Gross domestic product

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File:Gdp nominal and ppp 2005 world map single colour.png
CIA World Factbook 2008 figures of total nominal GDP (bottom) compared to PPP-adjusted GDP (top)
File:GDP nominal per capita world map IMF 2008.png
Countries by 2008 GDP (nominal) per capita (IMF, October 2008 estimate)
File:GDP PPP Per Capita IMF 2008.png
GDP (PPP) per capita

The gross domestic product (GDP) or gross domestic income (GDI) is a basic measure of a country's economic performance and is the market value of all final goods and services made within the borders of a country in a year. It is a fundamental measurement of production and is very often positively correlated with the standard of living,[1] though its use as a stand-in for measuring progress in increasing the standard of living has come under increasing criticism and many countries are actively exploring alternative measures.[1][1] GDP can be defined in three ways, all of which are conceptually identical. First, it is equal to the total expenditures for all final goods and services produced within the country in a stipulated period of time (usually a 365-day year). Second, it is equal to the sum of the value added at every stage of production (the intermediate stages) by all the industries within a country, plus taxes less subsidies on products, in the period. Third, it is equal to the sum of the income generated by production in the country in the period—that is, compensation of employees, taxes on production and imports less subsidies, and gross operating surplus (or profits).[1][1]


The most common approach to measuring and quantifying GDP is the expenditure method:

GDP = private consumption + gross investment + government spending + (exports − imports), or,
GDP = C + I + G + (X − M).

"Gross" means that depreciation of capital stock is not subtracted out of GDP. If net investment (which is gross investment minus depreciation) is substituted for gross investment in the equation above, then the formula for net domestic product is obtained. Consumption and investment in this equation are expenditure on final goods and services. The exports-minus-imports part of the equation (often called net exports) adjusts this by subtracting the part of this expenditure not produced domestically (the imports), and adding back in domestic area (the exports).

Economists (since Keynes) have preferred to split the general consumption term into two parts; private consumption, and public sector (or government) spending. Two advantages of dividing total consumption this way in theoretical macroeconomics are:

  • Private consumption is a central concern of welfare economics. The private investment and trade portions of the economy are ultimately directed (in mainstream economic models) to increases in long-term private consumption.
  • If separated from endogenous private consumption, government consumption can be treated as exogenous,Template:Citation needed so that different government spending levels can be considered within a meaningful macroeconomic framework.

Contents

Measuring GDP

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Components of GDP

GDP (Y) is a sum of Consumption (C), Investment (I), Government Spending (G) and Net Exports (X - M). This results in the common macroeconomics formula Y = C + I + G + (X − M). Here is a description of each GDP component:

  • C (consumption) is normally the largest GDP component, consisting of private household expenditures in the economy. These personal expenditures falls under one of the following categories: durable goods, non-durable goods, and services. Examples include food, rent, jewelry, gasoline, and medical expenses but does not include the purchase of new housing.
  • I (investment) includes business investment in plant, equipment, inventory, and structures, and 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. The distinction is (in theory) clear: if money is converted into goods or services, it is investment; but, if you buy a bond or a share of stock, this transfer payment is excluded from the GDP sum. That is because the stocks and bonds affect the financial capital which in turn affects the production and sales which in turn affects the investments. So stocks and bonds indirectly affect the GDP. Although such purchases would be called investments in normal speech, from the total-economy point of view, this is simply swapping of deeds, and not part of real production or the GDP formula.
  • G (government spending) is the sum of government expenditures on final goods and services. It includes salaries of public servants, purchase 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.

Examples of GDP component variables

C, I, G, and NX(net exports): If a person spends money to renovate a hotel to increase occupancy rates, the spending represents private investment, but if he buys shares in a consortium to execute the renovation, it is saving. The former is included when measuring GDP (in I), the latter is not. However, when the consortium conducted its own expenditure on renovation, that expenditure would be included in GDP.

If a hotel is a private home, spending for renovation would be measured as consumption, but if a government agency converts the hotel into an office for civil servants, the spending would be included in the public sector spending, or G.

If the renovation involves the purchase of a chandelier from abroad, that spending would also be counted as an increase in imports, so that NX would fall and the total GDP is affected by the purchase. Such notion highlights the fact that GDP is intended to measure domestic production rather than total consumption or spending. Spending provides a convenient means of estimating production.

