In economics, the gross domestic product (GDP) is a measure of the amount of the economic production of a particular territory in financial capital terms during a specific time period. It is one of the measures of national income and output.
GDP is defined as the total value of all goods and services produced within that territory during a specified period (or, if not specified, annually, so that "the UK GDP" is the UK's annual product). GDP differs from gross national product (GNP) in excluding inter-country income transfers, in effect attributing to a territory the product generated within it rather than the incomes received in it.
Whereas nominal GDP refers to the total amount of money spent on GDP, real GDP refers to an effort to correct this number for the effects of inflation in order to estimate the sum of the actual quantity of goods and services making up GDP. The former is sometimes called "money GDP," while the latter is termed "constant-price" or "inflation-corrected" GDP -- or "GDP in base-year prices" (where the base year is the reference year of the index used). See real vs. nominal in economics.
A common equation for GDP is:
- GDP = consumption + investment + exports - imports
Economists (since Keynes) have prefered to split the general consumption term into two parts; private consumption, and public sector spending. Two advantages of dividing total consumption this way in theoretical macroeconomics are:
Private consumption is a central concern of welfare economics. The private investment and trade portions of the economy are ultimately directed (in mainstream economic models) to increases in long-term private consumption.
- If separated from endogenous private consumption, Government consumption can be treated as exogenous, so that different government spending levels can be considered within a meaningful macroeconomic framework.
Therefore the standard GDP formula is expressed as:
- GDP = private consumption + government + investment + net exports
- (or simply GDP = C + I + G + NX)
Definition of the components of GDP
The breakdown of GDP into the variables C, I, G, and NX helps economists define each part more exactly:
C is private consumption (or Consumer expenditures) in the economy. This is sometimes clarified as: consumer expenditures on final goods and services. All the variables in the GDP equation measure final goods & services expenditures rather than total expenditures; the distinction removes from total expenditure those items which are primarily assets. For instance, buying a Renoir doesn't boost GDP by $20m. (If it did, buying and selling the same painting repeatedly to a gallery would imply great wealth rather than penury.) Note that the Renoir purchase would effect the GDP figure, but not as a $20m receipt, the auctioneer's fees would appear in GDP under Consumer expenditure, because this is a final service.
I is defined as business investments in infrastructure, or any other spending intended to generate a subsequent return through business activities. Examples of investment are: training, R&D, marketing, and recruitment. The word 'investment' here is meant very specifically as non-financial product purchases. Buying financial products is classed as saving in macroeconomics, as opposed to investment (which, in the GDP formula is a form of spending). The distinction is (in theory) clear: if money is converted into goods or services, without a repayment liability it is investment. For example, if you buy a bond or share the ownership of the money has only nominally changed hands, and this transfer payment is excluded from the GDP sum. Although such purchases would be called investments in normal speech, from the total-economy point of view, this is simply swapping of deeds, and not part of the real economy or the GDP formula.
G is the sum of all government expenditures. The ratio of this to GDP as a whole is critical in the theory of crowding out, and the Keynesian cross .
NX are "net exports" in the economy (gross exports - gross imports). GDP captures the amount a country produces, including goods and services produced for overseas consumption, therefore exports are added. Imports are subtracted since imported goods will be included in the terms G, I, or C, and must be deducted to avoid counting foreign supply as domestic.
It is important to understand the meaning of each variable precisely in order to:
Examples of GDP component variables
Examples of C, I, G, & NX: If you spend money to renovate your hotel so that occupancy rates increase, that is private investment, but if you buy shares in a consortium to do the same thing it is saving. The former is included when measuring GDP (in I), the latter is not.
If the hotel is your private home your renovation spending would be measured as Consumption, but if a government agency is converting the hotel into an office for civil servants the renovation spending would be measured as part of public sector spending (G).
