As a consequence of the Great Depression, there was a need to develop a framework to help American policymakers to gauge the recovery from the Great Depression. In 1937, Simon Kuznets, an economist at the National Bureau of Economic Research, presents the original formulation of gross domestic product (GDP) in his report to the U.S. Congress, “National Income, 1929-35.” His idea was to capture all economic production by individuals, companies, and the government in a single measure, which should rise in good times and fall in bad. That is how GDP is born (Foreign Policy, 2011). President Roosevelt’s government used the statistics to justify policies and budgets to bring the US out of the depression (Costanza et al., 2009).
In 1944, the Bretton Woods Conference was a major event in history to strengthen the use of GDP worldwide. During the Conference, officially known as the United Nations Monetary and Financial Conference, delegates from 44 nations met from July 1 to 22, 1944, in Bretton Woods, New Hampshire, to agree upon a series of new rules for the post-WWII international monetary system. The conference's two major accomplishments were the creation of the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD). The meeting aimed to speed economic progress everywhere, aid political stability, foster peace, and create a process for international cooperation on trade and currency exchange.
Gross domestic product defined
Gross domestic product (GDP) is the standard measure of the value of final goods and services produced by a country during a period (OECD, 2009). GDP is a key measure of a nation’s economic development and growth (Eurostat, 2011).
Gross domestic product (GDP) is the value of the goods and services produced by the nation’s economy less the value of the goods and services used up in production. GDP is also equal to the sum of personal consumption expenditures, gross private domestic investment, net exports of goods and services, and government consumption expenditures and gross investment.
Bureau of Economic Analysis
GDP can be calculated using three different methods, which should all result in the same figure:
I. Output less intermediate consumption (i.e., gross value added) plus taxes on products (such as VAT) less subsidies on products;
Gross Value Added (GVA) measures the contribution to the economy of each individual producer, industry, or sector. Simplistically it is the value of the number of goods and services that have been produced, less the cost of all inputs and raw materials that are directly attributable to that production. In other words, GVA is the sum of all values added at each stage of the production.
To get from GVA to GDP is important to factor in the taxes and subsidies on products. GVA figures do not include taxes paid on goods and services, such as VAT and duties on petrol and alcohol (Sloman & Garratt, 2016), as they are not values added in production. However, GDP is measured at market prices (actual prices paid for goods and services that include taxes). Thus, to calculate GDP using the method of production, it is vital to add taxes on products to GVA and subtract subsidies on products, as shown below:
GDP = GVA + taxes on products - subsidies on products
II. Income earned from production, equal to the sum of: employee compensation; the gross operating surplus of enterprises and government; the gross mixed income of unincorporated enterprises; and net taxes on production and imports (VAT, payroll tax, import duties, etc., less subsidies);
The second approach to calculate GDP is to focus on the income earned from production. GDP is calculated as the difference between a firm’s revenue from sales and the costs of purchases from other firms. The difference is made up of the incomes earned by those involved in the production process, such as wages and salaries, rent, interest, and profit. Sloman & Garratt (2016) explains since GVA is the sum of all values added, it must also be the sum of all incomes generated.
III. Expenditure on final goods and services minus imports: final consumption
expenditures, gross capital formation, and exports less imports.
The final method of calculating GDP is to add up all expenditure on final production (output) at market prices. This approach includes the following (Sloman & Garratt, 2016)*:
Figure 1. GDP: The Expenditure Approach
Consumer expenditure (C). This includes all expenditure on goods and services by households and by non-profit institutions serving households.
Government expenditure (G). This includes central and local government expenditure on final goods and services, It includes non-marketed services, such as health or education, but it excludes transfer payments (pension or social security payments).
Investment expenditure (I). This includes investment in capital, such as buildings and machinery. It also includes the value of any increase (+) or decrease (-) in inventories, whether of raw materials, semi-finished or finished goods.
