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GDP: Definition, History, Components, Types          

GDP (Gross Domestic Product): Definition, History, Components, Types, and Ways to Determine

GDP (Gross Domestic Product): Definition, History, Components, Types, and Ways to Determine

Gross Domestic Product (GDP) is one of the primary indicators of economic performance for any country. GDP represents total market value as measured against all finished goods and services produced within its borders within a specified time period.

GDP was introduced as a measurement tool in the 1940s to assess economic output and income across a country. GDP has become the principal indicator of national economic health used by governments, investors, and businesses to assess overall strength and standard of living across nations since then.

Consumption, investment, government spending, and net exports are the four key components of GDP. Consumption includes purchases made by private households for goods and services while investments refer to businesses purchasing capital goods like plants and machinery; government expenditures on infrastructure or social programs comprise government expenditures while net exports record the value of exports less imports;

What does GDP mean?

GDP stands for Gross Domestic Product. GDP is the total monetary or market value of all the finished goods and services produced within a country’s borders in a specific time period.

GDP is a measure of a nation’s economic output and income. It represents the total rupee value of all goods and services produced over a specific time period, typically a year or a quarter. GDP growth rate refers to the percentage increase in GDP from one period to another, which is an important indicator of the overall health and stability of a nation’s economy.

Business investment contributes significantly to GDP by way of spending by companies on capital goods like plants, machinery and equipment. Government spending also adds significantly, comprising expenditures on public goods and services like roads, schools and hospitals.

Net exports, which measure exports minus imports, measure the impact of trade with foreign countries on GDP. Finally, inventories provide another element for measuring changes in unsold goods that impact the GDP – all these figures combined can give an accurate portrait of a country’s economic health.

There are three popular ways to calculate GDP. The first is the Output/Product approach. The sum of the market values of all goods and services produced in an economy is considered. This is the most direct approach. The second is the income approach. The income approach considers the sum of all the income generated from production like employee compensation, profits, rental income, and interest. The final expenditure approach takes into account the sum of expenditures by consumers, businesses, the government, and net exports. This is the most common approach.

How did GDP start?

Gross Domestic Product was developed during the early 20th century to monitor economic progress and compare between nations, GDP provides a valuable measurement tool. The concept of GDP is traced back to 17th-century economist William Petty. Modern versions were introduced by American economist Simon Kuznets during the Great Depression after being asked by US Congress. Kuznets first published his report on national income in 1934 and, by 1944, GDP had become official. Furthermore, after Bretton Woods Conference established International Monetary Fund and World Bank and led to widespread acceptance of GDP as the measure of economic performance, GDP became the standard economic measurement.

Kuznets and his team collected data on production, income and expenditure to form an accurate picture of the U.S. economy. They divided up each sector into various subcategories and estimated their values as goods and services were produced within each sector before totaling up all these values to arrive at one number representing the total output produced across all of America.A

From its inception, economists and organizations have worked to refine and perfect the methodology and concept behind GDP. Some notable improvements include the below.

Richard Stone

An esteemed British economist, Richard Stone developed a system of national accounts that provided a foundation for GDP calculation. For his achievements, he received the Nobel Memorial Prize in Economic Sciences in 1984.

 United Nations System of National Accounts (UNSNA)

First established in 1953, UNSNA offers a set of guidelines that allows more accurate comparisons across nations when measuring GDP or other economic indicators.

Satellite accounts

First introduced in the 1990s, these satellite accounts provide additional insight into aspects of the economy that go beyond GDP’s grasp, such as environmental protection or natural resource usage.

GDP continues to be a source of debate and controversy, as critics contend it does not adequately capture well-being or human development as a whole. Alternative measures, including Human Development Index (HDI) and Genuine Progress Indicator (GPI), have been proposed as additional indicators that complement or even replace GDP in certain circumstances.

How does GDP work?

GDP or Gross Domestic Product is calculated to find the economic status of a country. It is calculated by taking the income or the expense into consideration or by taking the value of all the goods and services produced and consumed by the customers during a given period of time. But not every productive activity is taken into consideration.

For instance, activities or goods produced by volunteers or home made items are not counted even if the materials used for this process are accounted for. GDP is also used as a measure of economic health and it is used by nations to compare wealth.

What is the importance of GDP?

GDP is important because by tracking GDP, we can see whether a country’s economy is expanding or slowing down, and how fast. GDP is important because it measures the overall output and growth of a nation’s economy. GDP alone does not capture everything that contributes to people’s well-being, but it is still an important indicator of living standards. Countries with higher GDP per capita usually have higher living standards as people have greater incomes and can consume more goods and services. GDP growth is one of the primary indicators used to determine the health of an economy. Policymakers closely monitor GDP to see whether any policy adjustments are needed. GDP growth slowing down substantially or turns negative signals there is an increased chance of recession. Economists evaluate the likelihood of a recession occurring by comparing historic GDP figures.

