Measure of a nation’s Standard of Living
Gross Domestic Product
Erskine S. Walther, Ph.D.
GDP: The market value of all final goods and services produced in an economy in a specific period of time.
Market Value: The measurement is in current prices, this known as Nominal GDP or just GDP.
Final Goods and Services: Goods and services that have reached their final usage. They are not used to produce another good or service. Goods that are used in that way are Intermediate Goods.
Intermediate Goods and Services are those that are used as inputs into the production of other goods and services. There are not directly counted in GDP as their value is included in the value (price) of the final goods and services. Thus, counting them directly would double count the same output. However, if the intermediate good has not been sold, it is counted in GDP as inventory.
GDP Defined: continued
Specific Period of Time: GDP can be computed for a month, a quarter or a year. The most common measures are annually and quarterly.
Formal, Legal Markets: Only goods and services that are traded in formal, legal markets are counted in GDP.
Underground Economy: The underground economy is composed of economic transactions involving activities that are not legal activities in a given society. These are not included in GDP. Illegal drugs and illegal gambling are common examples.
Informal Economy: These are legal activities that do no go through formal markets. They are not included in GDP. Income not reported for taxation purposes or work done for barter are examples of informal economic activities.
Some authors include legal activities as part of the underground economy definition.
GDP Defined: continued
Household Production: Productive activities done in and for the household are not counted in GDP as there is no direct monetary payment for such activities. (If you give children an allowance for household chores that would be part of the informal economy. If you clean your own home, that is household production.)
Leisure Activities: Leisure activities that do not involve the purchase of goods and services are not counted in GDP.
Spending an afternoon with family and friends that does not involve buying goods or services would not be counted in GDP as no economic transaction has occurred.
A vacation involving paid activities does count in GDP as goods and services are purchased.
The Purpose of GDP is to measure the total output of goods and services in any economy during a specific period of time.
GDP is Value Neutral: It makes no judgments regarding product quality or whether or not a good or service is “good” for you. Those judgments are left to the consumer who is assumed to be able to make intelligent decisions that reflect their own personal tastes, preferences and values.
Changes in GDP measure economic growth.
Economic growth is the increase in the output of goods and services in an economy over a specific period of time. This must be done using Real GDP values.
GDP: Real vs. Nominal
Nominal GDP is GDP measured in current prices. This is referred to simply as GDP.
Real GDP is Nominal GDP adjusted for price changes. To compare across time, Real GDP is required otherwise price changes will distort the values and lead to incorrect analysis.
GDP (Price) Deflator or just the GDP Deflator is the price index used to adjust Nominal GDP for price changes. This adjustment produces Real GDP values.
This is the broadest measure of price changes in the economy as it includes everything that is included in GDP.
GDP is a measure of total output. However, the production of output simultaneously involves the creation of income as the input (resources) used in the production process must be paid. That payment is income to the resource owners.
Thus, GDP can be computed as a Sum of Income created by the production process. While this is a useful computation, it is also a bit complicated.
GDP can also be computed as a Sum of Expenditures. This is a more straight forward approach which also has several analysis advantages.
Thus, the GDP measure tells us the National Income of the country as well as the production activity and the amount of spending in the economy.
GDP: The Expenditure Streams: PCE
GDP is composed for four Expenditure Streams. The major categories of spending.
Personal Consumption Expenditures (Consumption): This is the spending of the household sector of the economy. It is also referred to a Consumer Spending. In the developed world it is the largest of the expenditure streams. In the US it has normally been about 2/3’s of GDP. But in the last few years it has increased to 70% to 72% of GDP. Thus, it is a very important component of GDP, but it is relatively stable.
In addition to the household sector, the spending of private non-profit organizations is counted under PCE.
GDP: The Expenditure Streams: GPDI
Gross Private Domestic Investment is the spending of the business sector. It is commonly known simply as Investment Spending.
This is the most changeable of the spending streams.
It tends to be the leading factor in movements into recessions and in movements out of recessions. Thus, it is closely watched.
It is sensitive to interest rates and to expectations about the future.
Business confidence is a widely used measure of expectations about the future.
Investment spending is critical to long term economic growth.
It is a primary source of new technologies.
GDP: The Expenditure Streams: GPGS
Government Purchases of Good and Services is the spending the by government sector. It is commonly called Government Spending.
It includes spending by all levels of government.
It includes all types of expenditures by all levels of government. It counts everything from paper clips to welfare to highways to national defense, etc.
