What Is Gross Domestic Product (GDP)?
GDP, the acronym for Gross Domestic Product, is heard often in economic related discussions or news coverages. Well what exactly is GDP and what is its purpose? GDP is a monetary value which economists use to measure the health of an economy. To further understand how GDP is measured, let’s first familiarize ourselves with two different types of goods, final goods and intermediate goods. Final goods are the producer’s finished product which they are going to sell in the market. Intermediate goods are the goods required in assembling the final goods. GDP measures the monetary value of all final goods and services produced within an economy in a specific year. It is important to note that GDP does not consider the intermediate goods, the goods required to assemble the final goods. For example, if a consumer buys a car, then only the cost of purchasing the car will be included in GDP while the price of the intermediate goods used to make the car, such as the wheels or headlights will not be included in GDP. The reason for this is because these intermediate goods were once final goods and therefore have already been accounted for in GDP.
How do economists decide on a monetary value for each final good? There are three different methods which economists use to provide a monetary value for each final good in order to calculate an economy’s GDP.
Expenditure Approach:
The first method which economists use is called the “Expenditure Approach”. This method takes the sum of all consumer purchases made in a particular year. Various groups in an economy participate in purchasing goods and services. The Expenditure Approach takes the sum of all purchases made by all the different groups to calculate the GDP. To identify the specific groups which participate in making purchases, we can look at the formula for calculating GDP using the Expenditure Approach.
Expenditure Approach Formula
GDP = Consumer Spending + Investment + Government Spending + Net Exports
Consumer spending includes all purchases made by households in the product market. Investment includes all purchases made by the firms in the economy. Government Spending includes all purchases made by the government. Net Exports include all the purchases made abroad through trade. Net exports are calculated by finding the difference between the amount exported and the amount imported in a country (Net Exports = Exports — Imports). An increase in any one of these spendings will lead to an increase in GDP while a decrease in these spendings will lead to a decrease in GDP.
Income Approach:
The second method is called the “Income Approach”. This method takes the sum of the money received by all producers for each final good or service sold in a particular year. Measuring the amount of money received from selling, as in the Income Approach, and measuring the amount of money employed in spending, as in the Expenditure Approach, will yield the same value since one group’s spending is another group’s income. In other words, the monetary value spent and the monetary value received from one final good will be the same; therefore, the Income Approach and the Expenditure Approach will calculate the same GDP. Similar to the Expenditure approach, the Income Approach also accounts for all the different groups of producers receiving money. To identify the specific groups of producers, we can take a look at the formula for calculating GDP using the income approach.
Income Approach Formula
GDP = Wages + Rent + Interest + Profit
Wages include the money received by workers from providing services. Rent includes the money received from renting out land. Interest includes the money received from selling capital. Profit includes the money received by businesses from selling a good or service. Add all these together and we would be able to calculate the GDP for an economy.
Value-Added Approach:
The third method for measuring GDP is called the “Value-Added Approach”. This approach sums together the monetary value added at each step in the production process of each good. At each step in the production process, this approach considers the difference between the total cost of inputs and the current price of the goods being produced. This difference is essentially the amount of monetary value added to the good. The added monetary value at each step is summed up and included in the GDP. The final monetary value calculated for a good will be equal to the amount of money paid by the consumers and the amount of money received by the producers. Therefore, the value-added approach will also yield the same GDP as both the expenditure approach and the income approach.
Now that we know what’s in GDP, let’s look at what is left out of GDP. Intermediate goods and used goods are both not included in the GDP because they have already been accounted for in the GDP during their time as final goods. Financial transactions such as the purchase of stocks and bonds are also not included in GDP since the monetary value of producing a good or service is not being measured; rather, money is just being lended out or burrowed having no connection with the production of an economy. We will dive deeper into financial transactions in future articles. Lastly, transfer payments, which are payments given by the government to help a certain sector of the economy, are also not included in the GDP since they are not measuring the monetary value of producing goods and services.
It is important to note that GDP does not give a fully accurate picture of the health of an economy since GDP does not consider various aspects regarding the health of an economy. Any purchases made on the black market are not included in GDP. This could leave out certain productions and misrepresent an economy’s GDP. Furthermore, GDP does not account for other important aspects in measuring the health of an economy such as environmental cleanliness or the wellbeing of the people within the economy. Due to some of these limitations of GDP, it does not offer a completely accurate measure of the health of an economy and therefore is used by economists to receive only a general understanding of the welfare of an economy.