be deducted to avoid
counting foreign supply as domestic.

A fully equivalent definition is that GDP (Y) is the sum of final consumption
expenditure (FCE), gross capital formation (GCF), and net exports (X - M).

Y = FCE + GCF+ (X − M)

FCE can then be further broken down by three sectors (households, governments and
non-profit institutions serving households) and GCF by five sectors (non-financial
corporations, financial corporations, households, governments and non-profit institutions
serving households). The advantage of this second definition is that expenditure is
systematically broken down, firstly, by type of final use (final consumption or capital
formation) and, secondly, by sectors making the expenditure, whereas the first definition
partly follows a mixed delimitation concept by type of final use and sector.

Note that C, G, and I are expenditures on final goods and services; expenditures on
intermediate goods and services do not count. (Intermediate goods and services are
those used by businesses to produce other goods and services within the accounting
year.[4] )

According to the U.S. Bureau of Economic Analysis, which is responsible for calculating
the national accounts in the United States, "In general, the source data for the
expenditures components are considered more reliable than those for the income
components [see income method, below]."

Examples of GDP component variables

C, I, G, and NX (net exports): If a person spends money to renovate a hotel to increase

occupancy rates, the spending represents private investment, but if he buys shares in a
consortium to execute the renovation, it is saving. The former is included
when measuring GDP (in I), the latter is not. However, when the consortium conducted
its own expenditure on renovation, that expenditure would be included in GDP.

If a hotel is a private home, spending for renovation would be measured

as consumption, but if a government agency converts the hotel into an office for civil
servants, the spending would be included in the public sector spending, or G.

If the renovation involves the purchase of a chandelier from abroad, that spending would
be counted as C, G, or I(depending on whether a private individual, the government, or a
business is doing the renovation), but then counted again as an import and subtracted
from the GDP so that GDP counts only goods produced within the country.
If a domestic producer is paid to make the chandelier for a foreign hotel, the payment
would not be counted as C,G, or I, but would be counted as an export.

Income approach

Another way of measuring GDP is to measure total income. If GDP is calculated this way
it is sometimes called Gross Domestic Income (GDI), or GDP (I). GDI should provide the
same amount as the expenditure method described above. (By definition, GDI = GDP. In
practice, however, measurement errors will make the two figures slightly off when
reported by national statistical agencies.)

Total income can be subdivided according to various schemes, leading to various

formulae for GDP measured by the income approach. A common one is:

GDP = compensation of employees + gross operating surplus + gross mixed

income + taxes less subsidies on production and imports
GDP = COE + GOS + GMI + TP & M - SP & M

• Compensation of employees (COE) measures the total remuneration to

employees for work done. It includes wages and salaries, as well as employer
contributions to social security and other such programs.
• Gross operating surplus (GOS) is the surplus due to owners of incorporated
businesses. Often called profits, although only a subset of total costs are
subtracted from gross output to calculate GOS.
• Gross mixed income (GMI) is the same measure as GOS, but for
unincorporated businesses. This often includes most small businesses.

The sum of COE, GOS and GMI is called total factor income; it is the income of all of the
factors of production in society. It measures the value of GDP at factor (basic) prices.
The difference between basic prices and final prices (those used in the expenditure
calculation) is the total taxes and subsidies that the government has levied or paid on
that production. So adding taxes less subsidies on production and imports converts GDP
at factor cost to GDP(I).

Total factor income is also sometimes expressed as:

Total factor income = Employee compensation + Corporate profits + Proprieter's

income + Rental income + Net interest

Yet another formula for GDP by the income method is:

GDP = R + I + P + SA + W

Where R: rents
I: interests
P: profits
SA : statistical adjustments (corporate income taxes, dividends, undistributed corporate
profits)
W : wages
Note the mnemonic, "ripsaw".

A "production boundary" that delimits what will be counted as GDP.

"One of the fundamental questions that must be addressed in preparing the national
economic accounts is how to define the production boundary–that is, what parts of the
myriad human activities are to be included in or excluded from the measure of the
economic production."

All output for market is at least in theory included within the boundary. Market output is
defined as that which is sold for "economically significant" prices; economically
significant prices are "prices which have a significant influence on the amounts
producers are willing to supply and purchasers wish to buy." An exception is that illegal
goods and services are often excluded even if they are sold at economically significant
prices (Australia and the United States exclude them).

This leaves non-market output. It is partly excluded and partly included. First, "natural
processes without human involvement or direction" are excluded. Also, there must be a
person or institution that owns or is entitled to compensation for the product. An example
of what is included and excluded by these criteria is given by the United States' national
accounts agency: "the growth of trees in an uncultivated forest is not included in
production, but the harvesting of the trees from that forest is included."

Within the limits so far described, the boundary is further constricted by "functional
considerations."[11] The Australian Bureau for Statistics explains this: "The national
accounts are primarily constructed to assist governments and others to make market-
based macroeconomic policy decisions, including analysis of markets and factors
affecting market performance, such as inflation and unemployment." Consequently,
production that is, according to them, "relatively independent and isolated from markets,"
or "difficult to value in an economically meaningful way" [i.e., difficult to put a price on] is
excluded.[12] Thus excluded are services provided by people to members of their own
families free of charge, such as child rearing, meal preparation, cleaning, transportation,
entertainment of family members, emotional support, care of the elderly.[13] Most other
production for own (or one's family's) use is also excluded, with two notable exceptions
which are given in the list later in this section.

Nonmarket outputs that are included within the boundary are listed below. Since, by
definition, they do not have a market price, the compilers of GDP must impute a value to
them, usually either the cost of the goods and services used to produce them, or the
value of a similar item that is sold on the market.

• Goods and services provided by governments and non-profit organizations free

of charge or for economically insignificant prices are included. The value of these
goods and services is estimated as equal to their cost of production. This ignores
the consumer surplus generated by an efficient and effective government
supplied infrastructure. For example, government-provided clean water confers
substantial benefits above its cost. Ironically, lack of such infrastructure which
would result in higher water prices (and probably higher hospital and medication
expenditures) would be reflected as a higher GDP. This may also cause a bias
 that mistakenly favors inefficient privatizations since some of the consumer
surplus from privatized entities' sale of goods and services are indeed reflected in
GDP.[14]
• Goods and services produced for own-use by businesses are attempted to be
included. An example of this kind of production would be a machine constructed
by an engineering firm for use in its own plant.
• Renovations and upkeep by an individual to a home that she owns and occupies
are included. The value of the upkeep is estimated as the rent that she could
charge for the home if she did not occupy it herself. This is the largest item of
production for own use by an individual (as opposed to a business) that the
compilers include in GDP.[15] If the measure uses historical or book prices for real
estate, this will grossly underestimate the value of the rent in real estate markets
which have experienced significant price increases (or economies with general
inflation). Furthermore, depreciation schedules for houses often accelerate the
accounted depreciation relative to actual depreciation (a well built house can be
lived in for several hundred years - a very long time after it has been fully
depreciated). In summary, this is likely to grossly underestimate the value of
existing housing stock on consumers' actual consumption or income.
• Agricultural production for consumption by oneself or one's household is
included.
• Services (such as chequeing-account maintenance and services to borrowers)
provided by banks and other financial institutions without charge or for a fee that
does not reflect their full value have a value imputed to them by the compilers
and are included. The financial institutions provide these services by giving the
customer a less advantageous interest rate than they would if the services were
absent; the value imputed to these services by the compilers is the difference
between the interest rate of the account with the services and the interest rate of
a similar account that does not have the services. According to the United States
Bureau for Economic Analysis, this is one of the largest imputed items in the
GDP.[16]

GDP vs GNP
GDP can be contrasted with gross national product (GNP) or gross national
income (GNI). The difference is that GDP defines its scope according to location, while
GNP defines its scope according to ownership. In a global context, world GDP and world
GNP are therefore equivalent terms.

GDP is product produced within a country's borders; GNP is product produced by

enterprises owned by a country's citizens. The two would be the same if all of the
productive enterprises in a country were owned by its own citizens, and those citizens
did not own productive enterprises in any other countries. In practices, however, foreign
ownership makes GDP and GNP non-identical. Production within a country's borders,
but by an enterprise owned by somebody outside the country, counts as part of its GDP
but not its GNP; on the other hand, production by an enterprise located outside the
country, but owned by one of its citizens, counts as part of its GNP but not its GDP.

To take the United States as an example, the U.S.'s GNP is the value of output
produced by American-owned firms, regardless of where the firms are located. Similarly,
if a country becomes increasingly in debt, and spends large amounts of income servicing
this debt this will be reflected in a decreased GNI but not a decreased GDP. Similarly, if
a country sells off its resources to entities outside their country this will also be reflected
over time in decreased GNI, but not decreased GDP. This would make the use of GDP
more attractive for politicians in countries with increasing national debt and decreasing
assets.

Gross national income (GNI) equals GDP plus income receipts from the rest of the world
minus income payments to the rest of the world.

In 1991, the United States switched from using GNP to using GDP as its primary
measure of production. The relationship between United States GDP and GNP is shown
in table 1.7.5 of the National Income and Product Accounts.

International standards

The international standard for measuring GDP is contained in the book System of
National Accounts (1993), which was prepared by representatives of the International
Monetary Fund, European Union, Organization for Economic Co-operation and
Development, United Nations and World Bank. The publication is normally referred to as
SNA93 to distinguish it from the previous edition published in 1968 (called SNA68).

SNA93 provides a set of rules and procedures for the measurement of national
accounts. The standards are designed to be flexible, to allow for differences in local
statistical needs and conditions.

National measurement

Within each country GDP is normally measured by a national government statistical

agency, as private sector organizations normally do not have access to the information
required (especially information on expenditure and production by governments).

Main article: National agencies responsible for GDP measurement

Interest Rates

Net interest expense is a transfer payment in all sectors except the financial sector. Net
interest expenses in the financial sector are seen as production and value added and
are added to GDP.

Adjustments to GDP
When comparing GDP figures from one year to another, it is desirable to compensate for
changes in the value of money–inflation or deflation. The raw GDP figure as given by the
equations above is called the nominal, or historical, or current, GDP. To make it more
meaningful for year-to-year comparisons, it may be multiplied by the ratio between the
value of money in the year the GDP was measured and the value of money in some
base year. For example, suppose a country's GDP in 1990 was $100 million and its GDP
in 2000 was $300 million; but suppose that inflation had halved the value of its currency
over that period. To meaningfully compare its 2000 GDP to its 1990 GDP we could
multiply the 2000 GDP by one-half, to make it relative to 1990 as a base year. The result
would be that the 2000 GDP equals $300 million x one-half = $150 million, in 1990
monetary terms. We would see that the country's GDP had, realistically, increased 1.5
times over that period, not 3 times, as it might appear from the raw GDP data. The GDP
adjusted for changes in money-value in this way is called the real, or constant, GDP.

