What is GDP & How it is Calculated?
WHAT IS GDP?
Gross domestic product (GDP) is the value of all final goods and services produced within a country in each year, i.e. the geographic area of the country.
Let us break this sentence and explain each term in detail.
The measurement of GDP involves counting the production of millions of different goods and services—smart phones, cars, music downloads, computers, steel, bananas, college educations, and all other new goods and services produced in the current year—and summing them into a total rupee value.
Now, GDP counts the goods and services produced within the country and hence does not consider the products that the country imports from some other country. So, A car manufactured in India and exported to Europe would be included in the GDP but a bottle of wine manufactured in Scotland and imported in India would not be included in the calculation of GDP.
GDP only considers the product that are produced in the year of calculation. If a Mobile is produced and sold for 5000 rupees, it would be included in the calculation of GDP but if someone buys a second hand mobile, that would not be considered while calculating GDP.
Another important factor in calculation of GDP is that it only includes finished goods and not intermediate goods unless they are capital goods. Now what is the difference between finished and intermediate goods:
- Finished goods are those goods which cannot be sold again and are purchased for their final use. Foe e.g., when a person buys a shirt it is considered a finished good and its price is included in the calculation of GDP.
- Intermediate goods are those goods which are used to make a finished product, for e.g., cotton yarn used to make the shirt one buys comes under the intermediate goods and its price is not included in the calculation of GDP.
- Capital goods are goods that are used as intermediate goods to produce a final product but are still included in the calculation of GDP. For e.g., a tractor is used by farmers for producing potato, a final good, but is till included in the calculation of GDP.
How GDP is calculated?
The 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. What are factors of production? Factor of production are the inputs which goes into producing final product or service. There are 4 factors of production for a business – Labour, Capital, Land and Management.
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
Here is the 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 , Market cost.
GDP (Market Cost) = GDP (Factor Cost)+ (Indirect Taxes – Subsidies)
In India, we refer GDP (Market Cost) as India’s GDP from 2015 onwards. Before that we use to refer GDP Factor cost as India’s GDP.
The Expenditure Approach: Second approach is converse of Income approach as rather than Income, it begins with money spent on goods & services. For instance, consumers spend money to buy various goods and services, and businesses spend money as they invest in their business activities, by buying machinery, for instance. And governments also spend money. All these activities contribute to the GDP of a country.
GDP = Consumption +Investments +Govt Expenditures +(Exports-Imports)
- Consumption, for e.g. you paid for food, gas bill, car etc.
- Investments, for e.g., you bought house, invested in shares etc.
- Government expenditure, e.g., government constructed a bridge, money spent on that
- Exports, e.g., a pair of shoes are made in India and then exported to Europe
- imports, e.g., a dress made in Spain is imported to India
That is, 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. 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.
GDP is definitely one of the most important indicator of country’s economy. But it may not always give the right picture, there are few drawbacks of this parameter –
- GDP calculations doesn’t include Underground economy or Black money – Barter and cash transactions that take place outside of recorded marketplaces are referred to as the underground economy and are not included in GDP statistics. These activities are sometimes legal ones that are undertaken so as to avoid taxes and sometimes they are outright illegal acts, such as trafficking in illegal drugs.
- Non-Market Production – Goods and services produced but not exchanged for money, known as “nonmarket production”, are not measured, even though they have value. For instance, if you grow your own food, the value of that food will not be included in GDP. If you decide to watch TV instead of growing your own food and now have to purchase it, then the value of your food will be included in GDP
- Calculation complexities: As a concept GDP was introduced when market was Manufacturing driven but now with majorly services driven expenditures, calculating GDP has become a complex mechanism. Statisticians take many assumptions & factors to calculate complex outputs such as Financial Services, housing services (where most of the houses are self owned), govt services which are free etc. Another trickiest part of the calculation is adjusting for inflation and finding the GDP deflator.
- Changes in Quality: This year’s smartphone might cost more than last year’s, but if so it will also do more. It is difficult for statisticians to attribute change in price to change in quality as well. Due to this, inflation impact sometime is overstated. This calculation becomes more difficult in services, price of hair cut may have not just increase due to inflation but also due to better services provided by the barber which is almost impossible to determine.
With all these drawbacks, still GDP is the most important parameter to define country’s economic health.