Governments base their budget and spending projections on the anticipated performance of the economy, which GDP helps quantify. The larger a nation’s GDP, the more tax revenue a government can generate to fund its operations. GDP reports are closely followed by businesses and consumers. Positive GDP news can boost confidence and spur more spending, while negative reports can cause a drop in confidence and spending. Central banks consider GDP growth when determining interest rates. Strong growth may lead to rate hikes to prevent overheating. GDP data can also influence exchange rates as the currencies of countries with robust GDP may rise relative to others. GDP is crucial to understanding where an economy stands and where it may be heading. It greatly affects government policy, business decisions, exchange rates, interest rates and overall confidence.

GDP is very important as it is the broadest measure of economic activity. It reveals whether an economy is growing or slowing, which helps determine living standards, tax revenues, public spending, business investment, exchange rates, and interest rates. GDP gauges where an economy has been and where it’s headed.

What are the 4 Components of GDP?

The four components of GDP include consumption, investment, government spending and net exports.

Consumption (c)

This is the largest component of GDP and accounts for the consumption of goods and services by households. It includes expenditures on things like food, housing, transportation, and medical care.

Investment (I)

This component includes business investments in capital goods like equipment, software, buildings, and machinery. It also includes investments in residential housing. The investment adds to the capital stock of the economy and leads to higher production capacities.

Government Spending (G)

This component measures government expenditures on goods and services. It includes spending on things like infrastructure, education, healthcare, national defense, etc. Government spending is an injection into the economy and stimulates aggregate demand.

Net Exports (X-M)

This component calculates the net impact of exports (X) and imports (M) in the economy. Exports add to the GDP while imports reduce the GDP.  It leads to a trade surplus if exports exceed imports, which boosts the GDP. It leads to a trade deficit if imports exceed exports, which lowers the GDP.

To calculate GDP, we combine household spending (C), investments by businesses (I), government spending (G) and net exports (X-M).

GDP = C+I+G +(X-M) 

Gross Domestic Product, or GDP, measures the market value of all goods and services produced on the domestic territory of a country regardless of the nationality of the producer. It offers an indication of its overall economic activity and health.

What are the 4 Types of GDP?

There are four types of Gross Domestic Product (GDP). They are Nominal GDP, Real GDP, Potential GDP, and Actual GDP.

Nominal GDP

Nominal GDP is the market value of all final goods and services produced within a country during a specific period, measured at current market prices. It does not account for inflation or changes in the general price level.

Nominal GDP reflects current market prices, not adjusted for inflation. But it does not provide a comparison of economic growth over time due to price level changes.

Real GDP

Real GDP is the market value of all final goods and services produced within a country during a specific period, adjusted for inflation or changes in the general price level. Real GDP is a better measure of economic growth and comparison over time. Real GDP is adjusted for inflation, allowing for comparisons over time. It accounts for changes in the general price level, providing a more accurate reflection of economic growth.

Potential GDP

Potential GDP is an estimate of the maximum sustainable level of output an economy can produce when all its resources are fully employed, without triggering inflation. Potential GDP is a theoretical concept and not directly observable. It represents the maximum sustainable output level, not directly observable. Helps policymakers and economists assess the output gap and the degree of slack in the economy.

Actual GDP

Actual GDP is the real value of all final goods and services produced within a country during a specific period. Actual GDP is the actual output of an economy and may be above or below the potential GDP. Actual GDP  is important as it reflects the actual output of an economy. It is compared to potential GDP to understand the output gap and assess the overall economic performance.

The different types of GDP help us understand the economy better.

What are the 3 ways to determine GDP?

Gross Domestic Product (GDP) is an indicator of economic activity in any nation and is measured using three approaches: the Expenditure Approach, Income Approach and Production Approach.

3 ways to determine GDP
3 Ways to calculate GDP

Each provides a different insight into its economy while yielding the same GDP value; we will examine each in more depth below.

1. Expenditure Approach

The Expenditure Approach, also referred to as Demand-side or Aggregate Demand (AD) Approach, estimates GDP by totaling all expenditures made during a particular time period by economic agents within a country. To use this approach for computing GDP, use the below equation.

GDP = C + I + G + (X – M).

