What is Gross Domestic Product (GDP) and how is it calculated?
April 18, 2023
Let’s discover what GDP, Gross Domestic Product, is and how it is calculated, by defining it with 3 possible methods (production, income and expenditure). We’re going to look at the relationship with inflation, comparing different countries and tackling the main criticisms towards this index.
What is GDP: meaning and definition of Gross Domestic Product
To explain what GDP (Gross Domestic Product) is, so as to understand its meaning, definition and how it is calculated, we can start with the 3 components of the term.
First of all, it estimates the value of all goods produced and services offered in a country in a given period. Usually the calculation considers the calendar year, but the main focus is on the quarter: if growth were negative for two consecutive periods, i.e. 6 months, it would indicate a condition of ” technical recession ” for the state.
The adjective ‘domestic‘ excludes the results of work done by expatriates or citizens outside the country, but considers the value added by foreign enterprises operating within the national borders. For example, if you are born in the UK but your employment or business is abroad, you do not contribute to the british Gross Domestic Product. In short, to understand what GDP is, you have to count everything produced at home, regardless of who is responsible for it.
In contrast, the Gross National Product (GNP) also takes into account the fruits of the activities of citizens belonging to a given country but carried out on foreign territory; however, it subtracts the value generated by enterprises that are not native to the country in question or at least not owned by residents.
Finally, the GDP is gross of the depreciation of depleted capital: in simple terms, it considers the investments made by companies to replace or restore worn-out plants, machinery and buildings. Depreciation maintains productive capacity over time, counteracting the depreciation of physical resources. Subtracting this from GDP, however, gives the Net Domestic Product (NDP).
The meaning of GDP can be translated into a welfare index for the state, which assesses the level of economic health and growth. In this regard, considering value added as earnings distributed among the factors of production (the workers), Gross Domestic Product corresponds to Gross Domestic Income, a measure of national wealth.
When divided by the total national population, we obtain the GDP (or income) per capita: the hypothetical share produced by each person residing in a given country. This simple average extracts an estimate of the standard of living from the definition of GDP; in a very populous nation, therefore, a low GDP per capita underlines a condition of general poverty.
How is GDP calculated?
Studying what GDP (Gross Domestic Product) is, we can look at it from both sides of the law of supply and demand. Simply put, goods and services are produced to be consumed, so that the purchase returns profit. Given these facets in the meaning of GDP, then, how is it calculated? We have 3 methods, one for each facet: production, income and expenditure.
The first approach considers the value added to the raw materials and intermediate products from each stage of production, processed and incorporated to create the final products. The quantities thus obtained, when multiplied by market prices, return the most common measure for defining GDP. Services, in a similar way, are accounted for at their cost, although this is difficult to estimate for some: the value of government services, for example, is calculated on the basis of government expenditure.
The production method, therefore, subtracts the value of intermediate products from the value of goods, because they are already included in the final price, so as to obtain GDP at factor cost. Adding taxes (such as VAT) and subtracting government subsidies, on the other hand, yields GDP at producer price.
The primary income criterion, on the other hand, looks for the meaning of GDP in the revenues obtained and distributed by national production units. More specifically, GDP can be calculated as the sum of:
- Employee compensation – wages and salaries paid by the employer, in addition to social security programmes;
- Gross operating surplus – profits and interest on capital reserved for investors and owners of corporatised businesses. In the case of unstructured businesses (such as a small shop), however, we speak of gross mixed income;
- Depreciation and rental income: investments in upgrading means of production and rental payments.
To this definition of GDP as ‘total factor income’ we then add taxes and subtract government subsidies, so that we can calculate the Gross Domestic Product at the final price of goods.
Finally, the last method to understand what GDP is and how it is calculated is the expenditure approach: in practice, the total expenditure of households and of the government to buy goods and services is considered. Specifically, Gross Domestic Product results from the sum of:
- Consumption ( C ) – private expenditure on durable and non-durable goods, as well as on services. As a rule, it is the component that weighs most in the calculation of GDP;
- Investment (I) – use of money by companies to support production (including depreciation), or by citizens to buy houses. Unsold products (stocks) are part of investments, as if the seller had bought them from himself. Investment in financial instruments is not included because the capital thus raised by companies is already accounted for to buy instruments or pay wages;
- Public expenditure (G): money used by the state to purchase goods and pay for services, e.g. for public administration.