The factor used to convert GDP from current to constant values in this way is called
the GDP deflator. Unlike the Consumer price index, which measures inflation (or
deflation–rarely!) in the price of household consumer goods, the GDP deflator measures
changes in the prices all domestically produced goods and services in an economy–
including investment goods and government services, as well as household
consumption goods.

Constant-GDP figures allow us to calculate a GDP growth rate, which tells us how much
a country's production has increased (or decreased, if the growth rate is negative)
compared to the previous year.

Real GDP growth rate for year n = [(Real GDP in year n) - (Real GDP in year n -
1)]/ (Real GDP in year n - 1)

Another thing that it may be desirable to compensate for is population growth. If a

country's GDP doubled over some period but its population tripled, the increase in GDP
may not be deemed such a great accomplishment: the average person in the country is
producing less than they were before. Per-capita GDP is the measure compensated for
population growth.

Cross-border comparison
The level of GDP in different countries may be compared by converting their value in
national currency according to either the current currency exchange rate, or the
purchase power parity exchange rate.

• Current currency exchange rate is the exchange rate in the international

currency market.
• Purchasing power parity exchange rate is the exchange rate based on
the purchasing power parity (PPP) of a currency relative to a selected standard
(usually the United States dollar). This is a comparative (and theoretical)
exchange rate, the only way to directly realize this rate is to sell an
entire CPI basket in one country, convert the cash at the currency market rate &
then rebuy that same basket of goods in the other country (with the converted
cash). Going from country to country, the distribution of prices within the basket
will vary; typically, non-tradable purchases will consume a greater proportion of
the basket's total cost in the higher GDP country, per the Balassa-Samuelson
effect.

The ranking of countries may differ significantly based on which method is used.

• The current exchange rate method converts the value of goods and services
using global currency exchange rates. The method can offer better indications of
 a country's international purchasing power and relative economic strength. For
instance, if 10% of GDP is being spent on buying hi-tech foreign arms, the
number of weapons purchased is entirely governed by current exchange rates,
since arms are a traded product bought on the international market. There is no
meaningful 'local' price distinct from the international price for high technology
goods.
• The purchasing power parity method accounts for the relative effective domestic
purchasing power of the average producer or consumer within an economy. The
method can provide a better indicator of the living standards of less developed
countries, because it compensates for the weakness of local currencies in the
international markets. For example, India ranks 11th by nominal GDP, but fourth
by PPP. The PPP method of GDP conversion is more relevant to non-traded
goods and services.

There is a clear pattern of the purchasing power parity method decreasing the disparity
in GDP between high and low income (GDP) countries, as compared to the current
exchange rate method. This finding is called the Penn effect.

For more information, see Measures of national income and output.

Per unit GDP

GDP is an aggregate figure which does not account for differing sizes of nations.
Therefore, GDP can be stated asGDP per capita (per person) in which total GDP is
divided by the resident population on a given date, GDP per citizen where total GDP is
divided by the numbers of citizens residing in the country on a given date, and less
commonly GDP per unit of a resource input, such as GDP per GJ of energy or Gross
domestic product per barrel.GDP per citizen in the above case is pretty similar to GDP
per capita in most nations, however, in nations with very high proportions of temporary
foreign workers like in Persian Gulf nations, the two figures can be vastly different.

Standard of living and GDP

GDP per capita is not a measurement of the standard of living in an economy. However,
it is often used as such an indicator, on the rationale that all citizens would benefit from
their country's increased economic production. Similarly, GDP per capita is not a
measure of personal income. GDP may increase while real incomes for the majority
decline. For example, in the US from 1990 to 2006 the earnings (adjusted for inflation) of
individual workers, in private industry and services, increased by less than 0.5% per year
while GDP (adjusted for inflation) increased about 3.6% per year.

The major advantage of GDP per capita as an indicator of standard of living is that it is
measured frequently, widely, and consistently. It is measured frequently in that most
countries provide information on GDP on a quarterly basis, allowing trends to be seen
quickly. It is measured widely in that some measure of GDP is available for almost every
country in the world, allowing inter-country comparisons. It is measured consistently in
that the technical definition of GDP is relatively consistent among countries.
The major disadvantage is that it is not a measure of standard of living. GDP is intended
to be a measure of total national economic activity— a separate concept.

The argument for using GDP as a standard-of-living proxy is not that it is a good
indicator of the absolute level of standard of living, but that living standards tend to move
with per-capita GDP, so that changes in living standards are readily detected through
changes in GDP.

Limitations of GDP to judge the health of an economy

GDP is widely used by economists to gauge the health of an economy, as its variations
are relatively quickly identified. However, its value as an indicator for the standard of
living is considered to be limited. Not only that, but if the aim of economic activity is to
produce ecologically sustainable increases in the overall human standard of living, GDP
is a perverse measurement; it treats loss of ecosystem services as a benefit instead of a
cost. Other criticisms of how the GDP is used include:

• Wealth distribution–GDP does not take disparity in incomes between the rich
and poor into account. See income inequality metrics for discussion of a variety
of inequality-based economic measures.
• Non-market transactions–GDP excludes activities that are not provided through
the market, such as household production and volunteer or unpaid services. As a
result, GDP is understated. Unpaid work conducted on Free and Open Source
Software (such as Linux) contribute nothing to GDP, but it was estimated that it
would have cost more than a billion US dollars for a commercial company to
develop. Also, if Free and Open Source Software became identical to
its proprietary software counterparts, and the nation producing the propriety
software stops buying proprietary software and switches to Free and Open
Source Software, then the GDP of this nation would reduce, however there would
be no reduction in economic production or standard of living. The work of New
Zealand economist Marilyn Waring has highlighted that if a concerted attempt to
factor in unpaid work were made, then it would in part undo the injustices of
unpaid (and in some cases, slave) labour, and also provide the political
transparency and accountability necessary for democracy. Shedding some doubt
on this claim, however, is the theory that won economist Douglass North the
Nobel Prize in 1993. North argued that the creation and strengthening of the
patent system, by encouraging private invention and enterprise, became the
fundamental catalyst behind the Industrial Revolution in England.
• Underground economy–Official GDP estimates may not take into account
the underground economy, in which transactions contributing to production, such
as illegal trade and tax-avoiding activities, are unreported, causing GDP to be
underestimated.
• Non-monetary economy–GDP omits economies where no money comes into
play at all, resulting in inaccurate or abnormally low GDP figures. For example, in
countries with major business transactions occurring informally, portions of local
economy are not easily registered. Bartering may be more prominent than the
use of money, even extending to services (I helped you build your house ten
years ago, so now you help me).
• GDP also ignores subsistence production.
• Quality improvements and inclusion of new products–By not adjusting for
quality improvements and new products, GDP understates true economic growth.
For instance, although computers today are less expensive and more powerful
than computers from the past, GDP treats them as the same products by only
accounting for the monetary value. The introduction of new products is also
difficult to measure accurately and is not reflected in GDP despite the fact that it
may increase the standard of living. For example, even the richest person from
1900 could not purchase standard products, such as antibiotics and cell phones,
that an average consumer can buy today, since such modern conveniences did
not exist back then.
• What is being produced–GDP counts work that produces no net change or that
results from repairing harm. For example, rebuilding after a natural disaster or
war may produce a considerable amount of economic activity and thus boost
GDP. The economic value of health care is another classic example—it may
raise GDP if many people are sick and they are receiving expensive treatment,
but it is not a desirable situation. Alternative economic estimates, such as
the standard of living or discretionary income per capita try to measure the
human utility of economic activity. See uneconomic growth.
• Externalities–GDP ignores externalities or economic bads such as damage to
the environment. By counting goods which increase utility but not deducting bads
or accounting for the negative effects of higher production, such as more
pollution, GDP is overstating economic welfare. The Genuine Progress
Indicatoris thus proposed by ecological economists and green economists as a
substitute for GDP, supposing a consensus on relevant data to measure
"progress". In countries highly dependent on resource extraction or with high
ecological footprints the disparities between GDP and GPI can be very large,
indicating ecological overshoot. Some environmental costs, such as cleaning up
oil spills are included in GDP.
• Sustainability of growth–GDP is not a tool of economic projections, which
would make it subjective, it is just a measurement of economic activity. That is
why it does not measure what is considered the sustainability of growth. A
country may achieve a temporarily high GDP by over-exploiting natural resources
or by misallocating investment. For example, the large deposits
of phosphates gave the people of Nauru one of the highest per capita incomes
on earth, but since 1989 their standard of living has declined sharply as the
supply has run out. Oil-rich states can sustain high GDPs without industrializing,
but this high level would no longer be sustainable if the oil runs out. Economies
experiencing an economic bubble, such as a housing bubble or stock bubble, or
a low private-saving rate tend to appear to grow faster owing to higher
consumption, mortgaging their futures for present growth. Economic growth at
the expense of environmental degradation can end up costing dearly to clean up.
• One main problem in estimating GDP growth over time is that the purchasing
power of money varies in different proportion for different goods, so when the
GDP figure is deflated over time, GDP growth can vary greatly depending on the
basket of goods used and the relative proportions used to deflate the GDP figure.
For example, in the past 80 years the GDP per capita of the United States if
measured by purchasing power of potatoes, did not grow significantly. But if it is
measured by the purchasing power of eggs, it grew several times. For this
reason, economists comparing multiple countries usually use a varied basket of
goods.
 • Cross-border comparisons of GDP can be inaccurate as they do not take into
account local differences in the quality of goods, even when adjusted
for purchasing power parity. This type of adjustment to an exchange rate is
controversial because of the difficulties of finding comparable baskets of goods to
compare purchasing power across countries. For instance, people in country A
may consume the same number of locally produced apples as in country B, but
apples in country A are of a more tasty variety. This difference in material well
being will not show up in GDP statistics. This is especially true for goods that are
not traded globally, such as housing.
• Transfer pricing on cross-border trades between associated companies may
distort import and export measures.
• As a measure of actual sale prices, GDP does not capture the economic
surplus between the price paid and subjective value received, and can therefore
underestimate aggregate utility.

Simon Kuznets in his very first report to the US Congress in 1934 said:

...the welfare of a nation can, therefore, scarcely be inferred from a measure of national
income...

In 1962, Kuznets stated:

Distinctions must be kept in mind between quantity and quality of growth, between costs
and returns, and between the short and long run. Goals for more growth should specify
more growth of what and for what.

