Gross domestic product (GDP) is the value of all final goods and services produced within an economy in a given period. Equivalently, it also means total income earned by all households, companies, and government. GDP can be estimated either by summing up all incomes (income approach) or all expenses (expenditure approach).
Sum-of-value-added or value-of-final-goods
GDP is not simply the sum of all sales made in an economy because many goods are intermediate, i.e. they are used as inputs in other goods. This would double-count production. Hence, GDP is calculated either by adding final values of all goods or by adding value addition at each stage.
GDP includes the final value of only those goods and services which are produced in the measurement period and whose value can be determined by being sold in the market. Hence, it excludes items produced in prior periods, transfer payments (payments by the government such as unemployment benefits), capital gains, the value of self-service (such as reading, commuting, etc.), immeasurable externalities (such as pollution, etc.), undocumented economy, barter transactions, etc. However, it includes owner-occupied residences at imputed values and value of government services at their cost.
Nominal GDP vs real GDP
Nominal GDP is the value of output at the current prices of goods and services. Real GDP, on the other hand, is the value of output at some base period prices. Nominal GDP includes the effect of changes in the price level, but the real GDP just measures the effect of output change. Real GDP per capita is quoted as a measure of standard of living in an economy. Real economic growth equals changes in real GDP.
GDP deflator (implicit price deflator for GDP) is the ratio of nominal GDP to real GDP. GDP deflator broadly measures the aggregate changes in the price level across the economy and change in GDP deflator provides a broader inflation measure than the CPI. GDP deflator can be used to convert nominal GDP to real GDP because real GDP equals nominal GDP divided by the GDP deflator.
Components of GDP
An economy can be classified into the household sector, business sector, government sector, and external sector. Under the expenditure approach, GDP is the sum of consumer spending C, the gross private investment I (which includes changes in inventories), government spending G and net exports i.e. exports X minus imports M.
GDP = C + I + G + X – M
The household sector provides factors production to firms in the factor market and receives income in return which they either consume in the goods market or save through the financial market. In the business sector, firms incur private investment spending which is critical for future growth. They borrow capital in the financial market. While in developed countries, it forms a significant part of the GPD, it is the most significant in developing countries. At the same time, it is the most volatile component and many short-run fluctuations result from changes in inventory investment.
The government sector collects taxes and incurs both investment and consumption expenditures, which are clubbed together in government spending G. Government spending G does not include all payments made by governments, because transfer payments are excluded from this sum (because they reflected in consumption C). When a government has a fiscal deficit (its expenditures exceed taxes), it borrows in financial markets.
The external sector deals with exports, imports, and associated capital flows. Net exports equal exports minus imports. Imports include all items purchased by residents of an economy from the outside world (including consumption, investment, etc.) When net exports are negative, imports are greater than exports and the country is said to be running a balance of trade surplus, which is coupled with an associated equivalent borrowing by the country in the financial market.
Expenditure approach vs income approach
Most countries use expenditure and income approaches to calculate GDP, but the expenditure approach is typically more reliable. Theoretically, both should be equal, but in reality, a statistical discrepancy creeps in.
National income is the income earned by all factors of production. It is the sum of compensation paid to employees, gross operating surplus (a measure of income earned by all capital employed in a business i.e. debt and equity, which is equivalent to profit plus consumption of fixed capital) plus taxes minus subsidies.
Personal income is a broad measure of household income and measures their purchasing power. It is the sum of compensation received by employees plus all other income sources gross of taxes.
Personal disposable income equals personal income minus net taxes. Net taxes equal personal taxes minus transfer payments received by households.
Disposable income is the most relevant measure of after-tax income available with households for consumption.
Net household savings equals personal disposable income minus personal consumption expenditure.
In most economies, which of the following is the most volatile component of GDP?
A) Gross private investment
B) Government spending
A is correct. Gross private investment is the most volatile because it depends on the real interest rate, business confidence, future price expectations, etc. A major portion of consumption is insensitive to economic cycles.
Gross private investment component is more significant, as a percentage of GDP, in
A) Developed countries
B) Developing countries
B is correct. Since developing countries are undergoing rapid infrastructure development in order to catch-up the proportion of gross private investment in their GDP is higher.
Which of the following is not part of GDP?
A) Estimated rent on properties that are occupied by the owners themselves.
B) Unemployment benefits paid by governments.
C) Government services.
B is correct. Transfer payments do not represent any production; hence they are excluded from GDP. Estimate rent on owner-occupied properties is included in GDP. Government services are also included at cost.
You work as an economist at Iron Bank of Braavos tasked with determining GDP contribution of the shipbuilding industry. You find out that the total cost of design and materials was $5 million, $20 million was incurred on fabrication and assembly, $2 million on painting, outfitting, and testing. There were no beginning inventories, total ships worth $30 million were delivered to the customers and $3 million stayed in inventories. Further, total sales of used ships during the year amounted to $5 million. GDP of the shipbuilding industry would be:
A) $33 million
B) $30 million
C) $65 million
A is correct. In GDP, we include final prices of newly produced items including those who are held in inventories and are not sold outright. Further, all intermediate goods (such as cost of design, materials, etc.) are not counted because final prices already include these costs.