If a domestic producer is paid to make the chandelier for a foreign hotel, the situation would be reversed, and the payment would be counted in NX (positively, as an export). Again, GDP measures production through the means of expenditure. If the chandelier produced had been bought domestically, it would have been included in the GDP figures in C or I when purchased by a consumer or a business, but because it was exported, it is necessary to 'correct' the amount consumed domestically to assess the domestic production, as in gross domestic product.

Types of GDP and GDP growth

File:Gdp real growth rate 2007 CIA Factbook.PNG
GDP real growth rates for 2008
  1. Current GDP is GDP expressed in the current prices of the period being measured
  2. Nominal GDP is the production of goods and services valued at current prices.
  3. Real GDP is the production of goods and services valued at a constant price level (ie: not affected by changes in the value of money)

Calculating the real GDP growth allows economists to determine if production increased or decreased, regardless of changes in the purchasing power of the currency.

GDP income account

Another way of measuring GDP is to measure the total income payable in the GDP income accounts. In such situation, gross domestic income (GDI) may be used rather than gross domestic product. GDI should provide the same amount as the expenditure method described above. (By definition, GDI = GDP. In practice, however, measurement errors will make the two figures slightly off when reported by national statistical agencies.)

The formula for GDP measured using the income approach, called GDP(I), is:

GDP = compensation of employees + gross operating surplus + gross mixed income + taxes, less subsidies on production and imports
  • 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, and 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).

Another formula can be written as follows:Template:Citation needed

GDP = R + I + P + SA + W

where R : rents
I : interests
P : profits
SA : statistical adjustments (corporate income taxes, dividends, undistributed corporate profits)
W : wages

GDP vs GNP

GDP can be contrasted with gross national product (GNP, or gross national income, GNI), which the United States used in its national accounts until 1992. The difference is that GNP includes net foreign income (the current account) rather than net exports and imports (the balance of trade). Put simply, GNP adds net foreign investment income, unlike GDP. United States GDP, GNP and GNI (gross national income) can be compared at EconStats [1].

GDP is concerned with the region in which income is generated. It is the market value of all the output produced in a nation in one year. GDP focuses on where the output is produced rather than who produced it. GDP measures all domestic production, disregarding the producing entities' nationalities.

In contrast, GNP is a measure of the value of the output produced by the "nationals" of a region. GNP focuses on who owns the production. For example, in the United States, GNP measures the value of output produced by American firms, regardless of where the firms are located. Year-over-year real GNP growth in the year 2007 was 3.2%.

Measurement

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) Template:Citation needed Template:Why.

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.

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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). Template:Main

Interest rates

Net interest expense is a transfer payment in all sectors except the financial sector. Net interest expenses in the financial sector are seen as production and value added and are added to GDP.

Three approaches to measuring GDP (macroeconomics)

1. Expenditures approach:

The total spending on all final goods and services (Consumption goods and services (C) + Gross Investments (I) + Government Purchases (G) + (Exports (X) - Imports (M))

GDP = C + I + G + (X-M)

2. Income approach (NI = National Income)

Using the income approach, GDP is calculated by adding up the factor incomes to the factors of production in the society. These include

Employee compensation + Corporate profits + Proprietor's Income + Rental income + Net Interest

3. Value added approach:

The value of sales of goods - purchase of intermediate goods to produce the goods sold.

Cross-border comparison

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 purchase power parity exchange rate.

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 and relative economic strength. 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 purchasing power parity method accounts for the relative effective domestic purchasing power of the average producer or consumer within an economy. The method can provide a better indicator of the living standards of less developed countries, because it compensates for the weakness of local currencies in the international markets. For example, India ranks 12th by nominal GDP, but fourth by PPP. The PPP method of GDP conversion is more relevant to non-traded goods and services.

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

GDP per capita is not a measurement of the standard of living in an economy. However, it is often used as such an indicator, on the rationale that all citizens would benefit from their country's increased economic production. Similarly, GDP per capita is not a measure of personal income. GDP may increase while incomes for the majority of a country's citizens may even decrease or change disproportionally. For example, in the US from 1990 to 2006 the earnings (adjusted for inflation) of individual workers, in private industry and services, increased by less than 0.5% per year while GDP (adjusted for inflation) increased about 3.6% per year over the same period.[1]

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, which allows a user to spot trends regularly. It is measured widely in that some measure of GDP is available for almost every country in the world, allowing a comparison between the standard of living in different countries. It is measured consistently in that the technical definition of GDP is relatively consistent among countries.

The major disadvantage is that it is not, strictly speaking, a measure of standard of living. GDP is intended to be a measure of particular types of economic activity within a country. Nothing about the definition of GDP suggests that it is necessarily a measure of standard of living. For instance, in an extreme example, a country which exported 100 per cent of its production and imported nothing would still have a high GDP, but a very poor standard of living.