Alternatives to GDP

• Human development index (HDI) - HDI uses GDP as a part of its calculation and
then factors in indicators of life expectancy and education levels.
• Genuine progress indicator (GPI) or Index of Sustainable Economic
Welfare (ISEW) - The GPI and the ISEW attempt to address many of the above
criticisms by taking the same raw information supplied for GDP and then adjust
for income distribution, add for the value of household and volunteer work, and
subtract for crime and pollution.
• Gross national happiness (GNH) - GNH measures quality of life or social
progress in more holistic and psychological terms than GDP.
• Gini coefficient - The Gini coefficient measures the disparity of income within a
nation.
• Wealth estimates - The World Bank has developed a system for combining
monetary wealth with intangible wealth (institutions and human capital) and
environmental capital.[25]
• Private Product Remaining - Murray Newton Rothbard and other Austrian
economists argue as if government spending is taken from productive sectors
and produces goods that consumers do not want, it is a burden on the economy
and thus should be deducted. In his book, America's Great Depression,
Rothbard argues that even government surpluses from taxation should be
deducted to create an estimate of PPR.
Some people have looked beyond standard of living at a broader sense of quality of life
or well-being:

• European Quality of Life Survey - The survey, first published in 2005, assessed
quality of life across European countries through a series of questions on
overall subjective life satisfaction, satisfaction with different aspects of life, and
sets of questions used to calculate deficits of time, loving, being and having.
• Gross national happiness - The Centre for Bhutanese Studies in Bhutan is
working on a complex set of subjective and objective indicators to measure
'national happiness' in various domains (living standards, health, education, eco-
system diversity and resilience, cultural vitality and diversity, time use and
balance, good governance, community vitality and psychological well-being).
This set of indicators would be used to assess progress towards gross national
happiness, which they have already identified as being the nation's priority,
above GDP.
• Happy Planet Index - The happy planet index (HPI) is an index of human well-
being and environmental impact, introduced by the New Economics
Foundation (NEF) in 2006. It measures the environmental efficiency with which
human well-being is achieved within a given country or group. Human well-being
is defined in terms of subjective life satisfaction and life expectancy while
environmental impact is defined by the Ecological Footprint.

Net national product

Net national product (NNP) is the total market value of all

final goods and services produced by residents in a country or other polity during a given
period (gross national product or GNP) minus depreciation. The net domestic product
(NDP) is the equivalent application of NNP within macroeconomics, and NDP is equal
to gross domestic product (GDP) minus depreciation: NDP = GDP - depreciation.

Depreciation (also known as consumption of fixed capital) measures the amount of GNP
that must be spent on new capital goods to maintain the existing physical capital stock.

NNP is the amount of goods in a given year which can be consumed without reducing
future consumption. Setting part of NNP aside for investment permits capital stock
growth (see economic growth and capital formation), and greater future consumption.

NNP also equals total compensation of employees + net indirect tax paid on current
production + operating surplus.

Depreciation

Depreciation refers to two very different but related concepts:

1. decline in value of assets, and

2. allocation of the cost of assets to periods in which the assets are used.
The former affects values of businesses and entities. The latter affects net income.
Generally the cost is allocated, as depreciation expense, among the periods in which the
asset is expected to be used. Such expense is recognized by businesses for financial
reporting and tax purposes. Methods of computing depreciation may vary by asset for
the same business. Methods and lives may be specified in accounting and/or tax rules in
a country. Several standard methods of computing depreciation expense may be used,
including fixed percentage, straight line, and declining balance methods. Depreciation
expense generally begins when the asset is placed in service. Example: a depreciation
expense of 100 per year for 5 years may be recognized for an asset costing 500.

In economics, depreciation is the gradual and permanent decrease in the

economic value of the capital stock of a firm, nation or other entity, either through
physical depreciation, obsolescence or changes in the demand for the services of the
capital in question. If capital stock is C0 at the beginning of a period, investment is I and
depreciation D, the capital stock at the end of the period, C1, isC0 + I - D.

Accounting concept
In determining the profits (net income) from an activity, the receipts from the activity
must be reduced by appropriate costs. One such cost is the cost of assets used but not
currently consumed in the activity. Such costs must be allocated to the period of use.
The cost of an asset so allocated is the difference between the amount paid for the asset
and the amount expected to be received upon its disposition. Depreciation is any
method of allocating such net cost to those periods expected to benefit from use of the
asset. The asset is referred to as a depreciable asset. Depreciation is a method of
allocation, not valuation.

Any business or income producing activity using tangible assets may incur costs related
to those assets. Where the assets produce benefit in future periods, the costs must be
deferred rather than treated as a current expense. The business then records
depreciation expense as an allocation of such costs for financial reporting. The costs are
allocated in a rational and systematic manner as depreciation expense to each period in
which the asset is used, beginning when the asset is placed in service. Generally this
involves four criteria:

• cost of the asset,

• expected salvage value of the asset,
• estimated useful life of the asset, and
• a method of apportioning the cost over such life.

Cost generally is the amount paid for the asset, including all costs related to
acquisition. In some countries or for some purposes, salvage value may be ignored. The
rules of some countries specify lives and methods to be used for particular types of
assets. However, in most countries the life is based on business experience, and the
method may be chosen from one of several acceptable methods.

When a depreciable asset is sold, the business recognizes gain or loss based on net
basis of the asset. This net basis is cost less depreciation.
Accounting rules also require that an impairment charge or expense be recognized if the
value of assets declines unexpectedly. Such charges are usually nonrecurring, and may
relate to any type of asset.

Depletion and amortization are similar concepts for mineral assets (including oil) and
intangible assets, respectively.

Depreciation expense does not require current outlay of cash. However, the cost of
acquiring depreciable assets may require such outlay. Thus, depreciation does not affect
a statement of cash flows, but cost of acquiring assets does.

Depreciation is generally recognized under historical cost systems of accounting. Some

proposals for fair value accounting have no provision for systematic depreciation
expense.

Depreciation expense is recorded in the income statement of a business. The impact of

accumulated depreciation expense is generally recorded in a separate account and
disclosed in financial statements under most accounting principles. Generally, the net
cost in excess of accumulted depreciation is disclosed in the presentation of assets and
liabilities (balance sheet) of a business.

Methods of depreciation
There are several methods for calculating depreciation, generally based on either the
passage of time or the level of activity (or use) of the asset.

Straight-line depreciation

Straight-line depreciation is the simplest and most-often-used technique, in which the

company estimates the salvage value of the asset at the end of the period during which
it will be used to generate revenues (useful life) and will expense a portion of original
costin equal increments over that period. The salvage value is an estimate of the value
of the asset at the time it will be sold or disposed of; it may be zero or even negative.
Salvage value is also known as scrap value or residual value.

Straight-line method:

For example, a vehicle that depreciates over 5 years, is purchased at a cost

of US$17,000, and will have a salvage value of US$2000, will depreciate
at US$3,000 per year: ($17,000 − $2,000)/ 5 years = $3,000 annual straight-
line depreciation expense. In other words, it is the depreciable cost of the asset
divided by the number of years of its useful life.
This table illustrates the straight-line method of depreciation. Book value at the
beginning of the first year of depreciation is the original cost of the asset. At any time
book value equals original cost minus accumulated depreciation.

book value = original cost − accumulated depreciation Book value at the end of year
becomes book value at the beginning of next year. The asset is depreciated until the
book value equals scrap value.

Book value at Depreciation Accumulated Book value at

beginning of year expense depreciation end of year

$17,000 (original cost) $3,000 $3,000 $14,000

$14,000 $3,000 $6,000 $11,000

$11,000 $3,000 $9,000 $8,000

$8,000 $3,000 $12,000 $5,000

$5,000 $3,000 $15,000 $2,000 (scrap value)

If the vehicle were to be sold and the sales price exceeded the depreciated value (net
book value) then the excess would be considered a gain and subject to depreciation
recapture. In addition, this gain above the depreciated value would be recognized as
ordinary income by the tax office. If the sales price is ever less than the book value, the
resulting capital loss is tax deductible. If the sale price were ever more than the original
book value, then the gain above the original book value is recognized as a capital gain.

If a company chooses to depreciate an asset at a different rate from that used by the tax
office then this generates a timing difference in the income statement due to the
difference (at a point in time) between the taxation department's and company's view of
the profit.

Declining-balance method (or Reducing balance method)

Depreciation methods that provide for a higher depreciation charge in the first year of an
asset's life and gradually decreasing charges in subsequent years are
called accelerated depreciation methods. This may be a more realistic reflection of an
asset's actual expected benefit from the use of the asset: many assets are most useful
when they are new. One popular accelerated method is the declining-balance method.
Under this method the book value is multiplied by a fixed rate.
Annual depreciation = depreciation rate * book value at beginning of year

The most common rate used is double the straight-line rate. For this reason, this
technique is referred to as the double-declining-balance method. To illustrate,
suppose a business has an asset with $1,000 original cost, $100 salvage value, and 5
years useful life. First, calculate straight-line depreciation rate. Since the asset has 5
years useful life, the straight-line depreciation rate equals(100% / 5) 20% per year. With
double-declining-balance method, as the name suggests, double that rate,
or 40% depreciation rate is used. The table below illustrates the double-declining-
balance method of depreciation.

Book value at Depreciation Depreciation Accumulated Book value at

beginning of year rate expense depreciation end of year

$1,000 (original cost) 40% $400 $400 $600

$600 40% $240 $640 $360

$360 40% $144 $784 $216

$216 40% $86.40 $870.40 $129.60

$129.60 $129.60 - $100 $29.60 $900 $100 (scrap value)

When using the double-declining-balance method, the salvage value is not considered in
determining the annual depreciation, but the book value of the asset being depreciated
is never brought below its salvage value, regardless of the method used. The process
continues until the salvage value or the end of the asset's useful life, is reached. In the
last year of depreciation a subtraction might be needed in order to prevent book value
from falling below estimated Scrap Value.

Since double-declining-balance depreciation does not always depreciate an asset fully

by its end of life, some methods also compute a straight-line depreciation each year, and
apply the greater of the two. This has the effect of converting from declining-balance
depreciation to straight-line depreciation at a midpoint in the asset's life.

It is possible to find a rate that would allow for full depreciation by its end of life with the
formula:

,
where N is the estimated life of the asset (for example, in years).

Activity depreciation

Activity depreciation methods are not based on time, but on a level of activity. This could
be miles driven for a vehicle, or a cycle count for a machine. When the asset is acquired,
its life is estimated in terms of this level of activity. Assume the vehicle above is
estimated to go 50,000 miles in its lifetime. The per-mile depreciation rate is calculated
as: ($17,000 cost - $2,000 salvage) / 50,000 miles = $0.30 per mile. Each year, the
depreciation expense is then calculated by multiplying the rate by the actual activity
level.

Sum-of-years' digits method

Sum-of-years' digits is a depreciation method that results in a more accelerated write-off

than straight line, but less than declining-balance method. Under this method annual
depreciation is determined by multiplying the Depreciable Cost by a schedule of
fractions.

