What is GDP? Does it represent the real growth of a country?

Updated on: 2020-09-18 - 3 mins read
GDPEconomic GrowthWorld Bank

A country defines its progress in terms of its GDP. Is it a correct measure to define a country’s growth? Whenever there is an increase in a country’s GDP, why there is no or very little change in people’s wellbeing? What does it really mean for people when a country’s GDP increases? To know the answers do check out this blog and video:

What is the Gross Domestic Product (GDP)?https://en.wikipedia.org/wiki/Gross_domestic_product

Gross domestic product (GDP) is the total monetary or market value of all the finished goods and services produced within a country in a specific period. It functions as a comprehensive scorecard of a given country’s economic health and acts as a broad measure of overall domestic production.

Though GDP is typically calculated on an annual basis, it is sometimes calculated on a quarterly basis as well. In the U.S., for example, the government releases an annualized GDP estimate for each fiscal quarter and for the calendar year which is their financial year.

Let us see how GDP is calculated:

The Gross Domestic Product

Image Source: https://econ101help.com/three-different-ways-to-calculate-gdp/

There are 3 approaches as shown above:

Expenditure method

This approach is where you add up all the various types of spending which occur within a country’s economy. There are 4 different types:

  • Consumption (C):
    • Consumption is all the spending that households or people do on goods and services. For example, the number of bananas a household purchases; the amount of money spent on the house; the amount of money spent purchasing new products and the money spent on restaurant foods are all examples of consumption spending.
  • Investment (I):
    • As the word suggests, Investment is the spending that firms do to buy machinery and equipment to operate their offices and factories. Examples of investment spending would be a Coal mining company purchases mining equipment to mine coal; IT companies purchasing new computers, servers, desks, etc. and the purchase of a new plane for an airline company.
  • Government Spending (G):
    • Government spending is the spending that the government conducts within its economy. For example, government spending includes spending on the military; spending on health care and education; the building of highways, and social amenity spending.
  • Net Exports (NX):
    • Every country needs to import some goods and it exports some goods. Net exports are defined as the purchases of domestically produced goods by foreigner countries (Export) subtracted from the purchases of internationally produced goods by local residents (Import). In simple words, it is the value of what is sent overseas minus the value of stuff that comes here.

    If an airline company operating in India purchases a new plane from France, this would be considered an import for India and an export for France. This would cause the net exports to decrease for India whilst causing the net exports to increase for France.

    An interesting case is where a foreign student from India comes and studies at a school in the USA. This is considered an export from USA to India since the USA is producing a service (education) which is essentially being 'sent' to an Indian student who is from the Indian economy. Thus, India is importing education from the USA.

    Therefore, we get the formula for GDP if we add up these 4 components:

    GDP = C + I + G +NX

    This is also called the demand approach to calculating GDP since all these components are demands for goods and services. It is looking at the demand side of the economy.

    For example, consider the following figures for India for 2019 to calculate GDP:

    C=$900,173

    I=$500,703

    G=$400,325

    X=$300,306

    M=$300,121

    Giving GDP=$900,173+$500,703+$400,325+$300,306−$300,121

    GDP=$1,801,386

    where GDP is measured in billions of dollars.

    Income method

    The income approach is where you add together all factor payments to calculate GDP. Factor payments are all the payments that are used to buy inputs to produce outputs. Generally, the main factor payments are: profits, returns to capital, and returns to the labor. The formula to calculate the GDP using the income approach is as follows:

    GDP = π + wl + rk

    where:

    π = profits that firms make

    wl (this is the returns to labor) = Wage X Total labor provided

    rk = Rental rate of capital X The amount of capital provided

    Production method

    The production method is also known as the value-added method. This method is where we calculate the total value of all goods produced in the country’s economy minus the value of intermediate goods.

    For example, consider an economy that produces steel and cars. Suppose the economy produces 100 units of steel which it sells for $1 and it produces 10 cars, using 5 units of steel, which it sells for $100.

    As the production of steel requires no intermediate inputs, the value added from the production of steel is $100.

    The production of cars produces $1000 worth of cars using $50 of steel. Therefore, the value-added is $950.

    The total value-added or the GDP of the economy is thus $1050. Alternatively, we could have added the total amount spent on the cars $1000 and total spend on steel $100 giving $1100 and then subtracted the $50 of intermediate inputs to also get $1050.

    GDP_Inflation_India_USA_China

    Image Source: https://www.worldbank.org/

    As GDP is based on the monetary value of goods and services in a country, it is subject to inflation https://en.wikipedia.org/wiki/Inflation. Because of inflation, rising prices will tend to increase a country's GDP, but this does not necessarily reflect any change in the quantity or quality of goods and services produced. Thus, by looking just at an economy’s nominal GDP, it can be difficult to tell whether the figure has risen because of real expansion in production, or simply because prices rose.

    GDP’s Limitations as a criterion for Country’s economic growth:

    As you can see, GDP only considers tangible income. There are many drawbacks to using GDP as an indicator. In addition to the lack of timeliness, some criticisms of GDP as a measure are:

    1. GDP does not account for several unofficial income sources. For example, GDP considers only official data, so it does not consider the extent of informal economic activity. GDP fails to quantify the value of under-the-table employment, black market activity, volunteer work, and household production, which can be significant in some nations.

    2. GDP emphasizes material output without considering overall well-being. GDP growth alone cannot be considered a nation's development or its citizens' well-being. For example, a nation may be experiencing rapid GDP growth, but this may bring a significant cost to society in terms of environmental damages and an increase in income inequality.

    3. GDP only considers market transactions. For example, if you grow food for your own consumption then it will not be considered as income by GDP. Also, voluntary work that people bring in more value to society is left out by the GDP.

    4. The most ridiculous thing about GDP is, that it considers the tragedy as an income as well. For example, if there is an earthquake and then money required to compensate for the damages caused by the earthquake is considered as an income by GDP.