3 Methods of GDP Calculation
How is GDP Measured?
In our earlier article, What Is Gross Domestic Product (GDP), we have discussed the term GDP in detail. Now, Let’s understand what this GDP number tells us? How it is calculated? What are Methods of GDP Calculation?
What Is Gross Domestic Product (GDP)?
- GDP is the final value of the final goods and services produced within the geographic boundaries of a country during a specified period of time, normally a year.
- It counts the goods and services produced within the country and hence does not consider the products that the country imports from another country.
GDP Growth Rate
- GDP growth rate is an important indicator of the economic performance of a country. It is the percentage increase in GDP from year to year.
- It tells us exactly whether the economy is growing quicker or slower than the preceeding year. Most countries use real GDP to remove the effect of inflation.
- If the economy produces less than the preceeding year, it contracts and the growth rate is negative. This signals a recession. If it stays negative long enough, the recession turns into a depression.
Significance of GDP
- GDP is a broad measure of a country’s economic activity, used to estimate the size of an economy and growth rate. Because GDP provides a direct indication of the health and growth of the economy, businesses can use GDP as a guide to their business strategy. Investors also watch GDP since it provides a framework for investment decision-making.
- The “corporate profits” and “inventory” data in the GDP report are a great resource for equity investors, as both categories show total growth during the period. Corporate profits data also displays pre-tax profits, operating cash flows and breakdowns for all major sectors of the economy.
Methods of GDP Calculation
Gross Domestic Product (GDP) can be measured by 3 methods :
1. Income Approach :
- The income approach starts with the income earned from the production of goods and services. Under income approach we calculate the income earned by all the factors of production in an economy.
- Factors of production are the inputs which goes into producing final product or service. Thus, the factors of production for a business are – Land, Labour, Capital and Management within the domestic boundaries of a country.
- In this approach, we calculate income from each of these Factor of production which includes the wages got by labour, the rent earned by land, the return on capital in the form of interest, as well as business profits earned by management. Sum of All these incomes constitutes national income and is a way to calculate GDP.
- Formula : Net National Income = Wages + Rent + Interest + Profits
- To make it gross, we need to do two adjustments – Add depreciation of capital & Add Net Foreign Factor Income. NFFI is (income earned by the rest of the world in the country – income earned by the country from the rest of the world)
- GDP (Factor Cost) = Wages + Rent + Interest + Profits+ Depreciation + Net Foreign Factor Income
- This basically is the sum of final income of all factors of production contributing to a business in a country before tax.
- Now if we add taxes and deduct subsidies, then it become GDP at Market cost.
- GDP (Market Cost) = GDP (Factor Cost)+ (Indirect Taxes – Subsidies)
2. Expenditure Approach :
- Second approach is converse of Income approach as rather than Income, it begins with money spent on goods & services. This measures the total expenditure incurred by all entities on goods and services within the domestic boundaries of a country.
- Mathematically, GDP (as per expenditure method) = C + I + G + (EX-IM)
- C: Consumption Expenditure, ie when consumers spend money to buy various goods and services. For example – food, gas bill, car etc.
- I: Investment Expenditure, ie. when businesses spend money as they invest in their business activities. For eaxmple, buying land, machinery etc.
- G: Government Expenditure, ie. when government spends money on various development activities and
- (EX-IM): Exports minus Imports, that is, Net Exports. ie. we include the exports to other countries in calculation of GDP and subtract the imports from other countries to our country.
- The calculation of GDP from the above methods gives us the nominal GDP of the country. We will consider the difference between the Nominal and Real GDP in the coming article.
- Mostly GDP is calculated with both approaches and calculations are done in such a way that the values from both approaches should come almost equivalent.
3. Output (Production) Approach :
- This measures the monetary or market value of all the goods and services produced within the borders of the country.
- In order to avoid a distorted measure of GDP due to price level changes, GDP at constant prices or Real GDP is computed.
- GDP (as per output method) = Real GDP (GDP at constant prices) – Taxes + Subsidies.
Trend of India’s GDP & GDP Growth Rate
- In India, contributions to GDP are mainly divided into 3 broad sectors – Agriculture and allied services, Industry(Manufacturing) sector and Service sector. In India, GDP is measured as market prices and the base year for computation is 2011-12.
- As we have discussed above, GDP at market prices = GDP at factor cost + Indirect Taxes – Subsidies
- The trend of India’s GDP growth from 2011-12 to 2018-19 is shown in the following graph :
- GDP is a broad measure of a country’s economic activity, used to estimate the size of an economy and growth rate.
- 3 Methods of Gross Domestic Product (GDP) Calculation are : income method, expenditure method and production(output) method. It can be adjusted for inflation and population to provide deeper insights.
- In India, contributions to GDP are mainly divided into 3 broad sectors – Agriculture and Allied Services, Manufacturing Sector and Service Sector.
- GDP is considered as a key tool to guide policy makers, investors, and businesses in strategic decision making.