The argument in favor of using GDP is not that it is a good indicator of the standard of living, but that, all other things being equal, the standard of living tends to increase when GDP per capita increases. As such, GDP can be a proxy for the standard of living, rather than a direct measure. GDP per capita can also be seen as a proxy of labor productivity. As the productivity of the workers increases, employers would offer higher wages to employ better workers.Template:Citation needed Conversely, if productivity is low, then wages must be low, or the businesses will not be able to make a profit.

Limitations of GDP to judge the health of an economy

Template:Confusing GDP is widely used by economists to gauge the health of an economy, as its variations are relatively quickly identified. However, its value as an indicator for the standard of living is considered to be limited. Not only that, but if the aim of economic activity is to produce ecologically sustainable increases in the overall human standard of living, GDP is a perverse measurement; it treats loss of ecosystem services as a benefit instead of a cost. Other criticisms of how the GDP is used include:

  • Wealth distribution – GDP does not take disparity in incomes between the rich and poor into account. However, numerous Nobel-prize winning economists have disputed the importance of income inequality as a factor in improving long-term economic growth. In fact, short term increases in income inequality may even lead to long term decreases in income inequality. See income inequality metrics for discussion of a variety of inequality-based economic measures.
  • Non-market transactions – GDP excludes activities that are not provided through the market, such as household production and volunteer or unpaid services. As a result, GDP is understated. Unpaid work conducted on Free and Open Source Software (such as Linux) contribute nothing to GDP, but it was estimated that it would have cost more than a billion US dollars for a commercial company to develop. Also, if Free and Open Source Software became identical to its proprietary software counterparts, and the nation producing the propriety software stops buying proprietary software and switches to Free and Open Source Software, then the GDP of this nation would reduce, however there would be no reduction in economic production or standard of living. The work of New Zealand economist Marilyn Waring has highlighted that if a concerted attempt to factor in unpaid work were made, then it would in part undo the injustices of unpaid (and in some cases, slave) labour, and also provide the political transparency and accountability necessary for democracy. Shedding some doubt on this claim, however, is the theory that won economist Douglass North the Nobel Prize in 1993. North argued that the creation and strengthening of the patent system, by encouraging private invention and enterprise, became the fundamental catalyst behind the Industrial Revolution in England.
  • Underground economy – Official GDP estimates may not take into account the underground economy, in which transactions contributing to production, such as illegal trade and tax-avoiding activities, are unreported, causing GDP to be underestimated.
  • 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 (I helped you build your house ten years ago, so now you help me).
  • GDP also ignores subsistence production.
  • Quality of goods – People may buy cheap, low-durability goods over and over again, or they may buy high-durability goods less often. It is possible that the monetary value of the items sold in the first case is higher than that in the second case, in which case a higher GDP is simply the result of greater inefficiency and waste.
  • Quality improvements and inclusion of new products – By not 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 from 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 back then.
  • What is being produced – GDP counts work that produces no net change or that results from repairing harm. For example, rebuilding after a natural disaster or war may produce a considerable amount of economic activity and thus boost GDP. The economic value of health care is another classic example—it may raise GDP if many people are sick and they are receiving expensive treatment, but it is not a desirable situation. Alternative economic measures, such as the standard of living or discretionary income per capita better measure the human utility of economic activity. See uneconomic growth.
  • Externalities – GDP ignores externalities or economic bads such as damage to the environment. By counting goods which increase utility but not deducting bads or accounting for the negative effects of higher production, such as more pollution, GDP is overstating economic welfare. The Genuine Progress Indicator is thus proposed by ecological economists and green economists as a substitute for GDP. In countries highly dependent on resource extraction or with high ecological footprints the disparities between GDP and GPI can be very large, indicating ecological overshoot. Some environmental costs, such as cleaning up oil spills are included in GDP.
  • Sustainability of growth – GDP does not measure the sustainability of growth. A country may achieve a temporarily high GDP by over-exploiting natural resources or by misallocating investment. For example, the large deposits of phosphates gave the people of Nauru one of the highest per capita incomes on earth, but since 1989 their standard of living has declined sharply as the supply has run out. Oil-rich states can sustain high GDPs without industrializing, but this high level would no longer be sustainable if the oil runs out. Economies experiencing an economic bubble, such as a housing bubble or stock bubble, or a low private-saving rate tend to appear to grow faster owing to higher consumption, mortgaging their futures for present growth. Economic growth at the expense of environmental degradation can end up costing dearly to clean up; GDP does not account for this.
  • One main problem in estimating GDP growth over time is that the purchasing power of money varies in different proportion for different goods, so when the GDP figure is deflated over time, GDP growth can vary greatly depending on the basket of goods used and the relative proportions used to deflate the GDP figure. For example, in the past 80 years the GDP per capita of the United States if measured by purchasing power of potatoes, did not grow significantly. But if it is measured by the purchasing power of eggs, it grew several times. For this reason, economists comparing multiple countries usually use a varied basket of goods.
  • Cross-border comparisons of GDP can be inaccurate as they do not take into account local differences in the quality of goods, even when adjusted for purchasing power parity. This type of adjustment to an exchange rate is controversial because of the difficulties of finding comparable baskets of goods to compare purchasing power across countries. For instance, people in country A may consume the same number of locally produced apples as in country B, but apples in country A are of a more tasty variety. This difference in material well being will not show up in GDP statistics. This is especially true for goods that are not traded globally, such as housing.
  • Transfer pricing on cross-border trades between associated companies may distort import and export measuresTemplate:Citation needed.
  • As a measure of actual sale prices, GDP does not capture the economic surplus between the price paid and subjective value received, and can therefore underestimate aggregate utility.
  • Austrian economist critique – Criticisms of GDP figures were expressed by Austrian economist Frank Shostak.[1] Among other criticisms, he stated the following:
    The GDP framework cannot tell us whether final goods and services that were produced during a particular period of time are a reflection of real wealth expansion, or a reflection of capital consumption.
    He goes on:
    For instance, if a government embarks on the building of a pyramid, which adds absolutely nothing to the well-being of individuals, the GDP framework will regard this as economic growth. In reality, however, the building of the pyramid will divert real funding from wealth-generating activities, thereby stifling the production of wealth.
    Austrian economists are critical of the basic idea of attempting to quantify national output. Shostak quotes Austrian economist Ludwig von Mises:
    The attempt to determine in money the wealth of a nation or the whole mankind are as childish as the mystic efforts to solve the riddles of the universe by worrying about the dimension of the pyramid of Cheops.
Simon Kuznets in his very first report to the US Congress in 1934 said:[1]
...the welfare of a nation [can] scarcely be inferred from a measure of national income...
In 1962, Kuznets stated:[1]
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.