 Where: C denotes consumption by households, I stands for investment by businesses, G government spending, X exports goods and services whilst M imports them

 2. Income Approach

The Income Approach, sometimes referred to as the Factor Income Approach or Cost-side Approach, calculates GDP by adding up all income generated by production factors within a country during a specific time frame, such as wages, rents, interest payments and profits. Using this approach for measuring GDP would give rise to:

Compensation of Employees + Gross Operating Surplus + Gross Mixed Income + Subsidies for Production and Imports = GDP.

By this definition, GDP represents the sum total of incomes generated from production within a nation’s borders and only those earned domestically are considered when computing GDP.

 3. Production Approach

The Production Approach, also referred to as Value-added Approach or Supply-side Approach, measures gross domestic product (GDP) by adding up all of the value added by all industries within a country during a certain time frame. Value added refers to the difference between an industry’s output and the cost of its intermediate inputs – for this approach, the GDP formula would look like this:

GDP = S (Output minus Intermediate Consumption) plus Taxes on Production and Imports plus Subsidies.

GDP is defined as the sum of all value created from producing goods and services within a country’s borders, including manufacturing. This method measures each economic sector’s contribution to the overall GDP.

What impact does GDP have on our economy?

GDP, or Gross Domestic Product, is the primary measure of economic growth and is essential to its well-being. An increase in GDP indicates expansion while any decline signals contraction – sustained economic growth often results in higher living standards, expanded employment opportunities and better public services – all important elements for improved well-being in any nation. Policymakers often set target GDP levels when designing economic policies or evaluating their effectiveness.

GDP figures have a profound effect on business confidence and investment decisions. GDP growth being strong and consistent means businesses are more likely to invest in new projects, expand operations and hire additional employees – fuelling economic expansion. Conversely, when GDP growth is weak or negative, businesses become more cautious, cutting investment and possibly leading to reduced growth or even recession.

GDP data plays a pivotal role in shaping government fiscal policy. Governments rely on GDP figures to set their budgetary priorities, including spending on infrastructure, education, healthcare and social programs. GDP growth is strong enough means governments may allocate additional resources towards these areas while weaker GDP growth necessitates cuts backs. Furthermore, GDP can inform central banks’ monetary policy decisions such as setting interest rates or controlling the money supply to ensure price stability and foster economic expansion.

What happens if GDP increases?

A rising GDP indicates that the economy is growing. GDP increasing generally means that personal incomes and tax revenues are increasing. As people’s incomes rise, they tend to spend more on goods and services. This boosts demand and spurs further economic growth. Businesses also benefit from increased demand and higher profits. Stronger growth and profits lead to businesses are more likely to invest in expansion and job creation. All of this activity leads to a virtuous cycle of increasing spending, production, income, demand and job growth.

What happens if GDP decreases?

A declining GDP indicates that the economy is slowing down or contracting. When GDP decreases, it generally means that personal incomes and tax revenues are decreasing. As people’s incomes drop, they reduce their spending on goods and services. This slowdown in demand leads to a decline in production and profits for businesses. With weaker growth and profits, businesses are less likely to invest in expansion and more likely to cut costs by reducing jobs or wages. All of this activity leads to a vicious cycle of declining spending, production, income, demand and job losses. Economic growth slows or reverses, and a recession may take hold.

Does GDP affect the Standard of Living of each country?

Yes, GDP and standard of living are related, but GDP alone does not determine the standard of living in a country.

What are the factors in the Standard of Living that GDP fails to account for?

GDP, or Gross Domestic Product, is a widely used measure of a country’s economic activity and is often used to gauge the standard of living. However, there are factors that GDP fails to account for when assessing the standard of living. Below are six such factors

  1. Externalities

GDP does not take into account the negative effects of economic activity on the environment or people’s well-being, such as pollution, traffic congestion, or depletion of natural resources.

  1. Wealth Distribution

A high GDP may indicate a wealthy country, but it does not reveal how that wealth is distributed among the population. Income inequality can lead to a lower standard of living for many people in a country with a high GDP.

  1. Non-monetary Economy

GDP only measures the value of goods and services exchanged in the market. It does not capture non-market activities, such as volunteer work, care work, or subsistence agriculture, which can contribute significantly to a society’s well-being.

  1. Sustainability of Growth

GDP does not address whether economic growth is sustainable over the long term. A high GDP may be associated with resource depletion or environmental degradation, which could negatively affect the standard of living in the future.

  1. Non-market Transactions

GDP does not capture non-market transactions, such as bartering or informal exchanges, which can play an important role in people’s lives, especially in developing countries.

  1. Quality Improvements and Inclusion of New Products

GDP does not fully capture the benefits of technological advancements, new products, and improved quality of goods and services. These factors can contribute to a higher standard of living but are not adequately reflected in GDP.