Depreciable cost = original cost − salvage value

Book value = original cost − accumulated depreciation

Example: If an asset has original cost of $1000, a useful life of 5 years and a salvage
value of $100, compute its depreciation schedule.

First, determine years' digits. Since the asset has useful life of 5 years, the years' digits
are: 5, 4, 3, 2, and 1.

Next, calculate the sum of the digits. 5+4+3+2+1=15

The sum of the digits can also be determined by using the formula (n2+n)/2 where n is
equal to the useful life of the asset. The example would be shown as (52+5)/2=15

Depreciation rates are as follows:

5/15 for the 1st year, 4/15 for the 2nd year, 3/15 for the 3rd year, 2/15 for the 4th year,
and 1/15 for the 5th year.

Total
Book value at Depreciation Depreciation Accumulated Book value at
depreciable
beginning of year rate expense depreciation end of year
cost

$1,000 (original cost) $900 5/15 $300 ($900 * 5/15) $300 $700

$700 $900 4/15 $240 ($900 * 4/15) $540 $460

$460 $900 3/15 $180 ($900 * 3/15) $720 $280

$280 $900 2/15 $120 ($900 * 2/15) $840 $160

$160 $900 1/15 $60 ($900 * 1/15) $900 $100 (scrap value)

Units-of-production depreciation method

Under the units-of-production method, useful life of the asset is expressed in terms of
the total number of units expected to be produced:

Suppose, an asset has original cost $70,000, salvage value $10,000, and is expected
to produce 6,000 units.

Depreciation per unit = ($70,000−10,000) / 6,000 = $10

10 x actual production will give you the depreciation cost of the current year.

The table below illustrates the units-of-production depreciation schedule of the asset.

Book value at Units of Depreciation Depreciation Accumulated Book value at

beginning of year production cost per unit expense depreciation end of year

$70,000 (original cost) 1,000 $10 $10,000 $10,000 $60,000

$60,000 1,100 $10 $11,000 $21,000 $49,000

$49,000 1,200 $10 $12,000 $33,000 $37,000

$37,000 1,300 $10 $13,000 $46,000 $24,000

$24,000 1,400 $10 $14,000 $60,000 $10,000 (scrap value)

Depreciation stops when book value is equal to the Scrap Value of the asset. In the end
the sum of accumulated depreciation and scrap value equals to the original cost.

Units of time depreciation

Units of time depreciation are similar to units of production, and are used for
depreciation equipment used in mine or natural resource exploration, or a case where
the amount the asset is used is not linear year to year.

A simple example can be given for construction companies, where some equipment is
used only for some specific purpose. Depending on the number of projects, the
equipment will be used and depreciation charged accordingly.

Group depreciation method

Group depreciation method is used for depreciating multiple-asset accounts using

straight-line-depreciation method. Assets must be similar in nature and have
approximately the same useful lives.

Historical Salvage Depreciable Depreciation

Asset Life
cost value cost per year

Computers $5,500 $500 $5,000 5 $1,000

Composite depreciation method

The composite method is applied to a collection of assets that are not similar, and have
different service lives. For example, computers and printers are not similar, but both are
part of the office equipment. Depreciation on all assets is determined by using the
straight-line-depreciation method.

Historical Salvage Depreciable Depreciation

Asset Life
cost value cost per year

Computers $5,500 $500 $5,000 5 $1,000

Printers $1,000 $100 $ 900 3 $ 300

Total $ 6,500 $600 $5,900 4.5 $1,300

Composite life equals the total depreciable cost divided by the total depreciation per
year. $5,900 / $1,300 = 4.5 years.

Composite depreciation rate equals depreciation per year divided by total historical
cost. $1,300 / $6,500 = 0.20 = 20%

Depreciation expense equals the composite depreciation rate times the balance in the
asset account (historical cost). (0.20 * $6,500) $1,300. Debit depreciation expense and
credit accumulated depreciation.

When an asset is sold, debit cash for the amount received and credit the asset account
for its original cost. Debit the difference between the two to accumulated depreciation.
Under the composite method no gain or loss is recognized on the sale of an asset.
Theoretically, this makes sense because the gains and losses from assets sold before
and after the composite life will average themselves out.

To calculate composite depreciation rate, divide depreciation per year by total historical
cost. To calculate depreciation expense, multiply the result by the same total historical
cost. The result, not surprisingly, will equal to the total depreciation Per Year again.

Common sense requires depreciation expense to be equal to total depreciation per year,
without first dividing and then multiplying total depreciation per year by the same
number.

Tax depreciation
Most income tax systems allow a tax deduction for recovery of the cost of assets used in
a business or for the production of income. Such deductions are allowed for individuals
and companies. Where the assets are consumed currently, the cost may be deducted
currently as an expense or treated as part of cost of goods sold. The cost of assets not
currently consumed generally must be deferred and recovered over time, such as
through depreciation. Some systems permit full deduction of the cost, at least in part, in
the year the assets are acquired. Other systems allow depreciation expense over some
life using some depreciation method or percentage. Rules vary highly by country, and
may vary within a country based on type of asset or type of taxpayer. Many systems that
specify depreciation lives and methods for financial reporting require the same lives and
methods be used for tax purposes. Most tax systems provide different rules for real
property (buildings, etc.) and personal property (equipment, etc.).

Capital allowances

A common system is to allow a fixed percentage of the cost of depreciable assets to be

deducted each year. This is often referred to as a capital allowance. United Kingdome
capital allowance deductions are permitted to individuals and businesses based on
assets placed in service during or before the assessment year. Canada capital
allowances are fixed percentages of assets within a class or type of asset. Fixed
percentage rates are specified by type of asset. The fixed percentage is multiplied by the
tax basis of assets in service to determine the capital allowance deduction. The tax law
or regulations of the country specifies these percentages. Capital allowance calculations
may be based on the total set of assets, on sets or pools by year (vintage pools) or pools
by classes of assets.

Tax lives and methods

Some systems specify lives based on classes of property defined by the tax authority.
Canada Revenue Agency specifies numerous classes based on the type of property and
how it is used. Under the United States depreciation system, the Internal Revenue
Servicepublishes a detailed guide which includes a table of lives based on types of
businesses in which assets are used. The table also incorporates specified lives for
certain commonly used assets (e.g., office furniture, computers, automobiles) which
override the business use lives. U.S. tax depreciation is computed under the double
declining balance method switching to straight line or the straight line method, at the
option of the taxpayer.[7] IRS tables specify percentages to apply to the basis of an asset
for each year in which it is in service. Depreciation first becomes deductible when an
asset is placed in service.

Additional depreciation

Many systems allow an additional deduction for a portion of the cost of depreciable
assets acquired in the current tax year. The UK system provides a first year capital
allowance of £50,000. In the United States, two such deductions are available.
A deduction for the full cost of depreciable tangible personal property is allowed up to
$250,000. This deduction is fully phased out for businesses acquiring over $800,000 of
such property during the year.[8] In addition, additional first year depreciation of 50% of
the cost of most other depreciable tangible personal property is allowed as a deduction.
[9]
Some other systems have similar first year or accelerated allowances.

Real property

Many tax systems prescribe longer depreciable lives for buildings and land
improvements. Such lives may vary by type of use. Many such systems, including the
United States and Canada, permit depreciation for real property using only the straight
line method, or a small fixed percentage of cost. Generally, no depreciation tax
deduction is allowed for bare land. In the United States, residential rental buildings are
depreciable over a 27.5 year or 40 year life, other buildings over a 39 or 40 year life, and
land improvements over a 15 or 20 year life, all using the straight line method.[10]

Averaging conventions

Depreciation calculations can become complex if done for each asset a business owns.
Many systems therefore permit combining assets of a similar type acquired in the same
year into a “pool.” Depreciation is then computed for all assets in the pool as a single
calculation. Calculations for such pool must make assumptions regarding the date of
acquisition. The United States system allows a taxpayer to use a half year convention for
personal property or mid-month convention for real property.[11] Under such a convention,
all property of a particular type is considered acquired at the midpoint of the acquisition
period. One half of a full period depreciation is allowed in the acquisition period and in
the final depreciation period. United States rules require a mid-quarter convention for
personal property if more than 40% of the acquisitions for the year are in the final
quarter.

Economics

Models

In economics, the value of a capital asset may be modeled as the present value of the
flow of services the asset will generate in future, appropriately adjusted for uncertainty.
Economic depreciation over a given period is the reduction in the remaining value of
future services.

Under certain circumstances, such as an unanticipated increase in the price of the

services generated by an asset or a reduction in the discount rate, its value may
increase rather than decline. Depreciation is then negative.

Depreciation can alternatively be measured as the change in the market value of capital
over a given period: the market price of the capital at the beginning of the period minus
its market price at the end of the period.

Such a method in calculating depreciation differs from other methods, such as straight-
line depreciation in that it is included in the calculation of implicit cost, and thus
economic profit.

Modeling depreciation of a durable as delivering the same services from purchase until
failure, with zero scrap value (rather than slowing degrading and retaining residual
value), is referred to as the light bulb model of depreciation, or more colorfully as the
one-hoss shay model, after a poem by Oliver Wendell Holmes, Sr., about a carriage
which worked perfectly for exactly one hundred years, then fell completely apart in an
instant.[12]

National accounts

In national accounts the decline in the aggregate capital stock arising from the use of
fixed assets in production is referred to asconsumption of fixed capital (CFC). Hence,
CFC is equal to the difference between aggregate gross fixed capital formation (gross
investment) and net fixed capital formation (net investment) or between Gross National
Product and Net National Product. Unlike depreciation in business accounting, CFC in
national accounts is, in principle, not a method of allocating the costs of past
expenditures on fixed assets over subsequent accounting periods. Rather, fixed assets
at a given moment in time are valued according to the remaining benefits to be derived
from their use.

Capital formation
Gross capital formation in % of gross domestic product in world economy

Capital formation is a concept used in macro-economics, national

accounts and financial economics. Occasionally it is also used in corporate accounts. It
can be defined in three ways:

• It is a specific statistical concept used in national

accounts statistics, econometrics and macroeconomics. In that sense, it refers to
a measure of the net additions to the (physical) capital stock of a country (or an
economic sector) in an accounting interval, or, a measure of the amount by which
the total physical capital stock increased during an accounting period. To arrive
at this measure, standard valuation principles are used.

• It is used also in economic theory, as a modern general term for capital

accumulation, referring to the total "stock of capital" that has been formed, or to
the growth of this total capital stock.

• In a much broader or vaguer sense, the term "capital formation" has in more
recent times been used in financial economics to refer to savings drives, setting
up financial institutions, fiscal measures, public borrowing, development of capital
markets, privatization of financial institutions, development of secondary financial
markets. In this usage, it refers to any method for increasing the amount of
capital owned or under one's control, or any method in utilising or mobilizing
capital resources for investment purposes. Thus, capital could be "formed" in the
sense of "being brought together for investment purposes" in many different
ways. This broadened meaning is not related to the statistical measurement
concept nor to the classical understanding of the concept in economic theory.

