Gross Domestic Product (GDP) means the value of all final goods and services that a nation produces during a given period-usually a year. GDP is the most common measure of growth or lack of it of an economy. This article looks at the different terms used in the process and methods of measuring it. It is a continuation of the Circular Flow Models of an economy discussed earlier in two separate articles. GDP measure is also called as the National Income Accounting. In measuring GDP we need to note the following important points:
A. The Stress on Final Output: GDP does not count intermediate goods (goods used used entirely in the production of final goods) because to do so would be to double count.
B. Exclusion of Financial Transactions, Secondhand Goods and Transfer Payments: Many transactions occur that have nothing to do with final goods and services produced.
1. Financial Transactions:
a. Buying and Selling Securities: The value of broker's services is included in GDP because they perform a service.
b. Government Transfer Payments: Transfer payments are payments for which no productive services are concurrently provided in exchange
c. Private Transfer Payments: This is a private transfer of funds from one person to another and these are not included in GDP.
2. Transfer of Secondhand Goods: The value of secondhand goods is included in the GDP in the year they were produced.
3. Other Excluded Transactions:
a. Household Production: Tasks performed by homemakers within their households for which they are not paid through the marketplace.
b. Otherwise Legal Underground Transactions: Legal transactions that are not reported and not taxed.
c. Illegal Underground Activities: These activities include prostitution, illegal gambling and sale of illegal drugs, etc.
d. Recognizing GDP's Limitations: GDP is a measure of production and an indicator of economic activity. It is not a measure of a nation's welfare. For example, it excludes non-market activity and says little about our environmental quality of life.
The two methods of measuring GDP are known as:
Expenditure Method that adds up the aggregate expenditure on all final goods and services (products) produced during a given year. Income Method on the other hand sums up the income of all those owners of resources who helped produced those products.
We would now look at each of the two methods in detail.
Deriving GDP by the Expenditure Approach: The expenditure approach is a way of adding up the dollar value at current market prices of all final goods and services consisting of the following:
1. Consumption Expenditures (C): Consumption expenditures fall into three categories: durable consumer goods, non-durable goods, and services.
2. Gross Private Domestic Investment (I): When economists refer to investment, they are referring to fixed investment, inventory investment, and consumer expenditures on new residential structures. Investment represents an addition to our future productive capacity.
3. Government Expenditures (G): The government buys goods and services from private firms and pays wages and salaries to government employees. Government goods that are not sold in the market we value them at their cost.
4. Foreign Expenditures (Net Exports: X - M): Net exports are equal to total value of exports (X) minus total value of imports (M).
Mathematical Representation for GDP Using the Expenditure Approach
GDP = C + I + G + X - M.
Where C is consumption spending, I is investment spending, G is governmentpurchases and X - M is net exports.
Depreciation and Net Domestic Product (NDP)
Depreciation is a reduction in the value of capital goods over a one-year period due to physical wear and obsolescence; also, called capital consumption allowance.
NDP = GDP - depreciation (capital consumption allowances)
NDP = C + I + G + net exports - depreciation.
Deriving GDP by the Income Approach: The second approach to calculating GDP is the income approach, which looks at total factor payments. Total income is all income earned by the owners of resources who put their factors of production to work. Using this approach gross domestic income or GDI is computed and GDI is identically equal to GDP.
1. Wages: Wages, salaries, and other forms of labor income, such as income in kind and incentive payments. Social Security taxes paid by both the employees and employers are also counted.
2. Interest: Only interest received by households plus net interest paid to us by foreigners is included.
3. Rent: Income earned by individuals for the use of their real (non-monetary) assets, such as farms and houses.
4. Profits: Total corporate profits plus proprietors' income, i.e. income earned from the operation of unincorporated businesses, which include sole proprietorships, partnerships and producers' cooperatives.
5. Indirect Business Taxes: All business taxes except the tax on corporate profits. Indirect business taxes include sales and business property taxes.
6. Depreciation: Depreciation must be added to Net Domestic Income to get Gross Domestic Income. Depreciation can be thought of as the portion of the current year's GDP that is used to replace physical capital consumed in the process of production. Since somebody has paid for the replacement, depreciation must be added as a component of gross domestic income
Other Components of National Income Accounting:
1. National Income (NI): National Income is the total of all factor payments to resource owners. It is obtained by subtracting indirect business taxes from NDP.
2. Personal Income (PI): Personal Income (PI) is the amount of income that households actually receive before they pay personal income taxes.
3. Disposable Personal Income (DPI): DPI is personal income after personal income taxes have been paid.
Per Capita GDP: This is the calculation of the amount of GDP per person. It is computed by dividing the real GDP by the total population. Per capita GDP of the United States is about $46,000 which is ranked ninth in the world.
(Note: Converting nominal GDP into real GDP is the subject of a separate article.)
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