- Balance of trade (X-M): the difference between exports and imports, to add in income from abroad and subtract expenses for the international supply of goods and services.
The formula for calculating GDP from expenditure forms, therefore, is this:
GDP = C+I+G+(X-M)
In general, the three methods should return the same result for Gross Domestic Product, but the expenditure approach is usually more reliable than the income-based calculation.
Nominal and real GDP: deflator and purchasing power parity
Knowing what GDP is provides an insight into the economic condition of a country, calculating year-on-year rises or falls. Considering the formula GDP = quantity * product price, however, we can see that changes may not only depend on production increases: inflation increases costs, ‘falsifying’ the Gross Domestic Product.
In this regard, the specification ‘nominal‘ is added to the meaning of GDP if the value is obtained by considering prices of the current period; however, if a ‘base year’ were taken as a reference, a real measure of Gross Domestic Product would be obtained. In practice, to calculate GDP growth net of inflation, new quantities produced are multiplied by the prices of a specific year.
The value obtained by dividing nominal GDP (current prices) by real GDP (constant prices) is called the GDP deflator and measures the inflation rate between the years considered. Unlike the consumer price index (CPI), the deflator considers the change in the prices of all goods and services produced and not just a narrow basket.
Similarly, to compare the definition of Gross Domestic Product between different countries, we need to normalise prices to a common standard. However, we cannot simply convert GDP figures into dollars, because exchange rates between fiat currencies are determined by supply and demand in the Forex market, which does not reflect the real cost of goods, especially those that are not traded internationally.
Thus, the International Monetary Fund and the World Bank calculate GDP at Purchasing Power Parity (PPP): they consider the ratio between the prices of certain goods and services in different countries, sometimes corrected for the national inflation rate. The most famous PPP index is the Big Mac Index, created by Pam Woodall: to correct for exchange rates between currencies, they consider the price in different countries of the famous Mcdonald sandwich.
The Big Mac index, in the comparison between the UK (London) and the US, measures approximately 4.19£/5.15$ = 0,81, exactly the same as the dollar/pound sterling exchange rate in April 2023 (1$ : 0.81£). This is not a common situation, but the purchasing power of the pound converges with that of the dollar, as predicted by PPP theory for the long run. According to the Big Mac index, for example, the euro is overvalued against the dollar.
The PPP standard sets, internationally, a single meaning of GDP in order to identify optimal growth levels for the economy. For example, the EU Stability Pact has two common targets for member states:
- Debt-to-GDP ratio below 60%
- Deficit-to-GDP ratio below 3%.
The two measures are linked, because the deficit is the difference between a country’s income and expenditure which, if negative, forces the issuance of government bonds to finance the debt.
Criticism of Gross Domestic Product
Reflecting on what GDP is, scholars and organisations over time have raised some criticisms:
- It neglects unpaid services, such as voluntary or non-profit activities, which contribute to social welfare, even if they do not generate cash flow;
- It ignores the environmental impact of production, in terms of consumption and renewal of natural resources;
- It only considers the quantity of goods produced and not the quality, it does not distinguish between ‘positive’ and ‘negative’ expenditure, such as buying a book from a packet of cigarettes.
In general, the recognised limitation in the definition of GDP is its purely economic value: growth should be related to the actual improvement of the quality of life in the nation. For this purpose, alternative models have been proposed, such as the Genuine Progress Indicator (GPI), which considers factors such as pollution, road accident rates and the cost burden of crime.
Alternatively, to complement the meaning of GDP, there is the Gross National Happiness Index, which gives more weight to popular well-being than to consumption, based on elements such as the level of education, health, air quality and wealth of social relations.Finally, looking at what GDP is and how it is calculated, we realised that it is an estimate ‘lagging’ behind the economic cycle: Gross Domestic Product is a lagging indicator, i.e. a retrospective calculated at the end of a reference period.
European monetary policies (such as quantitative easing) observe the past in order to intervene in the future, but must combine GDP with leading indicators: forecasting tools, on which states also base their fiscal reforms.