Gross Domestic Product (GDP) Demystified


GDP
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Gross Domestic Product is widely accepted as a measure of the economic development of a country. GDP measures both nation’s total output and income. There is a strong correlation between a country’s GDP and its standard of living. Countries that have high GDP like US, UK, France, Germany, Japan, Singapore etc have a higher standard of living for its masses.

What is GDP?

GDP is the final value of all goods and services produced in the economy in a given time period.

Imagine an economy which produces only two goods: bread and guns (and maybe import the rest of the things like butter, cars etc. from other countries). We’ll calculate the GDP of the country by multiplying quantities of bread and guns produced with their respective prices and sum it up.

GDP= ( quantity of bread produced  *  price of bread ) + (quantity of guns produced * price of guns  )

But, an economy produces many goods. To avoid double counting we calculate value-added of each product.

What is value-added?

Let us take another example to explain it. Now, the economy produces bread, guns and flour.  Flour is used as an intermediate good (raw material/ input) in the production of bread. If we take the final value of all goods in GDP, there will be double-counting of the flour that was used in the production of bread (as the price of flour is included in the price of bread also).

So, to avoid double counting of flour, we will take only the value-added of each product.

Value-added of bread= Value of bread – Value of intermediate goods (flour etc.),

This is a very simplified calculation of GDP. There are many intermediate goods required in the production of a good and so, to calculate value-added, we’ll deduct the prices of all those intermediate goods.

What is nominal and real GDP?

If we use current prices of goods and services to calculate GDP, we get nominal GDP. But, to get real GDP we do not multiply the quantity with current prices, but with prices in the base year. This is done to eliminate the effect of price rise in GDP.

Let us assume that an economy produces only bread. It produces 5 loaves of bread at Rs.20 in the year 2014. So, the total value of bread produced is Rs.100 (20 * 5). In the year 2015 also, the economy produces 5 loaves of bread (same as previous year), but price this year has increased to Rs.25. So, the total value of bread in the year 2015 is Rs.125 (25 * 5). Thus, it leads to an increase in GDP by 25%. (GDP increase from Rs.100 to Rs.125. So, the growth in GDP is 25%).

This increment happens even when there is no increase in the physical output produced in the economy.  So, to eliminate the effect of price increase in GDP, we calculate the GDP of both the years at one single constant price.

The base year to calculate GDP in India is 2011- 2012.

What are the different ways in which GDP is calculated?

We already have a conceptual understanding of what GDP is. Now we look at the three ways to calculate GDP:

Production method (or output method or value-added method):

In this method:

(i) an economy is classified into various sectors like manufacturing, agriculture, energy, construction etc.

(ii) Final value added is computed for each sector.

(iii) The GDP is the summation of value-added of the sectors.

Expenditure method

In this method, expenditure of all entities in the economy is added together to arrive at GDP. It works on the principle that the output produced in the economy is ultimately bought by somebody. So,  theoretically, the total expenditure must be equal to the total output of goods and services produced in the economy.

GDP= consumption by households (C) + Investment by businesses (I) + Government expenditure (G) + exports – imports. 

We add exports to take into account foreign expenditure on goods produced domestically. We subtract imports from total expenditure because this is the expenditure done by the people on foreign goods or services.

3. Income method

In this method, the income of all the factors of production, that is, land, labour, capital, and entrepreneur is added together to arrive at the GDP. Theoretically, all the three methods should arrive at the same total. The value-added of the economy (which we get from production method) is divided among the factors of production in the form of rent, wages, interest, and profits. Also, people spend what they earn (if we ignore savings).

Hence, output = expenditure= income.

GDP = rent + wages + interest + profits

How is National Income (Net National Income) calculated from Gross Domestic Product (GDP)?

First, we subtract the depreciation in the capital assets used during production from the Gross Domestic Product (GDP) to arrive at Net Domestic Product (NDP)

Then, we add net factor payments to the Net domestic product to arrive at Net National Product or National Income.

GDP is output produced or income within the geographical boundaries of a country. To get national income, we add income earned by the people outside the geographical boundaries of their country. Likewise, we subtract the income earned by foreign residents within our boundaries.

Thus, NationaI Income = GDP – Depreciation – net factor payments. 

Who calculates GDP in India?

It is calculated by Central Statistical Office (CSO). It is released quarterly with a lag of two months. Annual GDP is released on 31st May every year.

Further readings:

What is the difference between Nominal GDP and PPP GDP?

Changes in Methodology of Calculating GDP in India

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Have any Question or Comment?

4 comments on “Gross Domestic Product (GDP) Demystified

Varun Bhandari

“GDP is a true measure of economic development”. Do you really agree with the statement?

Reply
Mridusmita

No, GDP is just a “widely accepted” measure of the economic development of a country. There are other measures of development also like Human Development Index (HDI), Gross National Happiness (GNH) etc. These measures capture non-economic dimensions of development as well, along with economic dimensions.

Reply
Varun Bhandari

Explain the concept of GDP Deflator as well in this article, if possible.

Reply
Mridusmita

GDP deflator is the ratio of nominal GDP to the real GDP. Nominal GDP is calculated using the prices of the current year while the real GDP is calculated using the prices of the base year. In India, the base year is 2011-12 that is real GDP is calculated at the price of the year 2011-12.
GDP deflator is used as a measure of inflation like the consumer price index and the wholesale price index.

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