Exports of goods and services (X). The value of British goods and services exported overseas.
Imports of goods and services (M). The value of imported goods and services must be subtracted from the total in order to account for the expenditure on domestic products. In other words, we subtract the part of consumer expenditure, government expenditure and investment that goes on imports as well as the imported components (e.g. raw materials) from exports. Therefore, the third approach to calculate the GDP uses the following formula:
GDP = C + I + G + X - M
*The passage was taken from the book ‘Essentials of Economics’ written by J. Sloman and D. Garratt (2016). Available at https://www.perlego.com/book/811343/essentials-of-economics-/pdf?queryID=68cc11ae127b60ee2ddb25ff2365b58c&searchIndexType=books Figure 1, retrieved from Economics by Parkin et al. (2017), presents the expenditure method to calculate GDP in the UK, which equaled £1.87 trillion in 2015 (published by Office for National Statistics). We can see that consumer consumption (C) accounted for 65% of total UK GDP in 2015 and that the value of products imported from overseas was greater than exported British goods, resulting in negative net exports.
GDP and inflation
Figure 2: Real and Nominal GDP
It is important to clarify the difference between nominal GDP and real GDP. The first indicates that GDP was measured using current prices and that inflation was not taken into account. The latter measures GDP that ruled in some particular year called the base year; thus, inflation is taken into account when working out the real GDP. According to Sloman & Garratt (2006), real GDP allows us to ‘’measure each year’s GDP, say 2011 prices (known as ‘GDP at constant 2011 prices’)… (that) would enable us to see how much real GDP had changed from one year to another. In other words, it would eliminate increases in nominal GDP that were merely due to an increase in prices (inflation).’’
How to calculate real GDP
Only to understand the idea of nominal and real GDP better, imagine that in 2010, total GPD in the UK accounted for 10 sold cars, each at £10,000. A year later, the same amount of cars was sold at £12,000. Thus, using the following calculation, we could conclude that the UK’s economy grew by 20%.
However, this could be a short-sighted and perhaps misleading way of looking at economic growth as we may have omitted the fact that prices of cars may have risen due to inflation, causing the nominal GDP to rise even though the number of cars sold was the same in both years. In other words, if we were going to determine the economic growth based on the number of cars sold, we would have realised that the growth of the economy from 2010 to 2011 was exactly 0%.
Figure 3: Calculating Nominal GDP and Real GDP
Parkin et al. (2017) provide an example of a simplified economy (see figure 3) that produces one consumption good (shirts), one capital good (computer chips), and one government service (security services) while net exports are zero (value of exported goods equals to the value of imported). Nominal GDP in 2015 was £300 million, while in 2013 it was £100 million. However, to calculate real GDP, the quantity produced in 2015 is multiplied by its price in 2013 (the base year). As a result, the real GDP in 2015 is £160 million compared to nominal values of £300 million. Calculating real GDP helps to isolate the increase in production from the rise of prices.
Real GDP can be also calculated using the GDP deflator, a ‘’type of price index, or form of measurement, that tracks changes in the value of goods produced in a nation from one year to another’’.
If the GDP deflator is not provided, the following formula can be used:
Using example from Figure 3, we can calculate the GDP deflator for year 2015 and then apply it to calculate the real GDP:
real GDP = 300,000,000 / 187.5 x 100 = 160,000,000
In both cases the real GDP is equal to £160,000,000.
Purchasing power parities (PPPs)
Countries calculate GDP levels using their own national currency. To compare GDP and the size of the economy across countries, these estimates have to be converted into a common currency. Often the conversion is made using current exchange rates, but these can give a misleading comparison of the true volumes of final goods and services in GDP. A better approach is to use purchasing power parity (PPP). According to Taylor & Taylor (2004), the PPP is:
''…a disarmingly simple theory that holds that the nominal exchange rate between two currencies should be equal to the ratio of aggregate price levels between the two countries, so that a unit of currency of one country will have the same purchasing power in a foreign country.''