Use in national accounts statistics

In the national accounts (e.g. in the United Nations System of National Accounts and
the European System of Accounts) gross capital formation is the total value of the gross
fixed capital formation (GFCF), plus changes in inventories, plus acquisitions less
disposals of valuables for a unit or sector.

Total capital formation in national accounting equals fixed capital investment, plus the
increase in the value of inventories held, plus (net) lending to foreign countries, during
an accounting period (a year or a quarter). Capital is said to be "formed" when savings
are utilized for investment purposes, often investment in production.
In the USA, statistical measures for capital formation were pioneered by Simon
Kuznets in the 1930s and 1940s, and from the 1950s onwards the standard accounting
system devised under the auspices of the United Nations to measure capital flows was
adopted officially by the governments of most countries. International bodies such as the
IMF and the World Bank have been influential in revising the system.

Different interpretations
The use of the term "capital formation" and can be somewhat confusing, partly because
the concept of capital itself can be understood in different ways.

• Firstly, capital formation is frequently thought of as a measure of total

"investment", in the sense of that portion of capital actually used for investment
purposes and not held as savings or consumed. But in fact, in national accounts,
the concept of gross capital formation refers only to the accounting value of
the additions of non-financial produced assets to the capital stock less the
disposals of these assets. "Investment" is a broader concept that includes
investment in all kinds of capital assets, whether physical property or financial
assets. In its statistical meaning, capital formation does not include financial
assets such as stocks and securities.

• Secondly, capital formation may be used synonymously with the notion of capital
accumulation in the sense of a reinvestment of profits into capital assets. But
"capital accumulation" is not normally an accounting concept in modern accounts
(although it is sometimes used by the IMF and UNCTAD), and contains the
ambiguity that an amassment of wealth could occur either through
a redistribution of capital assets from one person or institution to another, or
through a net addition to the total stock of capital in existence. As regards capital
accumulation, it can flourish, so that some people get much wealthier, even
although society as a whole becomes poorer, and the net capital
formation decreases. In other words the gain could be a net total gain, or a gain
at the expense of loss by others that cancels out (or more than cancels out) the
gain in aggregate.

• Thirdly, gross capital formation is often used synonymously with gross fixed
capital formation but strictly speaking this is an error because gross capital
formation refers to more net asset gains than just fixed capital (it also includes
net gains in inventory stocklevels and the balance of funds lent abroad).

Capital formation measures were originally designed to provide a picture of investment

and growth of the "real economy" in which goods and services are produced using
tangible capital assets. However, the international growth of the financial sector has
created many structural changes in the way that business investments occur, and in the
way capital finance is really organized. This not only affects the definition of the
measures, but also how economists interpret capital formation.

Gross and net capital formation

In economic statistics and accounts, capital formation can be valued gross, i.e. before
deduction of consumption of fixed capital (or "depreciation"), or net, i.e. after deduction
of "depreciation" write-offs.

• The gross valuation method views "depreciation" as a portion of the new income
or wealth earned or created by the enterprise, and hence as part of the formation
of new capital by the enterprise.

• The net valuation method views "depreciation" as the compensation for

the cost of replacing fixed equipment used up or worn out, which must be
deducted from the total investment volume to obtain a measure of the "real"
value of investments; the depreciation write-off compensates and cancels out the
loss in capital value of assets used due to wear & tear, obsolescence, etc.

Technical measurement issues

Capital formation is notoriously difficult to measure statistically, mainly because of the
valuation problems involved in establishing what the value of capital assets is. When a
fixed asset or inventory is bought, it may be reasonably clear what its market value is,
namely the purchaser's price. But as soon as it is bought, its value may change, and it
may change even before it is put to use. Things often become more complicated to
measure when a new fixed asset is acquired within some kind of lease agreement.
Finally, the rate the value of the fixed asset depreciates at affects the gross and net
valuation of the asset, and different methods are typically used to value what assets are
worth. Capital assets can for instance be valued at:

• historic cost (acquisition cost)

• current replacement cost
• current sale or resale value
• average market value
• business value, assuming a certain profit yield
• value for tax purposes,
• value for insurance purposes
• purchasing power parity value
• scrap value.

A business owner may in fact not even know what his business is "worth" as a going
concern, in terms of its current market value. The "book value" of a capital stock may
differ greatly from its "market value", and another figure may apply for taxation purposes.
The value of capital assets may also be overstated or understated using various legal
constructions. For any significant business, how assets are valued makes a big
difference to its earnings and thus the correct statement of asset values is a perpetually
controversial subject.

During an accounting period, additions may be made to capital assets (including those
that disproportionately increase the value of the capital stock) and capital assets are also
disposed of; at the same time, physical assets also incur depreciation or Consumption of
fixed capital. Also, price inflation may affect the value of the capital stock.

In national accounts, there are additional problems:

 • The sales/purchases of one enterprise can be the investment of another
enterprise. Therefore, to obtain a measure of the total net capital formation, a
system of grossing and netting of capital flows is required. Without this, double
counting would occur.

• Capital expenditure must be distinguished from intermediate expenditure and

other operating expenditure, but the boundaries are sometimes difficult to draw.

• There exists nowadays a large market in second-hand (used) assets. In principle,

statistical measures of gross fixed capital formation are supposed to refer to the
net additions of newly produced fixed assets, which enlarge the total stock of
fixed capital in the economy. But if a substantial trade occurs in fixed assets
resold from one enterprise or one country to another, it may become difficult to
know what the real net addition to the stock of fixed capital of a country actually
is, to the extent that the precise distinction between "new" and "used" assets is
more difficult to draw, and that how to value used assets and their depreciation
consistently becomes problematic.

Perpetual Inventory Method

A method often used in econometrics to estimate the value of the physical capital stock
of an industrial sector or the whole economy is the so-called Perpetual Inventory
Method (PIM). Starting off from a benchmark stock value for capital held, and expressing
all values in constant dollars using a price index, known additions to the stock are
added, and known disposals as well as depreciation are subtracted year by year (or
quarter by quarter). Thus, an historical data series is obtained for the growth of the
capital stock over a period of time. In so doing, assumptions are made about the real
rate of price inflation, realistic depreciation rates, average service lives of physical capital
assets, and so on. The PIM stock values can be compared with various other related
economic variables and trends, and adjusted further to obtain the most accurate and
credible valuation

Controversy
According to one popular kind of macro-economic definition in textbooks, capital
formation refers to "the transfer of savings from households and governments to the
business sector, resulting in increased output and economic expansion" (see Circular
flow of income). The idea here is that individuals and governments save money, and
then invest that money in the private sector, which produces more wealth with it. This
definition is however inaccurate on two counts:

• Firstly, many larger corporations engage in corporate self-financing, i.e. financing

from their own reserves and undistributed profits, or through loans from (or share
issues bought by) other corporations. In other words, the textbook definition
ignores that the largest source of investment capital consists of financial
institutions, not individuals or households or governments. Admittedly, financial
institutions are, "in the last instance", mostly owned by individuals, but those
individuals have little control over this transfer of funds, nor do they accomplish
the transfer themselves. Few individuals can say they "own" a corporation,
 anymore than individuals "own" the public sector. Poterba(1987) found that
changes in corporate saving are only partly offset (between 25% and 50%) by
changes in household saving in the United States. Social accountants Richard
Ruggles and Nancy D. Ruggles established for the USA that "almost all financial
savings done by households is used to pay for household capital formation -
particularly, housing and consumer durables. On net, the household sector
channels almost no financial savings to the enterprise sector. Conversely, almost
all the capital formation done by enterprises is financed through enterprise
savings - particularly, undistributed gross profits." (cited from Edward N. Wolff,
"In Memoriam: Richard Ruggles 1916-2001", in: Review of Income and Wealth,
Series 47, Number 3, September 2001, p. 414).

• Secondly, the transfer of funds to corporations may not result in increased output
or economic expansion at all; given excess capacity, a low rate of return and/or
lacklustre demand, corporations may not in fact invest those funds to
expand output, and engage in asset speculation instead, to obtain property
income that boosts shareholder returns. To illustrate, New Zealand's Finance
Minister Michael Cullen stated (NZ Herald, 24 February 2005) that "My sense is
that there are definite gains to be made, both economic and social, in increasing
the savings level of New Zealanders and in encouraging diversification in assets
away from the residential property market." This idea is based on a flawed
understanding of capital formation, ignoring the real issue - which is that the flow
of mortgage repayments by households to financial institutions is not being used
to expand output and employment on a scale that could repay escalating private
sector debts. In reality, more and more local income and assets are appropriated
by foreign share-holders and creditors in North America, Europe, Australia and
Japan [1].

The concept of "household saving" must itself also be looked at critically, since a lot of
this "saving" in reality consists precisely of investing in housing, which, given low interest
rates and rising real estate prices, yields a better return than if you kept your money in
the bank (or, in some cases, if you invested in shares). In other words, a mortgage from
a bank can effectively function as a "savings scheme" although officially it is not
regarded as "savings".

Subsidy

A subsidy (also known as a subvention) is a form of financial assistance paid to a

business or economic sector. Most subsidies are made by the government to producers
or distributors in an industry to prevent the decline of that industry (e.g., as a result of
continuous unprofitable operations) or an increase in the prices of its products or simply
to encourage it to hire more labor (as in the case of a wage subsidy). Examples are
subsidies to encourage the sale of exports; subsidies on some foods to keep down the
cost of living, especially in urban areas; and subsidies to encourage the expansion
of farm production and achieve self-reliance in food production.[1]

Subsidies can be regarded as a form of protectionism or trade barrier by making

domestic goods and services artificially competitive against imports. Subsidies may
distort markets, and can impose large economic costs.[2]Financial assistance in the form
of a subsidy may come from one's government, but the term subsidy may also refer to
assistance granted by others, such as individuals or non-governmental institutions.

Overview
In standard supply and demand curve diagrams, a subsidy will shift either the demand
curve up or the supply curve down. A subsidy that increases the production will tend to
result in a lower price, while a subsidy that increases demand will tend to result in an
increase in price. Both cases result in a new economic equilibrium. Therefore it is
essential to consider elasticity when estimating the total costs of a planned subsidy: it
equals the subsidy per unit (difference between market price and subsidized price) times
the new equilibrium quantity. One category of goods suffers less from this effect: Public
goods are—once created—in ample supply and the total costs of subsidies remain
constant regardless of the number of consumers; depending on the form of the subsidy,
however, the number of producers on demanding their share of benefits may still rise
and drive costs up.

