GDP stands for Gross Domestic Product and is the total amount of output produced by an economy. There are 3 ways of measuring GDP and all should equal the same, although in reality some discrepancies mean this isn’t always the case.

There are 3 ways of measuring GDP; all are equal – the total production output of all businesses (output/production), the total incomes and profits in the country (income), or the total of all spending by individuals and businesses (expenditure - aggregate demand formula; see below). Foreign businesses operating within a country are included in GDP, but domestic firms' foreign production isn't included (it is included in the GNP - gross national product - measure). Therefore GDP can be seen as the total output of all firms produced within a nations' borders.

National Output = National Income = National Expenditure

The income method can be shown by this formula:

GDP = Employment Income + Rent Income + Firms Profits

Transfer payments (e.g. benefits) and private transfers are not included in this measure.

What Goes In?

GDP is a measure of all goods produced in an economy, and unlike measures of inflation (e.g. CPI and RPI) is not a basket of goods. In fact the 'basket of goods' is everything that is produced in an economy. It therefore includes both goods and services, however it omits some items. For example, if a meal is produced at home, for family consumption, then it isn't included in GDP figures, however if the same meal were produced in a restaurant and then sold to paying customers; it would be included. If the restaurant produced a meal but was unable to sell it, it would have to be disposed off, and is therefore not included in GDP. If it made a meal and was able to freeze it for a period of time, and then sell it in, say, a month's time; it would. 

Used goods are not included in GDP figures, so as soon as it is sold new it no longer counts towards GDP. This is because selling used goods is considered the transfer of an asset, and it doesn't add income or output to an economy. 

Raw materials and other components which are intermediate goods (they are used in the production process of another good, but aren't purchased for their independent use) do not count towards GDP, otherwise their value would be double counted. For example the restaurant in our earlier example serves chips. It pays £0.50 for the potatoes required for a plate of chips, it then sells this plate of chips for £2. If the potatoes counted towards GDP then £0.50 would be counted when the restaurant purchased them, and another £2 (which already includes the £0.50 cost of purchasing the potatoes) when the restaurant sells them to customers. Hence the potatoes aren't included in that example, but they would be included if a customer bought them from a supermarket in order to produce chips at home.

Nominal v Real GDP and GDP Deflator

Nominal GDP is GDP set in current prices (i.e. not adjusted for inflation). This can mean that GDP can rise in value, without the quantity in an economy actually rising, if inflation occurs. Similarly, deflation can cause the opposite to occur. This means that nominal GDP doesn't effectively show how the economy is growing (or shrinking) to accommodate for higher living standards, or a larger population. For example, in Year 1 an economy might produce 5 cars with a total value of £2000 (hence GDP is £2000). Lets say that inflation is at 10% and in Year 2 the economy produces 5 cars again. GDP in Year 2 is now £2200 without there being an increase in output. This illustrates (imperfectly) the inadequacies of nominal GDP as a measure of economic growth.

Real GDP, on the other hand, is a much better indicator as it takes into account inflation. Therefore in our car-producing economy, GDP in Year 2 will still be £2000 as the economy isn't producing any more goods than in Year 1. 

Nominal GDP is calculated as the price of goods, multiplied by the quantity produced: P*Q. Real GDP on the other hand takes a given year as a base-rate in order to remove the effects of inflation. The calculation is P(base)*Q. For example in Year 1 an economy produces 6 cars each valued at £100. In year 2 it produces 6 cars again. In year 3 it produces 7 cars. Inflation is at 10% per annum. Nominal GDP for year 1 is £600 (£100*6), for year 2 it is £660 (6*£110 - due to inflation) and for year 3 it is £847 (£121*7). We can also calculate Real GDP using Year 1 as our base year. Therefore our base price is £100. Year 1 - £600 (£100*6), Year 2 - £600 (£100*6), Year 3 - £700 (£100*7), as we can see inflation is not included in our measure of price. Hence this example shows the difference between nominal and real GDP, and hopefully demonstrates that Real GDP is a better measure when making annual comparisons.

The GDP deflator (you can read more about the GDP deflator here) is the ratio of nominal GDP to real GDP and can be expressed as Nominal GDP / Real GDP. It is used to remove the effects of inflation in an economy. 

Negatives of High GDP

We normally associate high GDP as being beneficial for a country, however this might not be the case. High GDP may be achieved through a reduction in leisure time and an increase in time spent working. Some people would rather have more time spent pursuing leisure activities than working, even if it results in lower GDP (and national incomes). 

High GDP may come about at the detriment of the environment, to achieve high production land needs to be concreted, factories need to be built, and energy needs to be provided. This can result in deforestation, the loss of animals natural habitat, the extinction of certain species and the increase in pollution contributing to climate change. Not only does climate change have unknown potential costs (this can therefore be seen as a negative production externality issue) but can also result in worse health for citizens, e.g. asthma caused by smog and may other health problems associated with poor environmental standards. Furthermore deforestation can mean that unknown plants and species are destroyed, because these plants have not been catalogued and studied before it is unknown as to whether one of these plants has the potential to cure cancer or provide other health benefits. Therefore deforestation can have greater consequences than just contributing to global warming and lowering the stock of carbon absorbers.

Furthermore health could be further worsened if GDP is pursued with no regards to workers rights and health and safety. If a government targets high GDP they may look to encourage this by allowing firms to make employees work long hours thus resulting in health and psychological problems. Health and safety laws may also be abandoned causing increased harm in the workplace. 