Be sensitive to the context when you hear or read about government spending. Many speakers/authors only mean federal government spending when they use the term. But for GDP purposes it includes all levels of government.
GDP: The Expenditure Streams: NX
Net Exports is Exports – Imports. This is sometimes referred to as “the rest of the world”. It is the international component of GDP.
Exports are goods produced domestically, but sold internationally.
Imports are goods produced internationally (in a foreign country), but sold domestically.
Exports bring money into the economy and produce domestic jobs and income.
Imports send money out of the economy and produce jobs and income in other countries. (That may, in turn, increase the market for exports.).
GDP: Sum of Expenditures: Equation
GDP computed as a Sum of Expenditures can be summarized in the following equation:
GDP = C + I + G + NX
This can also be written as: Y = C + I + G + NX where Y is GDP or National Income, we’ll treat these different expressions as interchangeable.
C = Consumption
I = Investment
G = Government
NX = Net Exports
GDP: Per Capita GDP: Standard of Living
Per Capita GDP is GDP/Population
Per Capita GDP is normal measure of Standard of Living.
This is an average and tells us the amount of output that the economy produces per person.
It does not mean that each individual in the society receives that amount of output. It is not a measure of Income Distribution, just of what is potentially available to each individual.
Therefore, it is not a measure of Quality of Life (however that is defined).
But it does tell us about the potential that an economy has to provide for it’s members. A higher GDP means a greater potential that people have more opportunities, more goods and services available to them and that the public sector can offer more services as it has a larger tax base.
What is demanded is what is produced.
Thus, the specific goods and services that make up GDP are a reflection of those goods and services demanded by the expenditure streams.
In a market based economy, consumers are the primary determiners of what is demanded and; therefore, of what is produced. Consumer income determines how what is produced is distributed across the economy.
In a command economy, the government determines what is produced and how it is distributed across the economy.
Mixed economies have a market based element and a government based element. Developed economies are normally mixed economies. The relative mix of free market and government decision making varies widely across the developed world and more so in the developing world.
GDP: International Comparisons
When comparing the GDPs of different nations an adjustment must be made for the use of different currencies in order to put the values into the same currency, normally US Dollars.
Exchange Rate Method – this approach uses the current exchange rate to convert the GDP into US Dollars.
While this method is the easiest to calculate, it’s accuracy is diminished by the variability of exchange rates during any given year and the reality that exchange rates do not always reflect the domestic purchasing power of a currency.
Purchasing Power Parity (PPP) – this approach adjusts exchange rates for differences in the domestic purchasing power of different currencies. The core concept is that it should take the same amount of purchasing power (opportunity cost) to buy good X regardless of the country of purchase or the currency used.
This is the preferred method for calculating and comparing GDPs internationally. GDPs calculated in this way will be noted as GDP (PPP).
GDP (PPP) values will be expressed in a common currency, normally US Dollars.
GDP: International Comparisons: continued
Other factors that influence the ability to compare GDP values across countries include:
Accuracy of GDP data collection – This is not a problem with developed world countries as they have sophisticated data collection systems. However, it is a factor with developing country values. In the developing world, data collection methods are not as well developed and the informal economy can be a significant part of total economic activity.
There is nothing that can be done about this difficulty and for our purposes it can be ignored even in cases with the numbers may be significant.
Different legal structures – Since GDP only includes legal activities and only legal activities are counted in GDP, national law differences can impact GDP values.
Activities that are illegal in the US, for example, may well be legal in other countries.
The differences this would create are usually too small to be of significance, thus, they be safely ignored.
GDP: Summary of Key Points
GDP is the market value of all final goods and services produced in an economy during a specific time period.
Nominal GDP is GDP in current prices.
Real GDP is Nominal GDP adjusted for price changes and must be used for any cross-temporal comparisons.
The adjustment is made using the GDP Price Deflator – which is the broadest measure of price changes in use.
GDP: Summary of Key Points: continued
GDP is composed of four spending streams of which Consumption is the largest, but Investment is the most variable.
GDP includes only economic activity that is legal and occurs in formal markets.
GDP makes no value judgments about the non-monetary worth of what is produced.
Per Capita GDP is the measure of Standard of Living.
GDP: Summary of Key Points: continued
Purchasing Power Parity is the preferred method for calculating foreign GDP values for conversion into US Dollars for international comparisons.
GDP is the most widely used overall measure of economic performance and is essential for measuring economic growth.
Per Capita GDP is the normal measure of a nation’s Standard of Living.