Wednesday, 19 September 2012

What is GDP?

After several discussions and arguments recently, I discovered that although most people are bombarded with statements of the "GDP has retracted by 1%" or "the banks' assets are greater than the nation's GDP" kind, many do not have a clear image of what GDP is, or what it counts. To begin with, GDP is short for Gross Domestic Product, was developed by economist Simon Kouznets in a UN report in 1934, and has been the main measure of a country's economy since the Bretton Woods conference in 1944.

GDP is calculated as follows (based on the expenditure method, meaning that every good or service has a price and is therefore measurable):

GDP = Private Consumption (C) + Gross Investment (I) + Government Spending (G) + (Exports - Imports)

Now let's see what the components of GDP are (most of the definitions used here are from Wikipedia):
1. Private Consumption falls under one of the following categories: durable goods, non-durable goods, and services. Examples include food, rent, jewelry, gasoline, and medical expenses but do not include the purchase of new housing.
2. Investment includes, for instance, business investment in equipment, but does not include exchanges of existing assets. Examples include construction of a new mine, purchase of software, or purchase of machinery and equipment for a factory. Spending by households (not government) on new houses is also included in Investment. In lieu of the common use of investment, i.e. purchase of financial products, these are not considered as investment but as savings.
3. Government Spending is the sum of government expenditures on final goods and services. It includes salaries of public servants, purchase of weapons for the military, and any investment expenditure by a government. It does not include any transfer payments, such as social security or unemployment benefits.
4. Exports are gross exports within the year measured and Imports are the gross imports within the same year.

What some people believe is that GDP is some sort of state income, which is distributed to people in some way. This is far from true as GDP is merely a rough measure of the economy's ability to produce and not any sort of income, although it is measured on an annual basis. As economist note, the main driving force of the above equation is Private Consumption (C). If for example, due to a prolonged crisis, people are afraid to go out and shop, since they believe that they will need the money later on, or if their income has fallen, C will go down and drag GDP will it. Similarly, in a crisis, Investment usually falls, as less people are likely to buy new houses and less firms invest in new equipment. Imports usually fall as well since people, faced with less purchasing power than before due to their unwillingness to spend, or lack of income, are less eager to purchase foreign goods.

The only part of the equation which is really a matter of government is G (Government Spending). That is the reason why in most nations where budget cuts are implemented, in the form of wage reductions, GDP falls. However, as one may observe, transfers from the government to the people (e.g. social benefits, pensions) are not included in the definition for government spending. Nevertheless, this does not mean that it these will not affect GDP, since a reduction in pensions, such as the one currently occurring in Greece, affects GDP indirectly, as pensioners with fewer money will spend less and C will drop.

As a matter of fact, GDP is neither a measure of welfare as it can only measure what is measurable and lacks an ability to quantify quality. Although sometimes it is used as such, even Kuznets himself has separated the ability of GDP to measure an economy's production and its use as a measure of welfare:
"Distinctions must be kept in mind between quantity and quality of growth, between costs and returns, and between the short and long run. Goals for more growth should specify more growth of what and for what." (Kuznets, 1962)

1 comment:

  1. Great explainatory post, plus didn't knew that GDP only became fashionable after Bretton Woods. It's also intersting to note that the equation for GDP is the same as for aggregate demand - I have written a post myself explaining it here: