GDP stands for gross domestic product. It’s the social measure of the economy’s total output of goods and services. The definition of GDP is as follows: it is the total market value of all final goods and services produced during a given period within a nation’s domestic borders.
The word ‘domestic’ (in ‘gross domestic product’) means that we only count things produced within our domestic borders, even if foreigners pay them. It doesn’t matter. Nothing made outside of our domestic borders gets counted in the GDP.
What are different ways to Calculate GDP?
There are two widely accepted ways to measure the total production in an economy. One is called the income approach, and the other is called the expenditure approach.
The income approach measures the total income that is earned by all the households in a nation. In contrast, the expenditure approach measures the total spending on goods and services produced within the country’s domestic borders by households, firms, government, and foreigners.
Both of these methods of measuring GDP are directly tied to the circular flow model for an economy in which households exchange their factors of production (such as labor) for income. Then they spend their income on the products and services that firms produce. At the same time, the government receives taxes and makes purchases also within the circular ow of our economy.
The Income Approach
Let’s talk about the income approach.
The factors of production include land, labor, capital, and entrepreneurship. Each of these factors of production is exchanged for a corresponding source of income, which we call rent, wages, interest, and profit. When a person earns a paycheck, it is exchanged for the person’s factor of production, i.e., labor for wages.
When all the income in an economy is added, you get the gross domestic product using the income approach.
The Expenditure Approach
Now, let’s look at the same economy but from the expenditure (or spending) side. Economic decision makers within our economy include households, firms, governments, and foreigners. The spending directly connected with each of these decision-makers is Consumption, investment, government spending, and exports.
Now, when we combine all these types of spending, we get the formula for GDP: GDP = C + I + G + (X – M).
Another way to say this is Gross Domestic Product = Consumption + Investment + Government Spending + (Exports – Imports). Sometimes you’ll see (Exports – Imports) written as Net Exports, which means you subtract imports from exports.
Consumption: It represents all the purchases of goods and services made by households, accounts for the largest share of GDP, and has averaged between 65% and 70% for many decades. Consumption includes daily purchases: cars, computers, rent, food, utilities, clothes, and other consumer products.
Spending: Another component is government spending, which includes federal, state, and local expenditures on national defense, social security, and all levels of government operational expenses.
Investment: Investment (another GPD component) includes the costs of building factories, regular business expenses, the construction of new homes, and increases or decreases in business inventories.
Exports include goods and services produced within our borders but sold in other countries. Since money flows into our economy when we sell foreign products and services adds to our GDP. On the other hand, Imports are goods and services consumed within our country but produced in other countries. Again, because money flows out from our country to purchase these goods and services, imports subtract from GDP.
What’s Not Included in the GDP?
So here is a list of things that are not included:
- Sales of goods that were produced outside our domestic borders
- Sales of used goods
- Illegal sales of goods and services (which we call the black market)
- Transfer payments made by the government
- Intermediate goods that are used to produce other final goods
What are Nominal and Real GDP?
Nominal gross domestic product is the total market value of goods and services produced, measured in current monetary value, i.e., in today’s currency value. It represents present quantities at current prices.
The major drawback of using nominal GDP is that it creates a false impression of the amount of output taking place in a nation from one year to the next due to the change in prices. On the other hand, real gross domestic product is the total market value of goods and services produced, measured in constant currency value, i.e., adjusting it for inflation. It represents current quantities at past prices.
How to Calculate Real GDP?
The following formula calculates real GDP:
Real GDP = Nominal GDP / Deflator.
The deflator is a figure produced based on the rate of inflation. For example, the national inflation rate was 5% in a given year (indicating that the same goods and services cost an average of 5% more than they did the year before). In this case, the deflator will be 1.05.
For example, say an economy has a nominal GDP of $ 5 Trillion, the total of all goods and services as measured by their prices. Assume also that the economy has experienced 5% inflation over the year.
We would calculate real GDP as:
$ 5 Trillion / 1.05
= $ 4.76 Trillion.
GDP is a Great Tool for Investing & Business Planning
If you want to know the economic growth rate for a country, you can use the GDP.
GDP is an excellent tool for investing and business planning. It can be used as a reference when calculating returns on your investments. It also provides information about the current state of the economy in that country. . It is important to note that GDP does not always mean that a country is in good shape. For example, the GDP of a developing country may be strong, but its infrastructure may not be as well developed as that of a more economically advanced country.
We can also use it to compare different countries’ economic performance over time, which helps us to make better decisions on how we invest our money.