The recipient of the subsidy may need to be distinguished from the beneficiary of the
subsidy, and this analysis will depend on elasticity of supply and demand as well as
other factors. For example, a subsidy for consumption of milk by consumers may appear
to benefit consumers (or some may benefit and the consumer may derive no gain, as the
higher prices for milk offset the subsidy. The net effect and identification of winners and
losers is rarely straightforward, but subsidies generally result in a transfer of wealth from
one group to another (or transfer between sub-groups).

Subsidy may also be used to refer to government actions which limit competition or raise
the prices at which producers could sell their products, for example, by means of tariff
protection. Although economics generally holds that subsidies may distort the market
and produce inefficiencies, there are a number of recognized cases where subsidies
may be the most efficient solution.[citation needed]

In many instances, economics may (somewhat counter-intuitively) suggest that direct

subsidies are preferable to other forms of support, such as hidden subsidies or trade
barriers; although subsidies may be inefficient, they are often less inefficient than other
policy tools used to benefit certain groups. Direct subsidies may also be more
transparent, which may allow the political process more opportunity to eliminate wasteful
hidden subsidies. This problem—that hidden subsidies are more inefficient, but often
favored precisely because they are non-transparent—is central to the political-economy
of subsidies.

Examples of industries or sectors where subsidies are often found include

utilities, gasoline in the United States,welfare, farm subsidies, and (in some countries)
certain aspects of student loans.

Types of subsidies
There are many different ways to classify subsidies, such as the reason behind them,
the recipients of the subsidy, the source of the funds (government, consumer, general
tax revenues, etc). In economics, one of the primary ways to classify subsidies is the
means of distributing the subsidy.

In economics, the term subsidy may or may not have a negative connotation: that is, the
use of the term may be prescriptive but descriptive. In economics, a subsidy may
nonetheless be characterized as inefficient relative to no subsidies; inefficient relative to
other means of producing the same results; "second-best", implying an inefficient but
feasible solution (contrasted with an efficient but not feasible ideal), among other
possible terminology. In other cases, a subsidy may be an efficient means of correcting
a market failure.

For example, economic analysis may suggest that direct subsidies (cash benefits) would
be more efficient than indirect subsidies (such as trade barriers); this does not
necessarily imply that direct subsidies are bad, but that they may be more efficient or
effective than other mechanisms to achieve the same (or better) results.

Insofar as they are inefficient, however, subsidies would generally be considered by

economists to be bad, as economics is the study of efficient use of limited resources.
Ultimately, however, the choice to enact a subsidy is a political choice. Note that
subsidies are linked to the concept of economic transfers from one group to another.

Economics has also explicitly identified a number of areas where subsidies are entirely
justified by economics, particularly in the area of provision of public goods.

Indirect subsidies

Indirect subsidy is a term sufficiently broad that it may cover most other forms of
subsidy.[citation needed] The term would cover any form of subsidy that does not involve a
direct transfer.

Labor subsidies

A labor subsidy is any form of subsidy where the recipients receive subsidies to pay for
labor costs. Examples may include labor subsidies for workers in certain industries, such
as the film and/or television industries. (see:Runaway production).

Housing subsidies

Infrastructure subsidies

In some cases, subsidy may refer to favoring one type of production or consumption
over another, effectively reducing the competitiveness or retarding the development of
potential substitutes. For example, it has been argued that the use of petroleum, and
particularly gasoline, has been subsidized or favored by U.S. defense policy, reducing
the use of alternative energy sources and delaying their commercial development.

In other cases, the government may need to improve the public transport to ensure
Pareto improvement is attanied and sustained. This can therefore be done by
subsidising those transit agencies that provide the public services so that the services
can be affordable for everyone. This is the best way of helping different groups of
disabled and low income families in the society.

Trade protection (import restrictions)

Measures used to limit a given good than they would pay without the trade barrier; the
protected industry has effectively received a subsidy. Such measures include import
quotas, import tariffs, import bans, and others.

Export subsidies (trade promotion)

Various tax or other measures may be used to promote exports that constitute subsidies
to the industries favored. In other cases, tax measures may be used to ensure that
exports are treated "fairly" under the tax system. The determination of what constitutes a
subsidy (or the size of that subsidy) may be complex. In many cases, export subsidies
are justified as a means of compensating for the subsidies or protections provided by a
foreign state to its own producers.

Procurement subsidies

Governments everywhere are relatively small consumers of various goods and services.
Subsidies may occur in this process by choice of the products produced, the producer,
the nature of the product itself, and by other means, including payment of higher-than-
market prices for goods purchased.

Consumption subsidies

Governments everywhere provide consumption subsidies in a number of ways: by

actually giving away a good or service, providing use of government assets, property, or
services at lower than the cost of provision, or by providing economic incentives (cash
subsidies) to purchase or use such goods. In most countries, consumption of education,
health care, and infrastructure (such as roads) are heavily subsidized, and in many
cases provided free of charge. In other cases, governments literally purchase or produce
a good (such as bread, wheat, gasoline, or electricity) at a higher cost than the sales
price to the public (which may require rationing to control the cost).

The provision of true public goods through consumption subsidies is an example of a

type of subsidy that economics may recognize as efficient. In other cases, such
subsidies may be reasonable second-best solutions; for example, while it may be
theoretically efficient to charge for all use of public roads, in practice, the cost of
implementing a system to charge for such use may be unworkable or unjustified.[citation
needed]

In other cases, consumption subsidies may be targeted at a specific group of users,

such as large utilities, residential home-owners, and others.

Subsidies due to the effect of debt guarantees

Another form of subsidy is due to the practice of a government guaranteeing a lender
payment if a particular borrower defaults. This occurs in the United States, for example,
in certain airline industry loans, in most student loans, in small business administration
loans, in Ginnie Mae mortgage backed bonds, and is alleged to occur in the mortgage
backed bonds issued through Fannie Mae and Freddie Mac. A government guarantee of
payment lowers the risk of the loan for a lender, and since interest rates are primarily
based on risk, the interest rate for the borrower lowers as well.

Controversy
One of the most controversial classes of subsidies, especially according to publications
such as The Economist, are subsidies benefiting farmers in first-world countries.

Human-rights based non-governmental organizations like Oxfam describe such

subsidies as dumping millions of surplus commodities (like sugar) on world markets,
destroying opportunities for farmers in developing and poor countries, especially in
Africa. For example, the EU is currently spending €3.30 in subsidies to export sugar
worth €1.[3] Another example of trade distorting subsidies is the Common Agricultural
Policy of the European Union. It represents 48% of the entire EU's budget, €49.8 billion
in 2006 (up from €48.5 billion in 2005).[4] These subsidies have remained in place even
though many international accords have reduced other forms of subsidies or tariffs.

The Commitment to Development Index, published by the Center for Global

Development, measures the effect that subsidies and trade barriers actually have on the
developing world. It uses trade along with six other components such as aid or
investment to rank and evaluate developed countries on policies that affect the
developing world. It finds that the richest countries spend $106 billion per year
subsidizing their own farmers - almost exactly as much as they spend on foreign aid.[5]

The Austrian School of economics and other free-marketers hold the view that subsidies
generally do more harm than good by distorting economic signals.

Sometimes people believe profitable companies to be 'bullying' governments for

subsidies and rescue packages, an example of rent-seeking behaviour. For example, in
the case with Australian rail operator Pacific National, the company threatened
the Tasmanian Government with a pull-out of rail services unless a subsidization was
made.[6]

Historical meaning
In the 16th century "subsidy" referred to taxation, for example the tax introduced in
England by Thomas Wolsey in 1513 based on the ability to pay.

Stock Market

A stock market or equity market is a public (a loose network of economic transactions,

not a physical facility or discrete) entity for the trading of company stock (shares)
and derivatives at an agreed price; these are securities listed on a stock exchange as
well as those only traded privately.
The size of the world stock market was estimated at about $36.6 trillion at the start of
October 2008.[1] The total world derivatives market has been estimated at about
$791 trillion face or nominal value,[2] 11 times the size of the entire world economy.[3] The
value of the derivatives market, because it is stated in terms of notional, cannot be
directly compared to a stock or a fixed income security, which traditionally refers to
an actual value. Moreover, the vast majority of derivatives 'cancel' each other out (i.e., a
derivative 'bet' on an event occurring is offset by a comparable derivative 'bet' on the
event not occurring). Many such relatively illiquid securities are valued as marked to
model, rather than an actual market price.

The stocks are listed and traded on stock exchanges which are entities of a corporation
or mutual organization specialized in the business of bringing buyers and sellers of the
organizations to a listing of stocks and securities together. The largest stock market in
the United States, by market cap, is the New York Stock Exchange, NYSE. In Canada,
the largest stock market is the Toronto Stock Exchange. Major European examples of
stock exchanges include the London Stock Exchange, Paris Bourse, and the Deutsche
Börse (Frankfurt Stock Exchange). Asian examples include the Tokyo Stock Exchange,
the Hong Kong Stock Exchange, the Shanghai Stock Exchange, and the Bombay Stock
Exchange. In Latin America, there are such exchanges as the BM&F Bovespa and the
BMV.

Trading

The London Stock Exchange.

Participants in the stock market range from small individual stock investors to
largehedge fund traders, who can be based anywhere. Their orders usually end up with
a professional at a stock exchange, who executes the order.

Some exchanges are physical locations where transactions are carried out on a trading
floor, by a method known as open outcry. This type of auction is used in stock
exchanges and commodity exchanges where traders may enter "verbal" bids and offers
simultaneously. The other type of stock exchange is a virtual kind, composed of a
network of computers where trades are made electronically via traders.

Actual trades are based on an auction market model where a potential buyer bids a
specific price for a stock and a potential seller asks a specific price for the stock. (Buying
or selling at market means you will accept any ask price or bid price for the stock,
respectively.) When the bid and ask prices match, a sale takes place, on a first-come-
first-served basis if there are multiple bidders or askers at a given price.
The purpose of a stock exchange is to facilitate the exchange of securities between
buyers and sellers, thus providing a marketplace (virtual or real). The exchanges provide
real-time trading information on the listed securities, facilitating price discovery.

The New York Stock Exchange.

The New York Stock Exchange is a physical exchange, also referred to as

a listedexchange – only stocks listed with the exchange may be traded. Orders enter by
way of exchange members and flow down to a floor broker, who goes to the floor trading
post specialist for that stock to trade the order. The specialist's job is to match buy and
sell orders using open outcry. If a spread exists, no trade immediately takes place—in
this case the specialist should use his/her own resources (money or stock) to close the
difference after his/her judged time. Once a trade has been made the details are
reported on the "tape" and sent back to the brokerage firm, which then notifies the
investor who placed the order. Although there is a significant amount of human contact
in this process, computers play an important role, especially for so-called "program
trading".

