Gross Domestic Product

What is Gross Domestic Product?

Definition:

GDP stands for "Gross Domestic Product" and represents the total monetary value of all final goods and
services produced (and sold on the market) within a country during a period of time (typically 1 year).

Purpose:

GDP is the most commonly used measure of economic activity.

History:

The first basic concept of GDP was invented at the end of the 18th century. The modern concept was
developed by the American economist Simon Kuznets in 1934 and adopted as the main measure of a
country's economy at the Bretton Woods conference in 1944.

What Was the Bretton Woods Agreement and System?

The Bretton Woods Agreement was negotiated in July 1944 by delegates from 44 countries at the United
Nations Monetary and Financial Conference held in Bretton Woods, New Hampshire. Thus,
the name “Bretton Woods Agreement.

Under the Bretton Woods System, gold was the basis for the U.S. dollar and other currencies were pegged
to the U.S. dollar’s value. The Bretton Woods System effectively came to an end in the early 1970s when
President Richard M. Nixon announced that the U.S. would no longer exchange gold for U.S. currency.

Formula of GDP:

Y = C + I + G + NX

Because in this equation Y captures every segment of the national economy, Y represents both GDP and
the national income. This because when money changes hands, it is expenditure for one party and income
for the other, and Y, capturing all these values, thus represents the net of the entire economy.
What does “Gross" stand for?

"Gross" (in "Gross Domestic Product") indicates that products are counted regardless of their subsequent
use. A product can be used for consumption, for investment, or to replace an asset. In all cases, the
product's final "sales receipt" will be added to the total GDP figure.

In contrast, "Net" doesn't account for products used to replace an asset (in order to offset depreciation).
"Net" only shows products used for consumption or investment.

What does “Domestic" stand for? (GDP vs. GNP and GNI)

Domestic (GDP)

"Domestic" (in "Gross Domestic Product") indicates that the inclusion criterion is geographical: goods
and services counted are those produced within the country's border, regardless of the nationality of the
producer. For example, the production of a German-owned factory in the Pakistan will be counted as part
of Pakistan’s GDP.

National (GNP)

In contrast, "National" (in "Gross National Product") indicates that the inclusion criterion is based on
citizenship (nationality): goods and services are counted when produced by a national of the country,
regardless of where the production physically takes place.

In the example, the production of a German-owned factory in the Pakistan will be counted as part of
Germany's GNP (Gross National Product) in addition to being counted as part of Pakistan' GDP.

Gross National Income (GNI)

GNI (Gross National Income) is a metric similar to GNP, since both are based on nationality rather than
geography. The difference is that, when calculating the total value, GNI uses the income approach
whereas GNP uses the production approach to calculate GDP. Both GNP and GNI should theoretically
yield the same result.

Who Calculates?

GDP is one of the most widely used tools to measure a country’s economy, and it is calculated by
countries themselves as well as occasionally by world organizations such as the World Bank, the
International Monetary Fund, and the United Nations. In the Pakistan, Pakistan GDP is measured
annually by the Pakistan Bureau of Statistics (PBS).
What does "Product" stand for?

"Product" (in "Gross Domestic Product") stands for production, or economic output, of final goods and
services sold on the market.

Included in GDP:

 Final goods and services sold for money. Only sales of final goods are counted, because the
transaction concerning a good used to make the final good (for example, the purchase of wood
used to build a chair) is already incorporated in the final good total value (price at which the chair
is sold).

Not included in GDP:

 Unpaid work: work performed within the family, volunteer work, etc.
 non-monetary compensated work
 goods not produced for sale in the marketplace
 bartered goods and services
 black market
 illegal activities
 transfer payments
 sales of used goods
 intermediate goods and services that are used to produce other final goods and services

Methods of Calculation of GDP

There are three relevant ways that used by economists worldwide to calculate the GDP of their countries.
GDP in most countries is calculated on a quarterly basis and the figures are used to calculate annual GDP.

1. Expenditure Method
2. Income Method
3. Production Method

Expenditure Method:

“This is the value of everything that is purchased within the country plus that country’s net exports to
other countries”.
The expenditure method is the most widely used method by economists to calculate GDP. In this method,
you calculate GDP by the goods and services offered to people in terms of how they are purchased. In
other instances, some goods or services are produced but not sold. This means that the goods or services
are produced but not sold meaning that the producers have kind of bought the goods and services from
themselves. These methods therefore include.

Formula for GDP

GDP = C + I + G + NX

a) GDP (Y) – Gross Domestic Product

b) Consumption (C) – consumption includes all goods consumed within a country’s

economy in the private sector. This also includes durable goods: last a long time ex: cars,
home appliances, Non-durable goods: last a short time ex: food, clothing, services: work
done for consumers ex: dry cleaning, air travel.

c) Investment (I) – this is the sum of all investments that are spent on capital equipment,
inventory, and housing. Business fixed investment: Spending on plant and equipment that
firms will use to produce other goods & services, Residential fixed investment: Spending on
housing units by consumers and Landlords, Inventory investment: The change in the value of all
firms’ inventories.

d) Governments Spending (G) – Government spending includes the total expenditure by the
country’s central government in the year. This can range from salaries, expenditure on
infrastructure, education, etc.
e) Total Exports (X-M) – This is the net exports or a country’s total exports less total imports

Income Method:

“This is the income of all the individuals and businesses within the country, also called domestic
income”.

