Gross Domestic Product (GDP)

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GDP growth

“India’s GDP growth rate slowed down to 5.7%”

We come through such reports almost every day but not many of us know what GDP is. So, the question is, “what is GDP”? GDP stands for Gross Domestic Product. In layman’s term, the GDP is the total value of all final goods and services (goods and services produced for final usage) produced within a country in a fixed period of time.

Let’s imagine that our economy is like a supermarket with various goods like dresses, utensils etc. and services like massage. Now, every time a product is sold, we ring up its price and calculate the total after a fixed interval of time. The same is the case with GDP. In words of IMF publications, “GDP measures the monetary value of all final goods and services i.e. those that are bought by the final user, produced within a country in a given period of time”.

Albeit GDP is usually calculated on an annual basis, but countries like the USA and India estimates it on a quarterly basis and also for an entire year. Three very important points about GDP that should always be kept in mind are

1. GDP is a number and it expresses the worth of the output (final goods) of a country in local currency. E.g. the worth of all the final goods produced in India will be measured in Indian rupee.

2. GDP tries to cover all final goods and services as long as they are produced within a country in order to assure that the final value of everything produced is included in GDP.

3. As mentioned above, it is calculated for a specific period of time. GDP is a very useful number which can measure the standard of living but for that one needs to make a distinction between nominal and real GDP.

 

What is nominal and real GDP?

As we know that GDP is sum total of prices of all finished goods and services. Hence, it can be increased by two ways.

1. Increasing the prices of goods and services. This would lead to increase in GDP number. But this doesn’t mean that economy is producing more goods and services. This increase in GDP might look good on paper but it is nominal increase only which is due to inflation (rise in prices of goods and services).

2. Producing more valuable and better goods and services.

 

This is a real increase and this is what we really care about. It adds up the prices of all goods and services produced in an economy using the same set of prices over time. If we check US’ nominal GDP, we’ll find out the growth to be 55X since 1950, but the real GDP shows the growth to be only 8X bigger. And to know the average standard of living in the country, we divide the real GDP by country’s population. This would result in real GDP per capita which is found out to be 4X only. With this data, one can understand the real difference in the nominal and the real case and how important it is to distinguish between the two.

 

But, why is this GDP calculated?

GDP is an indicator used to check the health of a country’s economy. It is calculated to compare the economy’s growth to the previous quarter or year. For example, if GDP grows by 4%, it means that the economy has grown by 4% over the last year.

 

Calculation of GDP:

GDP can be calculated in three ways which more or less gives the same result.

1. Income approach

2. Production approach

3. Expenditure approach

The value-added approach or production approach is more realistic as it avoids double counting, helps us to figure out the sector which is contributing more. But can we rely upon GDP completely? Of course not!

GDP includes government expenditures too, which is the most significant shortcoming. For example, if the GDP of an economy increases by some percent due to increase in military expenditure or some other government expenditure, it does not mean that the economy’s consumption and investment have increased. GDP does not account nonmarket activities. For example, a mother raising a child is a very important activity but has nothing to do with the market. Hence, it isn’t taken in account albeit it can increase social welfare and is significant. Some destructive events which decrease social welfare can increase GDP. E.g. cutting a tree includes some market transactions and can increase GDP but it can be destructive. Thus, one should be cautious while judging the health of an economy using the GDP figures as it is clear that we cannot rely upon it.

 

Do all the countries use GDP?

Well! A very interesting fact is that Bhutan does not use GDP, but prefers GNH. GNH stands for gross national happiness which is used to measure the happiness of the people living in a nation.

King of Bhutan, Jigme Singye Wangchuk, said “ we do not believe in the gross national product. Gross national happiness is more important.” However, the critics did not appreciate it and described it as a propaganda tool to distract from ethnic cleansing and human right abuses which the Bhutanese government has committed.

 

Concluding it, more GDP does not necessarily point towards more human happiness. But, more GDP definitely indicates towards more market activities which includes production of goods and services, transactions etc. Hence, one can’t say advocate the abandoning the figure but for assessment of the health of an economy, one should prefer an index which does not ignore the important activities that GDP does not account.