Alternatives to GDP

  • Human development index (HDI) - HDI uses GDP as a part of its calculation and then factors in indicators of life expectancy and education levels.
  • Genuine progress indicator (GPI) or Index of Sustainable Economic Welfare (ISEW) - The GPI and the ISEW attempt to address many of the above criticisms by taking the same raw information supplied for GDP and then adjust for income distribution, add for the value of household and volunteer work, and subtract for crime and pollution.
  • Gini coefficient - The Gini coefficient measures the disparity of income within a nation.
  • Wealth estimates - The World Bank has developed a system for combining monetary wealth with intangible wealth (institutions and human capital) and environmental capital.[1]
  • Private Product Remaining - Murray Newton Rothbard and other Austrian economists argue that because government spending is taken from productive sectors and produces goods that consumers do not want, it is a burden on the economy and thus should be deducted. In his book, America's Great Depression, Rothbard argues that even government surpluses from taxation should be deducted to create an estimate of PPR.

Some people have looked beyond standard of living at a broader sense of quality of life or well-being:

  • European Quality of Life Survey - The survey, first published in 2005, assessed quality of life across European countries through a series of questions on overall subjective life satisfaction, satisfaction with different aspects of life, and sets of questions used to calculate deficits of time, loving, being and having.[1]
  • Gross national happiness - The Centre for Bhutanese Studies in Bhutan is working on a complex set of subjective and objective indicators to measure 'national happiness' in various domains (living standards, health, education, eco-system diversity and resilience, cultural vitality and diversity, time use and balance, good governance, community vitality and psychological well-being). This set of indicators would be used to assess progress towards gross national happiness, which they have already identified as being the nation's priority, above GDP.
  • Happy Planet Index - The happy planet index (HPI) is an index of human well-being and environmental impact, introduced by the New Economics Foundation (NEF) in 2006. It measures the environmental efficiency with which human well-being is achieved within a given country or group. Human well-being is defined in terms of subjective life satisfaction and life expectancy while environmental impact is defined by the Ecological Footprint.

Lists of countries by their GDP

See also

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References

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External links

Global

Data

Articles and books

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