Click on this link to read more about Purchasing Power Parities: https://scholar.harvard.edu/files/rogoff/files/51_jel1996.pdf GDP per capita
GDP per capita (or GDP per person) is a commonly used measure to compare economies across countries. It is an important indicator of economic performance and a useful unit used to compare average living standards and economic wellbeing between countries. GDP per capita is calculated using a country's GDP, divided by the nation's total population. UK GDP per person in 2019 was $42 330 (source: the World Bank), while in the U.S., it was $65 297.
GDP per capita is a great measure when comparing two countries' economies, whose size of the population differs significantly. Let's take into account UK and India.
Figure 4: India and UK: Comparison (2019)
Comparing India and the UK is a great example of how significant the GDP per capita measure can be. According to the World Bank, in 2019, India and the UK's total GDP were almost the same ($2.86bn vs. $2.82bn). Does it mean the economies of both countries are equally strong? Well… not necessarily. India has a total GDP so high because its total population is approximately 1.36 billion (the second-most populous country in the world, right after China) compared to the UK's 66.6 million.
While India's total GDP is one of the highest in the world, its GDP per capita is, in fact, one of the lowest. As a matter of fact, India's GDP per capita is smaller than the one of Angola ($2790), Honduras ($2574) or Nigeria (£2229) or slightly higher than in countries such as Bangladesh ($1855), Kenya ($1816) or Cambodia ($1643).
Nonetheless, GDP per capita has its weaknesses and limitations. For instance, it does not take into account the income distribution. It would not be impossible for a country to have a relatively high GDP per capita together with high poverty levels, indicating the there are few extremely wealthy people relative to the large population living in poverty or having little income.
Any thoughts?
Although the gross domestic product has been commonly used since the 30s and '40s to assess national economies' performance, there is no doubt this concept has some limitations.
First of all, some goods that people buy are not final goods and thus are not part of GDP. For example, if you invest in financial assets, such as shares or bonds, as well as second-hand goods, such as previously used cars or existing homes. Another weakness of the gross domestic product is the ''gross'' part, which means that depreciation of the capital (decrease in value of firm's goods due to tear and wear and obsolescence) was not deducted from the final value. As a matter of fact, a prominent economist Joe Stiglitz, suggests that GNNP (Green Net National Product) should replace GDP. In that case, GNNP would consider the depreciation of assets together with other measures such as the consideration of environmental damage derived from economic activities.
What is more, household production is not part of the GDP either. Imagine a large family with a rural estate that produces and consumes their own fruits, vegetables, meat, dairy products, and so on. If such products are home-produced but not sold on the market, it will not count toward GDP. Parkin et al. (2017) argue that the omission of household production from GDP underestimates the country's actual total production and thus its economic growth.
Economists' standard view is that despite its limitations, GDP is a useful measure of production and the overall level of economic activity in a country or region (Parkin et al., 2017). It is currently also one of the most important methods of showing how well, or badly, an economy is doing.
Bibliography
Costanza, R., Hart, M., Posner, S., Talberth, J. (2009). Beyond GDP: The Need for New Measures of Progress, Boston University. Available at https://www.bu.edu/pardee/files/documents/PP-004-GDP.pdf
Dickinson, E. (2011). Foreign Policy. GDP: A Brief History. Available at https://foreignpolicy.com/2011/01/03/gdp-a-brief-history/
OECD (2009). Aggregate national accounts: gross domestic product. OECD National Accounts Statistics (database). Available at http://dx.doi.org/10.1787/data-00001-en.
Parkin, M., Powell, M. and Matthews, K. (2017). Economics. 10th ed. [ebook] Pearson. Available at: https://www.perlego.com/book/811411/economics-pdf
Taylor, A.M., Taylor, M.P. (2004). Journal of Economic Perspectives. The Purchasing Power Parity Debate, 18(4), 135-158
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