How to calculate GDP using Income Method:

When using the income method to calculate GDP, there are various variables that should be collected.
When you want to calculate GDP using the income method, the following formula is applied;

GDP = Total National Income + Sales Tax + Depreciation + Net + Foreign Income Factor

Depreciation – This is the cost allocated to a tangible asset i.e. buildings over their economically viable
life.

The income approach starts with the income earned from the production of goods and services. Under
income approach we calculate the income earned by all the factors of production in an economy.

Factors of production are the input which goes into producing final product or service. Thus, the factors
of production for a business are – Land, Labour, Capital and Management within the domestic boundaries
of a country.

In this approach, we calculate income from each of these Factors of production which includes the wages
got by labour, the rent earned by land, the return on capital in the form of interest, as well as business
profits earned by management. Sum of All these incomes constitutes national income and is a way to
calculate GDP.

Formula: Net National Income = Wages + Rent + Interest + Profits

To make it gross, we need to do two adjustments – Add depreciation of capital & Add Net Foreign Factor
Income. NFFI is (income earned by the rest of the world in the country – income earned by the country
from the rest of the world)

GDP (Factor Cost) = Wages + Rent + Interest + Profits+ Depreciation + Net Foreign Factor Income

This basically is the sum of final income of all factors of production contributing to a business in a
country before tax.

Now if we add taxes and deduct subsidies, then it becomes GDP at Market cost.

GDP (Market Cost) = GDP (Factor Cost) + (Indirect Taxes – Subsidies)

Production Method / Output Method:

“This is the market value of everything that is produced within the country”.

I. This measures the monetary or market value of all the goods and services produced within the
borders of the country.
 II. In order to avoid a distorted measure of GDP due to price level changes, GDP at constant prices
or Real GDP is computed.
III. GDP (as per output method) = Real GDP (GDP at constant prices) – Taxes + Subsidies.

Growth Rate of GDP

GDP is an excellent index with which to compare the economy at two points in time. That
comparison can then be used formulate the growth rate of total output within a nation.

In order to calculate the GDP growth rate, subtract 1 from the value received by dividing the
GDP for the first year by the GDP for the second year.

GDP growth rate = [(GDP1)/(GDP2] - 1

For example, using , in year 1 Country B produced 5 bananas worth $1 each and 5 backrubs
worth $6 each. In year 2 Country B produced 10 bananas worth $1 each and 7 backrubs worth $6
each. In this case the GDP growth rate from year 1 to year 2 would be:
[(10 X $1) + (7 X $6)] / [(5 X $1) + (5 X $6)] - 1 = 49%
There is an obvious problem with this method of computing growth in total output: both
increases in the price of goods produced and increases in the quantity of goods produced lead to
increases in GDP. From the GDP growth rate it is therefore difficult to determine if it is
the amount of output that is changing or if it is the price of output undergoing change.

Types of GDP

There are four different types of GDP and it is important to know the difference between them, as they
each show different economic outlooks.

1. Real GDP. Real GDP is a calculation of GDP that is adjusted for inflation. The prices of goods
and services are calculated at a constant price level, which is usually set by a predetermined base
year or by using the price levels of the previous year. Real GDP is considered the most accurate
portrayal of a country’s economy and economic growth rate.
2. Nominal GDP. Nominal GDP is calculated with inflation. The prices of goods and services are
calculated at current price levels.
 3. Actual GDP. Actual GDP is the measurement of a country’s economy at the current moment in
time.
4. Potential GDP. Potential GDP is a calculation of a country’s economy under ideal conditions.
Like a steady currency, lo w inflation, and full employment.

What Are the Drawbacks of Using GDP in Calculations?

There are few drawbacks and criticisms of GDP.

 GDP as a whole does not indicate the standard of living . Even though China has largest
GDP, its standard of living is quite low and it is considered a “middle income” country. The
United States, on the other hand, has one of the highest standards of living in the world, with
high incomes and a large amount of consumer spending. The GDP can be divided by the total
population of a country to determine the standard of living, which is called GDP per capita.
 GDP does not include any black market economies. Though some countries, like the United
States, do try to make estimates based on tax revenues. Black markets include any goods and
services that are bought and sold but which are not reported because they are illegal. This
includes drugs and drug dealing, illegal prostitution, and illegal labor.
 GDP also does not include other forms of unreported labor. Unreported labor includes
childcare or household maintenance like cooking or cleaning. This means that, for example,
the sector of the economy made up of men and women, who choose to stay home to look after
their children, while they work full time, are not included in national figures on the economy
or labor.
 GDP does not include environmental costs of economic output. For example, the single-use
plastic cup that was produced and sold was included in the GDP but the long-term cost
associated with its disposal and harm it causes the environment are not included.

GDP is a crucial measure of economies. However, while GDP can portray a country’s standard of
living, it does not take into account a population’s overall wellbeing, health, and happiness. This is
why economics is an important, yet imperfect, science.