The NASDAQ is a virtual listed exchange, where all of the trading is done over a
computer network. The process is similar to the New York Stock Exchange. However,
buyers and sellers are electronically matched. One or more NASDAQ market makers will
always provide a bid and ask price at which they will always purchase or sell 'their' stock.
[4]

The Paris Bourse, now part of Euronext, is an order-driven, electronic stock exchange. It
was automated in the late 1980s. Prior to the 1980s, it consisted of an open outcry
exchange. Stockbrokers met on the trading floor or the Palais Brongniart. In 1986,
the CATS trading system was introduced, and the order matching process was fully
automated.

From time to time, active trading (especially in large blocks of securities) have moved
away from the 'active' exchanges. Securities firms, led by UBS AG, Goldman Sachs
Group Inc. and Credit Suisse Group, already steer 12 percent of U.S. security trades
away from the exchanges to their internal systems. That share probably will increase to
18 percent by 2010 as more investment banks bypass the NYSE and NASDAQ and pair
buyers and sellers of securities themselves, according to data compiled by Boston-
based Aite Group LLC, a brokerage-industry consultant.[5]

Now that computers have eliminated the need for trading floors like the Big Board's, the
balance of power in equity markets is shifting. By bringing more orders in-house, where
clients can move big blocks of stock anonymously, brokers pay the exchanges less in
fees and capture a bigger share of the $11 billion a year that institutional investors pay in
trading commissions as well as the surplus of the century had taken place.[citation needed].

Market participants
A few decades ago, worldwide, buyers and sellers were individual investors, such as
wealthy businessmen, usually with long family histories to particular corporations. Over
time, markets have become more "institutionalized"; buyers and sellers are largely
institutions (e.g., pension funds, insurance companies, mutual funds, index
funds, exchange-traded funds, hedge funds, investor groups, banks and various other
financial institutions).

The rise of the institutional investor has brought with it some improvements in market
operations. Thus, the government was responsible for "fixed" (and exorbitant) fees being
markedly reduced for the 'small' investor, but only after the large institutions had
managed to break the brokers' solid front on fees. (They then went to 'negotiated' fees,
but only for large institutions.[citation needed])

However, corporate governance (at least in the West) has been very much adversely
affected by the rise of (largely 'absentee') institutional 'owners'.[citation needed]

History

Established in 1875, the Bombay Stock Exchange is Asia's first stock exchange.

In 12th century France the courratiers de change were concerned with managing and
regulating the debts of agricultural communities on behalf of the banks. Because these
men also traded with debts, they could be called the first brokers. A common misbelief is
that in late 13th centuryBruges commodity traders gathered inside the house of a man
calledVan der Beurze, and in 1309 they became the "Brugse Beurse", institutionalizing
what had been, until then, an informal meeting, but actually, the family Van der Beurze
had a building in Antwerp where those gatherings occurred;[6] the Van der Beurze had
Antwerp, as most of the merchants of that period, as their primary place for trading. The
idea quickly spread around Flanders and neighboring counties and "Beurzen" soon
opened in Ghent and Amsterdam.

In the middle of the 13th century, Venetian bankers began to trade in government
securities. In 1351 the Venetian government outlawed spreading rumors intended to
lower the price of government funds. Bankers in Pisa, Verona, Genoa and Florence also
began trading in government securities during the 14th century. This was only possible
because these were independent city states not ruled by a duke but a council of
influential citizens. The Dutch later started joint stock companies, which
let shareholders invest in business ventures and get a share of their profits – or losses.
In 1602, the Dutch East India Company issued the first share on the Amsterdam Stock
Exchange. It was the first company to issue stocks and bonds.

The Amsterdam Stock Exchange (or Amsterdam Beurs) is also said to have been the
first stock exchange to introduce continuous trade in the early 17th century. The Dutch
"pioneered short selling, option trading, debt-equity swaps, merchant banking,
unit trusts and other speculative instruments, much as we know them".[7] There are now
stock markets in virtually every developed and most developing economies, with the
world's biggest market being in the United States, United Kingdom, Japan, India,
China, Canada, Germany's (Frankfurt Stock Exchange), France, South Korea and
the Netherlands.[8]

Importance of stock market

Function and purpose

The main trading room of the Tokyo Stock Exchange,where trading is currently completed through computers.

The stock market is one of the most important sources for companies to raise money.
This allows businesses to be publicly traded, or raise additional capital for expansion by
selling shares of ownership of the company in a public market. The liquidity that an
exchange provides affords investors the ability to quickly and easily sell securities. This
is an attractive feature of investing in stocks, compared to other less liquid investments
such as real estate.
History has shown that the price of shares and other assets is an important part of the
dynamics of economic activity, and can influence or be an indicator of social mood. An
economy where the stock market is on the rise is considered to be an up-and-coming
economy. In fact, the stock market is often considered the primary indicator of a
country's economic strength and development.

Rising share prices, for instance, tend to be associated with increased business
investment and vice versa. Share prices also affect the wealth of households and their
consumption. Therefore, central banks tend to keep an eye on the control and behavior
of the stock market and, in general, on the smooth operation of financial
system functions. Financial stability is the raison d'être of central banks.

Exchanges also act as the clearinghouse for each transaction, meaning that they collect
and deliver the shares, and guarantee payment to the seller of a security. This
eliminates the risk to an individual buyer or seller that thecounterparty could default on
the transaction.

The smooth functioning of all these activities facilitates economic growth in that lower
costs and enterprise risks promote the production of goods and services as well as
employment. In this way the financial system contributes to increased prosperity.

Relation of the stock market to the modern financial system

The financial system in most western countries has undergone a remarkable

transformation. One feature of this development is disintermediation. A portion of the
funds involved in saving and financing, flows directly to the financial markets instead of
being routed via the traditional bank lending and deposit operations. The general public's
heightened interest in investing in the stock market, either directly or through mutual
funds, has been an important component of this process.

Statistics show that in recent decades shares have made up an increasingly large
proportion of households' financial assets in many countries. In the 1970s,
in Sweden, deposit accounts and other very liquid assets with little risk made up almost
60 percent of households' financial wealth, compared to less than 20 percent in the
2000s. The major part of this adjustment in financial portfolios has gone directly to
shares but a good deal now takes the form of various kinds of institutional investment for
groups of individuals, e.g., pension funds, mutual funds, hedge funds, insurance
investment of premiums, etc.

The trend towards forms of saving with a higher risk has been accentuated by new rules
for most funds and insurance, permitting a higher proportion of shares to bonds. Similar
tendencies are to be found in other industrialized countries. In all developed economic
systems, such as the European Union, the United States, Japan and other developed
nations, the trend has been the same: saving has moved away from traditional
(government insured) bank deposits to more risky securities of one sort or another

United States stock market returns

Years to Dec. 31, Average Annual Return % Average Compounded Annual Return %
 2010

1 15.1 15.1

3 1.3 10.8

5 5.1 6.7

10 3.7 5.1

15 9.1 4.7

20 10.9 5.7

30 11.3 7.0

40 10.5 7.7

50 10.0 7.8

60 10.8 8.0

The behavior of the stock market

NASDAQ in Times Square, New York City.

From experience we know that investors may 'temporarily' move financial prices away
from their long term aggregate price 'trends'. (Positive or up trends are referred to as bull
markets; negative or down trends are referred to as bear markets.) Over-reactions may
occur—so that excessive optimism (euphoria) may drive prices unduly high or excessive
pessimism may drive prices unduly low. Economists continue to debate whether
financial markets are 'generally' efficient.

According to one interpretation of the efficient-market hypothesis (EMH), only changes in

fundamental factors, such as the outlook for margins, profits or dividends, ought to affect
share prices beyond the short term, where random 'noise' in the system may prevail.
(But this largely theoretic academic viewpoint—known as 'hard' EMH—also predicts that
little or no trading should take place, contrary to fact, since prices are already at or near
equilibrium, having priced in all public knowledge.) The 'hard' efficient-market hypothesis
is sorely tested by such events as the stock market crash in 1987, when the Dow Jones
index plummeted 22.6 percent—the largest-ever one-day fall in the United States.[9]

This event demonstrated that share prices can fall dramatically even though, to this day,
it is impossible to fix a generally agreed upon definite cause: a thorough search failed to
detect any 'reasonable' development that might have accounted for the crash. (But note
that such events are predicted to occur strictly by chance, although very rarely.) It seems
also to be the case more generally that many price movements (beyond that which are
predicted to occur 'randomly') arenot occasioned by new information; a study of the fifty
largest one-day share price movements in the United States in the post-war period
seems to confirm this.[9]

However, a 'soft' EMH has emerged which does not require that prices remain at or near
equilibrium, but only that market participants not be able to systematically profit from any
momentary market 'inefficiencies'. Moreover, while EMH predicts that all price movement
(in the absence of change in fundamental information) is random (i.e., non-trending),
many studies have shown a marked tendency for the stock market to trend over time
periods of weeks or longer. Various explanations for such large and apparently non-
random price movements have been promulgated. For instance, some research has
shown that changes in estimated risk, and the use of certain strategies, such as stop-
loss limits and Value at Risk limits, theoretically could cause financial markets to
overreact. But the best explanation seems to be that the distribution of stock market
prices is non-Gaussian (in which case EMH, in any of its current forms, would not be
strictly applicable).[10][11]

Other research has shown that psychological factors may result

in exaggerated (statistically anomalous) stock price movements (contrary to EMH which
assumes such behaviors 'cancel out'). Psychological research has demonstrated that
people are predisposed to 'seeing' patterns, and often will perceive a pattern in what is,
in fact, just noise. (Something like seeing familiar shapes in clouds or ink blots.) In the
present context this means that a succession of good news items about a company may
lead investors to overreact positively (unjustifiably driving the price up). A period of good
returns also boosts the investor's self-confidence, reducing his (psychological) risk
threshold.[12]

Another phenomenon—also from psychology—that works against

an objective assessment is group thinking. As social animals, it is not easy to stick to an
opinion that differs markedly from that of a majority of the group. An example with which
one may be familiar is the reluctance to enter a restaurant that is empty; people
generally prefer to have their opinion validated by those of others in the group.

In one paper the authors draw an analogy with gambling.[13] In normal times the market
behaves like a game ofroulette; the probabilities are known and largely independent of
the investment decisions of the different players. In times of market stress, however, the
game becomes more like poker (herding behavior takes over). The players now must
give heavy weight to the psychology of other investors and how they are likely to react
psychologically.