If the renovation envolves the purchase of a chandelier from abroad, that spending would also be counted as an increase in imports, so that NX drops and the total GDP is unaffected by the purchase. (This highlights the fact that GDP is intended to measure domestic production rather than total consumption or spending. Spending is really a convenient means of estimating production.)
If you are paid to manufacture the chandellier to hang in a foreign hotel the situation would be reversed, and the payment you receive would be counted in NX (positively, as an export). Again, we see that GDP is attempting to measure production through the lense of expenditure ; if the chandellier you produced had been bought domestically it would have been included in the GDP figures (in C or I) when the spending receipts of the purchaser was sampled, but because it was exported it is necessary to 'correct' the amount consumed domestically to give the amount produced domestically. (As in Gross Domestic Product.)
A measure of the economy to GDP is the Aggregate expenditure measure, which is identical to GDP except that it excludes items produced but not purchased (net inventory/stock level growth). If the economy produces more goods than are sold, the increase in inventory would generally be included in the GDP figure (as "Investment"). This fits into the GDP model by classing the inventory change as "unplanned investment" which will show a return in subsequent years. Technically, GDP is defined as total production quantity multiplied by observed fixed prices for all goods. Where supply exceeds demand it is possible to calculate the 'value' of the additional supply in this way without necessarily explaining why the market has not cleared.
The GDP is calculated by the Bureau of Economic Analysis (BEA).
Net interest expense is a transfer payment in all sectors except the financial sector. Net interest expenses in the financial sector is seen as production and value added and is added to GDP.
GDPs of different countries may be compared by converting their value in national currency according to either
The relative ranking of countries may differ dramatically between the two approaches.
- The current exchange rate method converts the value of goods and services using global currency exchange rates. This can offer better indications of a country's international purchasing power and relative economic strength. For instance, if 10% of GDP is being spent on buying hi-tech foreign arms, the number of weapons purchased is entirely governed by current exchange rates, since arms are a traded product bought on the international market (there is no meaningful 'local' price distinct from the international price for high technology goods).
- The purchasing power parity method accounts for the relative effective domestic purchasing power of the average producer or consumer within an economy. This can be a better indicator of the living standards of less-developed countries because it compensates for the weakness of local currencies in world markets. The PPP method of GDP conversion is most relevant to non-trade goods' and services.
There is a clear pattern of the purchasing power parity method decreasing the disparity in GDP between high and low income (GDP) countries, as compared to the current exchange rate method. This finding is called the Penn effect.
For more information see measures of national income.
Although GDP is widely used by economists, its value as an indicator has also been the subject of controversy. Criticisms of GDP include:
- Very often different calculations of the GDP are confused among each other. For cross-border comparisons one should especially regard whether it is calculated by purchasing power parity method or current exchange rate method.
- GDP doesn't take into account the black economy and the non-monetary economy Hence, in countries with major business transactions occurring informally, portions of local economy are not easily registered, resulting in inaccurate or abnormally low GDP figures.
- GDP doesn't measure the sustainability of growth. A country may achieve a temporary high GDP by over-exploiting natural resources. Oil rich states can sustain high GDPs without industrializing, but this high level will not be sustainable past the point that the oil runs out.
- GDP counts work that produces no net gain, and does not account for negative externalities. For example, if a factory pollutes a river, that boosts GDP, and when the taxpayers pay to have it cleaned up, that boosts GDP again. See parable of the broken window.
- As a measure of actual sale prices, GDP does not capture the economic surplus between the price paid and subjective value received.
United States GDP
To give an example of the components and their size. ()
Gross Domestic Product (Billions of dollars)
|Gross domestic product
Personal consumption expenditures
|Gross private domestic investment
| Equipment and software
|Change in private inventories
|Net exports of goods and services
|Government consumption expenditures and gross investment
|State and local
Lists of countries by their GDP
- Classification of Products by Activity (CPA)
- Financial Intermediation Services Indirectly Measured (FISIM)
Last updated: 10-17-2005 13:16:26