Gross domestic product (GDP) is a monetary measure of the market value of all final goods
and services produced in a period (quarterly or yearly) of time.
Nominal GDP estimates are commonly used to determine the economic performance of a whole
country or region, and to make international comparisons.
Nominal GDP per capita does not, however, reflect differences in the cost of living
and the inflation rates of the countries; therefore using a basis of GDP per capita
at purchasing power parity (PPP) is arguably more useful when comparing differences in
living standards between different nations.
Definition: The OECD defines GDP as "an aggregate measure
of production equal to the sum of the gross values added of all resident and institutional
units engaged in production (plus any taxes, and minus any subsidies, on products not included
in the value of their outputs)."
An IMF publication states that "GDP measures the monetary value of final goods and services
- that are bought by the final user - produced in a country in a given period of time (say
a quarter or a year)."
Total GDP can also be broken down into the contribution of each industry or sector of
the economy.
The ratio of GDP to the total population of the region is the per capita GDP and the same
is called Mean Standard of Living.
GDP is considered the "world's most powerful statistical indicator of national development
and progress".
History: William Petty came up with a basic concept
of GDP to defend landlords against unfair taxation during warfare between the Dutch
and the English between 1652 and 1674.
Charles Davenantdeveloped the method further in 1695.
The modern concept of GDP was first developed by Simon Kuznets for a US Congress report
in 1934.
In this report, Kuznets warned against its use as a measure of welfare (see below under
limitations and criticisms).
After the Bretton Woods conference in 1944, GDP became the main tool for measuring a country's
economy.
At that time gross national product (GNP) was the preferred estimate, which differed
from GDP in that it measured production by a country's citizens at home and abroad rather
than its 'resident institutional units' (see OECD definition above).
The switch from "GNP" to "GDP" in the US was in 1991, trailing behind most other nations.
Crucial to the development of GDP was its role in the wartime effort.A crucial role
was played here by the US Department of Commerce under Milton Gilbert where ideas from Kuznets
were embedded into governmental institutions.
The history of the concept of GDP should be distinguished from the history of changes
in ways of estimating it.
The value added by firms is relatively easy to calculate from their accounts, but the
value added by the public sector, by financial industries, and by intangible asset creation
is more complex.
These activities are increasingly important in developed economies, and the international
conventions governing their estimation and their inclusion or exclusion in GDP regularly
change in an attempt to keep up with industrial advances.
In the words of one academic economist "The actual number for GDP is therefore the product
of a vast patchwork of statistics and a complicated set of processes carried out on the raw data
to fit them to the conceptual framework."
Determining gross domestic product (GDP): GDP can be determined in three ways, all of
which should, in principle, give the same result.
They are the production (or output or value added) approach, the income approach, or the
speculated expenditure approach.
The most direct of the three is the production 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.
Production approach: This approach mirrors the OECD definition
given above.
1.
Estimate the gross value of domestic output out of the many various economic activities;
2.
Determine the [intermediate consumption], i.e., the cost of material, supplies and services
used to produce final goods or services.
3.
Deduct intermediate consumption from gross value to obtain the gross value added.
Gross value added = gross value of output – value of intermediate consumption.
Value of output = value of the total sales of goods and services plus value of changes
in the inventory.
The sum of the gross value added in the various economic activities is known as "GDP at factor
cost".
GDP at factor cost plus indirect taxes less subsidies on products = "GDP at producer price".
For measuring output of domestic product, economic activities (i.e. industries) are
classified into various sectors.
After classifying economic activities, the output of each sector is calculated by any
of the following two methods: 1.
By multiplying the output of each sector by their respective market price and adding them
together 2.
By collecting data on gross sales and inventories from the records of companies and adding them
together The gross value of all sectors is then added
to get the gross value added (GVA) at factor cost.
Subtracting each sector's intermediate consumption from gross output gives the GVA at factor
cost.
Adding indirect tax minus subsidies in GVA at factor cost gives the "GVA at producer
prices".
Income approach: The second way of estimating GDP is to use
"the sum of primary incomes distributed by resident producer units".
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 later.
(By definition, GDI = GDP.
In practice, however, measurement errors will make the two figures slightly off when reported
by national statistical agencies.)
This method measures GDP by adding incomes that firms pay households for factors of production
they hire - wages for labour, 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' incomes 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 allowance) is added to get from net domestic product
to gross domestic product.
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 + proprietor's income
+ rental income + net interest Expenditure approach:
The third way to estimate GDP is to calculate the sum of the final uses of goods and services
(all uses except intermediate consumption) measured in purchasers' prices.
Market goods which are produced are purchased by someone.
In the case where a good is produced and unsold, the standard accounting convention is that
the producer has bought the good from themselves.
Therefore, measuring the total expenditure used to buy things is a way of measuring production.
This is known as the expenditure method of calculating GDP.
Components of GDP by expenditure: Here is a description of each GDP component:
C (consumption) is normally the largest GDP component in the economy, consisting of
private expenditures in the economy (household final consumption expenditure).
These personal expenditures fall under one of the following categories: durable goods,
nondurable goods, and services.