The stock market, as with any other business, is quite unforgiving of amateurs.
Inexperienced investors rarely get the assistance and support they need. In the period
running up to the 1987 crash, less than 1 percent of the analyst's recommendations had
been to sell (and even during the 2000–2002 bear market, the average did not rise
above 5 %%). In the run up to 2000, the media amplified the general euphoria, with
reports of rapidly rising share prices and the notion that large sums of money could be
quickly earned in the so-called new economy stock market. (And later amplified the
gloom which descended during the 2000–2002 bear market, so that by summer of 2002,
predictions of a DOW average below 5000 were quite common.)

Irrational behavior

Sometimes the market seems to react irrationally to economic or financial news, even if
that news is likely to have no real effect on the fundamental value of securities itself. But
this may be more apparent than real, since often such news has been anticipated, and a
counterreaction may occur if the news is better (or worse) than expected. Therefore, the
stock market may be swayed in either direction by press releases, rumors, euphoria and
mass panic; but generally only briefly, as more experienced investors (especially the
hedge funds) quickly rally to take advantage of even the slightest, momentary hysteria.

Over the short-term, stocks and other securities can be battered or buoyed by any
number of fast market-changing events, making the stock market behavior difficult to
predict. Emotions can drive prices up and down, people are generally not as rational as
they think, and the reasons for buying and selling are generally obscure. Behaviorists
argue that investors often behave 'irrationally' when making investment decisions
thereby incorrectly pricing securities, which causes market inefficiencies, which, in turn,
are opportunities to make money.[14]However, the whole notion of EMH is that these non-
rational reactions to information cancel out, leaving the prices of stocks rationally
determined.

The Dow Jones Industrial Average biggest gain in one day was 936.42 points or 11
percent, this occurred on October 13, 2008.[15]

Crashes

Robert Shiller's plot of the S&P Composite Real Price Index, Earnings, Dividends, and
Interest Rates, from Irrational Exuberance, 2d ed.[16] In the preface to this edition,
Shiller warns, "The stock market has not come down to historical levels: the price-
earnings ratio as I define it in this book is still, at this writing [2005], in the mid-20s, far
higher than the historical average... People still place too much confidence in the
markets and have too strong a belief that paying attention to the gyrations in their
investments will someday make them rich, and so they do not make conservative
preparations for possible bad outcomes."
Price-Earnings ratios as a predictor of twenty-year returns based upon the plot by Robert
Shiller (Figure 10.1,[16] source). The horizontal axis shows the real price-earnings ratio of
the S&P Composite Stock Price Index as computed in Irrational Exuberance (inflation
adjusted price divided by the prior ten-year mean of inflation-adjusted earnings). The
vertical axis shows the geometric average real annual return on investing in the S&P
Composite Stock Price Index, reinvesting dividends, and selling twenty years later. Data
from different twenty year periods is color-coded as shown in the key. See also ten-year
returns. Shiller states that this plot "confirms that long-term investors—investors who
commit their money to an investment for ten full years—did do well when prices were
low relative to earnings at the beginning of the ten years. Long-term investors would be
well advised, individually, to lower their exposure to the stock market when it is high, as
it has been recently, and get into the market when it is low."[16]
Main article: Stock market crash

A stock market crash is often defined as a sharp dip in share prices of equities listed on
the stock exchanges. In parallel with various economic factors, a reason for stock market
crashes is also due to panic and investing public's loss of confidence. Often, stock
market crashes end speculative economic bubbles.

There have been famous stock market crashes that have ended in the loss of billions of
dollars and wealth destruction on a massive scale. An increasing number of people are
involved in the stock market, especially since the social security and retirement plans are
being increasingly privatized and linked tostocks and bonds and other elements of the
market. There have been a number of famous stock market crashes like theWall Street
Crash of 1929, the stock market crash of 1973–4, the Black Monday of 1987, the Dot-
com bubble of 2000, and the Stock Market Crash of 2008.

One of the most famous stock market crashes started October 24, 1929 on Black
Thursday. The Dow Jones Industrial lost 50 % during this stock market crash. It was the
beginning of the Great Depression. Another famous crash took place on October 19,
1987 – Black Monday. The crash began in Hong Kong and quickly spread around the
world.

By the end of October, stock markets in Hong Kong had fallen 45.5 %%, Australia
41.8 %%, Spain 31 %%, the United Kingdom 26.4 %%, the United States 22.68 %%,
and Canada 22.5 %%. Black Monday itself was the largest one-day percentage decline
in stock market history – the Dow Jones fell by 22.6 %% in a day. The names “Black
Monday” and “Black Tuesday” are also used for October 28–29, 1929, which followed
Terrible Thursday—the starting day of the stock market crash in 1929.

The crash in 1987 raised some puzzles-–main news and events did not predict the
catastrophe and visible reasons for the collapse were not identified. This event raised
questions about many important assumptions of modern economics, namely, the theory
of rational human conduct, the theory of market equilibrium and the hypothesis of market
efficiency. For some time after the crash, trading in stock exchanges worldwide was
halted, since the exchange computers did not perform well owing to enormous quantity
of trades being received at one time. This halt in trading allowed the Federal Reserve
system and central banks of other countries to take measures to control the spreading of
worldwide financial crisis. In the United States the SEC introduced several new
measures of control into the stock market in an attempt to prevent a re-occurrence of the
events of Black Monday.

Computer systems were upgraded in the stock exchanges to handle larger trading
volumes in a more accurate and controlled manner. The SEC modified the margin
requirements in an attempt to lower the volatility of common stocks, stock options and
the futures market. The New York Stock Exchange and the Chicago Mercantile
Exchange introduced the concept of a circuit breaker. The circuit breaker halts trading if
the Dow declines a prescribed number of points for a prescribed amount of time.

• New York Stock Exchange (NYSE) circuit breakers[17]

% drop time of drop close trading for

10 %%
before 2 pm one hour halt
drop

10 %%
2 pm – 2:30 pm half-hour halt
drop
10 %%
after 2:30 pm market stays open
drop

20 %%
before 1 pm halt for two hours
drop

20 %%
1 pm – 2 pm halt for one hour
drop

20 %%
after 2 pm close for the day
drop

30 %%
any time during day close for the day
drop

Stock market index

Main article: Stock market index

The movements of the prices in a market or section of a market are captured in price
indices called stock market indices, of which there are many, e.g., the S&P,
the FTSE and the Euronext indices. Such indices are usuallymarket
capitalization weighted, with the weights reflecting the contribution of the stock to the
index. The constituents of the index are reviewed frequently to include/exclude stocks in
order to reflect the changing business environment.

Derivative instruments
Main article: Derivative (finance)

Financial innovation has brought many new financial instruments whose pay-offs or
values depend on the prices of stocks. Some examples are exchange-traded
funds (ETFs), stock index and stock options, equity swaps, single-stock futures, and
stock index futures. These last two may be traded on futures exchanges (which are
distinct from stock exchanges—their history traces back to commodities futures
exchanges), or traded over-the-counter. As all of these products are only derived from
stocks, they are sometimes considered to be traded in a (hypothetical) derivatives
market, rather than the (hypothetical) stock market.

Leveraged strategies
Stock that a trader does not actually own may be traded using short selling; margin
buying may be used to purchase stock with borrowed funds; or, derivatives may be used
to control large blocks of stocks for a much smaller amount of money than would be
required by outright purchase or sale.

Short selling
Main article: Short selling

In short selling, the trader borrows stock (usually from his brokerage which holds its
clients' shares or its own shares on account to lend to short sellers) then sells it on the
market, hoping for the price to fall. The trader eventually buys back the stock, making
money if the price fell in the meantime and losing money if it rose. Exiting a short
position by buying back the stock is called "covering a short position." This strategy may
also be used by unscrupulous traders in illiquid or thinly traded markets to artificially
lower the price of a stock. Hence most markets either prevent short selling or place
restrictions on when and how a short sale can occur. The practice of naked shorting is
illegal in most (but not all) stock markets.

Margin buying
Main article: margin buying

In margin buying, the trader borrows money (at interest) to buy a stock and hopes for it
to rise. Most industrialized countries have regulations that require that if the borrowing is
based on collateral from other stocks the trader owns outright, it can be a maximum of a
certain percentage of those other stocks' value. In the United States, the margin
requirements have been 50 %% for many years (that is, if you want to make a $1000
investment, you need to put up $500, and there is often a maintenance margin below the
$500).

A margin call is made if the total value of the investor's account cannot support the loss
of the trade. (Upon a decline in the value of the margined securities additional funds may
be required to maintain the account's equity, and with or without notice the margined
security or any others within the account may be sold by the brokerage to protect its loan
position. The investor is responsible for any shortfall following such forced sales.)

Regulation of margin requirements (by the Federal Reserve) was implemented after the
Crash of 1929. Before that, speculators typically only needed to put up as little as 10
percent (or even less) of the total investment represented by the stocks purchased.
Other rules may include the prohibition of free-riding: putting in an order to buy stocks
without paying initially (there is normally a three-day grace period for delivery of the
stock), but then selling them (before the three-days are up) and using part of the
proceeds to make the original payment (assuming that the value of the stocks has not
declined in the interim).

New issuance
Main article: Thomson Financial league tables
Global issuance of equity and equity-related instruments totaled $505 billion in 2004, a
29.8 %% increase over the $389 billion raised in 2003. Initial public offerings (IPOs) by
US issuers increased 221 %% with 233 offerings that raised $45 billion, and IPOs
in Europe, Middle East and Africa (EMEA) increased by 333 %%, from $ 9 billion to
$39 billion.

Investment strategies
Main article: Stock valuation

One of the many things people always want to know about the stock market is, "How do
I make money investing?" There are many different approaches; two basic methods are
classified as either fundamental analysisor technical analysis. Fundamental
analysis refers to analyzing companies by their financial statements found in SEC
Filings, business trends, general economic conditions, etc. Technical analysis studies
price actions in markets through the use of charts and quantitative techniques to attempt
to forecast price trends regardless of the company's financial prospects. One example of
a technical strategy is the Trend following method, used by John W. Henry and Ed
Seykota, which uses price patterns, utilizes strict money management and is also rooted
in risk control and diversification.

Additionally, many choose to invest via the index method. In this method, one holds a
weighted or unweighted portfolio consisting of the entire stock market or some segment
of the stock market (such as the S&P 500 orWilshire 5000). The principal aim of this
strategy is to maximize diversification, minimize taxes from too frequent trading, and ride
the general trend of the stock market (which, in the U.S., has averaged nearly 10 %
%/year, compounded annually, since World War II).

⅔==Taxation==

Main article: Capital gains tax

According to much national or state legislation, a large array of fiscal obligations are
taxed for capital gains. Taxes are charged by the state over the transactions, dividends
and capital gains on the stock market, in particular in the stock exchanges. However,
these fiscal obligations may vary from jurisdictions to jurisdictions because, among other
reasons, it could be assumed that taxation is already incorporated into the stock price
through the different taxes companies pay to the state, or that tax free stock market
operations are useful to boost economic growth.