When the national economy is being discussed, often one term comes into the limelight, and that is Gross Domestic Product or GDP. This is a commonly used measure of the strength of an economy. When it is going up, the economy is getting stronger. When it falls, the economy is moving toward recession.
What Is GDP?
It measures the value of every good and service that an economy produces. Generally, it is used to measure national production over the course of a year. The higher a country’s GDP, the stronger economy is because it produces goods and services with higher value. Calculating the value of absolutely everything an economy produces is complicated and there are multiple different ways to calculate GDP.
Different Types of GDP
GDP is used for many purposes, such as comparing the economy of two countries or tracking changes in the size of the economy. To help with these comparisons, economists have come up with multiple types of GDP to track, each with pros and cons and different purposes.
Nominal GDP
It is the simplest type and also one of the most frequently used. It is simply the value of everything an economy produces without making any adjustments or worrying about things like inflation. This means it can be used for comparing different economies or measuring output but it is less useful for comparison across time periods.
Real GDP
It measures GDP with adjustments for inflation. In normal terms, inflation is the process through which money loses purchasing power over time. If you ever heard from grandparents that in our times a loaf of bread was costing Rs 2, which is now costing Rs 50, that is the impact of inflation. For example, picture a country that makes Rs 1000 Cr worth of biscuits and absolutely nothing else. The next year, that country produces the same number of biscuits, if inflation is 10%, the country will sell those biscuits for Rs 1100 Cr. So now the country’s GDP is risen to Rs 1100 Cr, even though it produces exactly the same number of biscuits.
Real GDP adjusts for the impacts of inflation, so the real GDP of the country would be the same in both years.
Per Capita GDP
GDP per capita accounts for the number of people participating in the economy and looks at how much an economy produces per person. Consider two countries, each producing Rs 1 Lakh Crore worth of goods and services. If one country has a population of 1 Cr, and another has a population of 2 Cr, their economies likely look different despite having the same amount of production. So workers in the smaller countries must produce higher value goods than workers in the larger country because there are far few of them. Here in the first case per capita, GDP is Rs 1 lakh, and in the second case per capita, GDP is Rs 50,000. Per capita GDP is a good measure of a country’s prosperity, if not of its total economic strength.
Purchasing Power Parity
Different products cost different amounts in different places. Purchasing Power Parity (PPP) is a measurement of the prices of a specific basket of goods and services in different countries. In general, the strong a country, the higher its PPP. Higher PPPs also correlate with a higher standard of living. GDP PPP is a measure of economic output that adjusts a country’s GDP for factors that influence PPP, including exchange rates and purchasing power.
How to Calculate GDP
Calculating GDP is a complicated process, so economists use a few different methods:
- Production-The production approach calculates GDP based on the value of all of the final goods that an economy produces. The formula is—Gross Value added minus Intermediate consumption= Value of Output (GDP). The problem here is, many times goods and services can go untracked. This method also ignores the underground economy, which includes goods and services that are not reported to the government. This can include the sale of illegal goods and services, bartering, or under-the-table transactions.
- Income– This method of calculating GDP considers all of the money that companies and people in an economy earn. The formula for this method is—Total national income + Sales Taxes+ Depreciation+ Net Foreign factor income= GDP. Here net foreign income is the difference between the income an economy’s citizens and businesses produce in other countries versus the income produced by foreign citizens and business produced in the domestic market. This method has a few flaws- one is that production can increase without a commensurate increase in incomes, especially for daily workers. Another is that it fails to account for people who save and invest money rather than spend it.
- Expenditure– In this method, the approach to calculating GDP adds up all of the money spent in an economy to determine the value of goods it produces. The formula for this method is— Consumption+ Government spending+ Investment +Net exports= GDP. Here Consumption is all private spending on goods, but not on real estate or other major investments. Government spending includes govt spending on goods and services as well as wages paid. Things that reallocate money between groups, like unemployment benefits or subsidies are excluded. The Investment includes spending on things like capital equipment, inventory, and housing. Net exports is the difference between the value of a country’s exports and imports.
A drawback of the expenditure approach is that ignores the true value of a product or service and only looks at what was paid.
In the end GDP matters because it is one of the best tools that economists have to measure economies. That means GDP gets used to quantify changes in a nation’s economy over a period and to compare different economies. While GDP is a good and rough indicator of economic health, it also has limitations. It does not consider wealth distribution or inequality, which can lower the standard of living of the average citizen even if GDP rises. It does not consider environmental damage, sustainability, or the value of non-market transactions.
Waiting for your views on this blog.
Anil Malik
Mumbai, India
21st February 2023