Examples include food, rent, jewelry, gasoline, and medical expenses, but not the purchase
of new housing.
I (investment) includes, for instance, business investment in equipment, but 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, purchases 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.
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.)
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]."
GDP vs GNI: GDP can be contrasted with gross national
product (GNP) or, as it is now known, gross national income (GNI).
The difference is that GDP defines its scope according to location, while GNI defines its
scope according to ownership.
In a global context, world GDP and world GNI are, therefore, equivalent terms.
GDP is product produced within a country's borders; GNI 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 practice, however, foreign ownership makes GDP and GNI 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 GNI; on the other hand, production
by an enterprise located outside the country, but owned by one of its citizens, counts as
part of its GNI but not its GDP.
For example, the GNI of the USA 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).
Nominal GDP and adjustments to GDP: The raw GDP figure as given by the equations
above is called the nominal, historical, or current, GDP.
When one compares GDP figures from one year to another, it is desirable to compensate
for changes in the value of money – i.e., for the effects of inflation or deflation.
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
a base year.
For example, suppose a country's GDP in 1990 was $100 million and its GDP in 2000 was $300
million.
Suppose also that inflation had halved the value of its currency over that period.
To meaningfully compare its GDP in 2000 to its GDP in 1990, we could multiply the GDP
in 2000 by one-half, to make it relative to 1990 as a base year.
The result would be that the GDP in 2000 equals $300 million × one-half = $150 million, in
1990 monetary terms.
We would see that the country's GDP had realistically increased 50 percent over that period, not
200 percent, 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 consumer price index, which measures inflation or deflation in the price of household
consumer goods, the GDP deflator measures changes in the prices of 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 indicates 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
account for is population growth.
If a country's GDP doubled over a certain period, but its population tripled, the increase
in GDP may not mean that the standard of living increased for the country's residents; the
average person in the country is producing less than they were before.
Per-capita GDP is a measure to account for population growth.
Cross-border comparison and purchasing power parity:
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 purchasing power parity
exchange rate.
Current currency exchange rate is the exchange rate in the international foreign
exchange 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.
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 PPP method of GDP conversion is more relevant to non-traded goods and services.
In the above example if hi-tech weapons are to be produced internally their amount will
be governed by GDP(PPP) rather than nominal GDP.
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.
Standard of living and GDP: Wealth distribution and externalities:
GDP per capita is often used as an indicator of living standards.
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.
GDP does not include several factors that influence the standard of living.
In particular, it fails to account for: Externalities – Economic growth may
entail an increase in negative externalities that are not directly measured in GDP.
Increased industrial output might grow GDP, but any pollution is not counted.
Non-market transactions– GDP excludes activities that are not provided through the
market, such as household production, bartering of goods and services, and volunteer or unpaid
services.
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.
Quality improvements and inclusion of new products– by not fully 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 in 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 then.
Sustainability of growth– GDP is a measurement of economic historic activity and is not necessarily
a projection.
Wealth distribution – GDP does not account for variances in incomes of various demographic
groups.
See income inequality metrics for discussion of a variety of inequality-based economic
measures.
It can be argued that GDP per capita as an indicator standard of living is correlated
with these factors, capturing them indirectly.
As a result, GDP per capita as a standard of living is a continued usage because most
people have a fairly accurate idea of what it is and know it is tough to come up with
quantitative measures for such constructs as happiness, quality of life, and well-being.
Limitations and criticisms: Limitations at introduction:
Simon Kuznets, the economist who developed the first comprehensive set of measures of
national income, stated in his first report to the US Congress in 1934, in a section titled
"Uses and Abuses of National Income Measurements": The valuable capacity of the human mind to
simplify a complex situation in a compact characterization becomes dangerous when not
controlled in terms of definitely stated criteria.
With quantitative measurements especially, the definiteness of the result suggests, often
misleadingly, a precision and simplicity in the outlines of the object measured.
Measurements of national income are subject to this type of illusion and resulting abuse,
especially since they deal with matters that are the center of conflict of opposing social
groups where the effectiveness of an argument is often contingent upon oversimplification.
All these qualifications upon estimates of national income as an index of productivity
are just as important when income measurements are interpreted from the point of view of
economic welfare.
But in the latter case additional difficulties will be suggested to anyone who wants to penetrate
below the surface of total figures and market values.
Economic welfare cannot be adequately measured unless the personal distribution of income
is known.
And no income measurement undertakes to estimate the reverse side of income, that is, the intensity
and unpleasantness of effort going into the earning of income.
The welfare of a nation can, therefore, scarcely be inferred from a measurement of national
income as defined above.
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.
Further criticisms: Ever since the development of GDP, multiple
observers have pointed out limitations of using GDP as the overarching measure of economic
and social progress.
Many environmentalists argue that GDP is a poor measure of social progress because it
does not take into account harm to the environment.
Although a high or rising level of GDP is often associated with increased economic and
social progress within a country, a number of scholars have pointed out that this does
not necessarily play out in many instances.