GDP measures production (output) but it doesn't measure where this goes to, so as well as having a problem with inequality using GDP as a measure, we also have the problem that GDP may be high because a country is producing a lot of goods BUT may not actually be consuming them. The country may be exporting goods for foreigners and thus won't enjoy the fruits of their labour. Again, this shows why GDP isn't perfect as a measure of economic growth and standards of living because unless a country enjoys all of the output it is producing it won't be able to increase in living standards in the short run.

GDP as a measure includes both consumption and investment, therefore high consumption may shroud a lack of investment, but because GDP is high the general public (and hence the politicians running a country) may not be concerned. If consumption is high indefinitely then it can lead to future problems for consumption if enough capital stock isn't produced due to a lack of investment. Without capital stock it may be harder to produce goods in the future (don't forget that capital stock depreciates over time, i.e. it gets damaged and worn out and hence needs to be replaced) and so there may have to be a future reduction in the amount which is consumed. If population increases simultaneously, then it means living standards will fall in the future. One other point, is that high consumption (and low investment) may be fuelled by high debts, debt which eventually has to be paid off. Therefore it is vital that an economy gets the correct balance between producing consumption goods and investment goods and isn't completely fixated on GDP as a number, but also in its components.

Problems with GDP

GDP is a common measure of how different countries are performing economically. It is a good measure as it is relatively straightforward and widely understood. It is also well established and is available for almost every country in the world therefore making it easy to compare income levels across countries. This can be done by dividing the population by GDP to get GDP per capita (per person). Higher GDP per capita means that citizens should have more money and therefore have higher living standards than citizens with a lower GDP per capita.

Exchange Rate Problems

Generally comparison of GDP occurs in $US Dollars. GDP is initially calculated in terms of local currency and then converted into US$ using the official exchange rate.

This is usually not representative of actual GDP as the exchange rate doesn’t necessarily take into account the purchasing power of the currency. One reason for this is due to government intervention. In LEDCs currencies are usually pegged to an international currency – usually the US$. Therefore the exchange rate usually reflects government action and policy.

Where the exchange rate finds its own equilibrium level it is likely to be strongly affected by the price of internationally traded goods. To counter this PPP (Purchasing Power Parity) can be calculated which is designed to reflect the purchasing power of incomes more accurately.

When looking at PPP the gap between the low income and high income countries seems to be less distinctive than when GDP is converted to US$. If GDP in PPP is used (as opposed to GDP in US$) then this may be a good way to measure the state on the economy; it is certainly better than measuring GDP in US dollars.

Exchange rates can also be quite volatile (they fluctuate a lot), therefore the GDP of a country could be $x at one period and then the next day be $y, despite their being no physical increase in GDP. Therefore GDP measured by a direct exchange rate is rather useless and doesn't tell much.

To find out more about purchasing power parity and exchange rates click here.

Inequality in Income Distribution

It has to be remembered that GDP per capita is the average income and not that every single person in the economy earns exactly the GDP per capita. The calculation for GDP per capita is (Total GDP/Population) and hence GDP per capita is only a mathematical figure, and is not a statistical measure of the average income of citizens. If all the wealth and income (thus GDP) is in the hands of the rich minority then the country will be highly unequal despite having a high GDP per capita.

As well as variations of GDP per capita distribution between incomes there may also be variations between other groups of societies. People living in different regions (e.g. North and South, or rural and urban) may have different shares of GDP; and those of different ethnic roots may also have different shares of GDP.

This leads to inequalities in income distribution, meaning some groups of society have less money whilst others have more. There are many problems associated with this, click here to find out more.

The Informal Sector and the Accuracy of Data

Another problem with international comparisons is that it isn’t always certain that the accuracy of which the data is collected is consistent. Definitions of GDP and other variables are now set out in a clear internationally agreed form but some countries may collect data more reliably than others.

An area where there is difficultly in gathering data is to do with the informal sector. In every economy there are some transactions that go unrecorded. This means it is hard to record these activities and so they are usually missed off GDP. This is especially prevalent in developing countries where substantial amounts of economic activity occur without an exchange of money. Bartering may be a method to remove the use of money and often in developing countries subsistence living remains an important factor in the lives of the population. If households are producing food for their own consumption then this will not be recorded as part of GDP whereas in developing countries food is usually bought and so is added to GDP. Furthermore, in some countries transactions aren't recorded due to tax reasons or because firms don't have the accounting knowledge. All of these factors can lead to distortions in the true value of GDP.

Non-marketed goods

We already know that only goods and services which provide an income or involve the transfer if money are included in GDP. This therefore means that goods and services which aren't marketed are not included in GDP and thus, may not accurately reflect the size of an economy accurately. We have already given the example that in some countries people grow their own food as opposed to buying it hence it isn't included in the official GDP figures and so undervalues the size of the economy. Another example is that in some countries childcare may be conducted by grandparents, mothers or other relatives instead of a paid nanny/baby sitter. This undervalues the size of the economy where baby-sitting is done informally and hence gives the advantage to a country who has paid nanny's. This can distort the figures between countries, and more importantly within a country over a period of time. If people decide to do more 'DIY' jobs themselves, instead of hiring someone to do it, then the economy can look smaller, even if there is still the same amount of production in an economy. 

Social Indicators

A final problem when using GDP is that it doesn’t take into account the country’s standard of living. Life expectancy, literacy rates and infant mortality rates are all important factors contributing to quality of life which aren't taken into account by GDP. Other measures have thus been created to try and establish a ranking of quality of life of citizens around the world. Such measures can be found here.

It is also worth noting that GDP can be distorted due to environmental issues or natural disasters. For example an economy might grow by 5% but on closer analysis it may be due to a hurricane which destroyed many homes which had to be rebuilt. Even though this is technically growth it isn’t positive for the country and there aren't more goods and services (there may even be less), they are just being replenished.