For example, Jean Drèze and Amartya Sen have pointed out that an increase in GDP or in
GDP growth does not necessarily lead to a higher standard of living, particularly in
areas such as healthcare and education.
Another important area that does not necessarily improve along with GDP is political liberty,
which is most notable in China, where GDP growth is strong yet political liberties are
heavily restricted.
GDP does not account for the distribution of income among the residents of a country,
because GDP is merely an aggregate measure.
An economy may be highly developed or growing rapidly, but also contain a wide gap between
the rich and the poor in a society.
These inequalities often occur on the lines of race, ethnicity, gender, religion, or other
minority status within countries.
This can lead to misleading characterizations of economic well-being if the income distribution
is heavily skewed toward the high end, as the poorer residents will not directly benefit
from the overall level of wealth and income generated in their country.
Even GDP per capita measures may have the same downside if inequality is high.
For example, South Africa during apartheid ranked high in terms of GDP per capita, but
the benefits of this immense wealth and income were not shared equally among the country.
GDP does not take into account the value of household and other unpaid work.
Some, including Martha Nussbaum, argue that this value should be included in measuring
GDP, as household labor is largely a substitute for goods and services that would otherwise
be purchased for value.
Even under conservative estimates, the value of unpaid labor in Australia has been calculated
to be over 50% of the country's GDP.
A later study analyzed this value in other countries, with results ranging from a low
of about 15% in Canada (using conservative estimates) to high of nearly 70% in the United
Kingdom (using more liberal estimates).
For the United States, the value was estimated to be between about 20% on the low end to
nearly 50% on the high end, depending on the methodology being used.
Because many public policies are shaped by GDP calculations and by the related field
of national accounts, the non-inclusion of unpaid work in calculating GDP can create
distortions in public policy, and some economists have advocated for changes in the way public
policies are formed and implemented.
The UK's Natural Capital Committee highlighted the shortcomings of GDP in its advice to the
UK Government in 2013, pointing out that GDP "focuses on flows, not stocks.
As a result, an economy can run down its assets yet, at the same time, record high levels
of GDP growth, until a point is reached where the depleted assets act as a check on future
growth".
They then went on to say that "it is apparent that the recorded GDP growth rate overstates
the sustainable growth rate.
Broader measures of wellbeing and wealth are needed for this and there is a danger that
short-term decisions based solely on what is currently measured by national accounts
may prove to be costly in the long-term".
Proposals to overcome GDP limitations: In response to these and other limitations
of using GDP, alternative approaches have emerged.
In the 1980s, Amartya Sen and Martha Nussbaum developed the capability approach, which focuses
on the functional capabilities enjoyed by people within a country, rather than the aggregate
wealth held within a country.
These capabilities consist of the functions that a person is able to achieve.
In 1990 Mahbub ul Haq, a Pakistani Economist at the United Nations, introduced the Human
Development Index (HDI).
The HDI is a composite index of life expectancy at birth, adult literacy rate and standard
of living measured as a logarithmic function of GDP, adjusted to purchasing power parity.
In 1989, John B. Cobb and Herman Daly introduced Index of Sustainable Economic Welfare
(ISEW) by taking into account various other factors such as consumption of nonrenewable
resources and degradation of the environment.
The new formula deducted from GDP (personal consumption + public non-defensive expenditures
- private defensive expenditures + capital formation + services from domestic labour
- costs of environmental degradation - depreciation of natural capital)
In 2005, Med Jones, an American Economist, at the International Institute of Management,
introduced the first secular Gross National Happiness Index a.k.a Gross National Well-beingframework
and Index to complement GDP economics with additional seven dimensions, including environment,
education, and government, work, social and health (mental and physical) indicators.
The proposal was inspired by the King of Bhutan's GNH philosophy.
In 2009 the European Union released a communication titled GDP and beyond: Measuring
progress in a changing world that identified five actions to improve the indicators of
progress in ways that make it more responsive to the concerns of its citizens: Introduced
a proposal to complementing GDP with environmental and social indicators
In 2009 Professors Joseph Stiglitz, Amartya Sen, and Jean-Paul Fitoussi at the Commission
on the Measurement of Economic Performance and Social Progress (CMEPSP), formed by French
President, Nicolas Sarkozy published a proposal to overcome the limitation of GDP economics
to expand the focus to well-being economics with wellbeing framework consisting of health,
environment, work, physical safety, economic safety, political freedom.
In 2012, the Karma Ura of the Center for Bhutan Studies published Bhutan Local GNH
Index contributors to happiness—physical, mental and spiritual health; time-balance;
social and community vitality; cultural vitality; education; living standards; good governance;
and ecological vitality.
The Bhutan GNH Index.
In 2013 OECD Better Life Index was published by the OECD.
The dimensions of the index included health, economic, workplace, income, jobs, housing,
civic engagement, life satisfaction In 2013 professors John Helliwell, Richard
Layard and Jeffrey Sachs published World Happiness Report and proposed to measure other wellbeing
indicators in addition to GDP.
The evaluation framework included GDP per capita, Gini (income inequality), life satisfaction,
health, freedom of life choices, trust and absence of corruption.
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