GDP is a useful measure of a country’s economic activity,  but it has limitations when it comes to assessing the standard of living. Other indicators, such as the Human Development Index (HDI) or the Genuine Progress Indicator (GPI), have been developed to provide a more comprehensive view of a country’s well-being and standard of living.

What are the benefits of GDP?

GDP is used as a tool by nations and individuals alike to know about a country’s economic well being. The other benefits of GDP are as given below:

  • Measurement: GDP gives numbers and figures about a nation’s wealth and prosperity and also vice versa. It can be used to compare other countries and rank them in order of growing economy and offer insights about the various financial activities. 
  • Policies: GDP tells a lot about a country’s economic policies as well. They can be heavily influenced and the government can intervene to legislate effective and improved laws. 
  • Resources: GDP allows the governmental bodies and institutions to judiciously allocate resources depending upon the growth and potential in the sector. 
  • FDI: A high GDP is also an indicator or an incentive for the foreign parties to invest in our country. It promotes Foreign Direct Investments. 

GDP is always a helpful tool, but be mindful that it does not portray the entire economic situation of a country. There are a lot of sections which it does not consider. 

What are the limitations of GDP?

GDP, although a good tool which provides insights to the general public, has some limitations. The three major ones are as given below: 

  • Quality of life: GDP does not talk about how the people are living in a country or what their living conditions are. 
  • Informal sector: Non market activities which are unpaid or voluntary in nature are not taken into consideration in the calculation of the GDP of a nation. 
  • Inflation: GDP can be influenced and affected by inflation and therefore, the GDP presented will not be an accurate measure of economic progress. 

The people who use the GDP measure to gain insights into the economic structure of a country should be aware that GDP does not provide facts or data about any environmental or societal factors that influence the economy or even vice versa. How the economy influences the environment or the society is also unknown. 

What are the proposals to overcome GDP?

There are limitations to GDP that need to be overcome. There have been multiple talks nationally and globally to incorporate indexes and proposals along with the GDP. Proposals to follow the Sustainable development goals (SDG’s) implemented by the United Nations is a viable idea which includes the environmental and societal statuses as well.

Another one is the Gross Happiness Index which is inspired by Bhutan. This proposal also gives importance to the equitable distribution among the masses and the cultural preservation of a country. Few other proposals include, Human Development Index, Inclusive wealth index, Happy planet index etc. These proposals can be considered and made use of to provide a more holistic measure of a country’s growth.

What do the critics say about GDP?

GDP does not measure the distribution of income and wealth in a nation. GDP per capita assumes that the total income of a nation is evenly distributed among its citizens, which is rarely the case. GDP does not account for income inequality and the concentration of wealth in a nation. A higher GDP per capita does not necessarily mean a higher standard of living for most citizens if income is unevenly distributed.

GDP does not measure important aspects of well-being like access to healthcare, education, housing, and infrastructure. Things that directly determine people’s well-being and standard of living are not accounted for in GDP. GDP mainly measures the total value of goods and services produced for sale in the economy. It does not measure essential public goods and services that are not sold in the market.

GDP does not adjust for externalities like environmental degradation and pollution. GDP may increase due to economic activities that generate negative externalities and reduce welfare. It does not distinguish between productive economic growth and growth that reduces natural and social capital. Sustainability is not addressed in GDP.

GDP does not capture activity that is not part of formal monetary transactions. Important economic activities like household production, bartering, and volunteer work are not measured in GDP since they are not part of the formal economy. Unpaid work that contributes to welfare and standard of living is largely invisible in GDP statistics.

GDP does not provide information on income security and volatility. While GDP may be rising overall, frequent changes in income, exposure to economic risks, and poverty rates can undermine economic well-being. But GDP does not capture information on income volatility and insecurity.

Is there a relationship between GDP and Inflation?

Yes, there is a relationship between GDP and inflation. Here are some of the key connections:

GDP growth leads to inflationary pressures in an economy. When the economy is growing rapidly, demand for goods and services outpaces supply, which bid up prices. Companies  increase prices in response to strong demand. The government also increases interest rates to slow growth and control inflation. Higher interest rates make it more expensive for businesses and consumers to borrow money, slowing the economy.

Moderate inflation is often a byproduct of a healthy, growing economy. The government aims for a stable and low inflation rate, around 2% annually in many countries. This modest inflation is a sign of a growing GDP and wages, without increasing prices too quickly. However, high inflation, often considered over 3% annually, is a sign of an overheated economy and reduced GDP growth over the long run.

Inflation reduces the purchasing power of money over time. When inflation is high, the money you have today buys less tomorrow. High inflation leads to a lower standard of living as money loses value. Sustained high inflation undermine economic growth as people spend more quickly before their money loses value, rather than saving and investing for the future.

Deflation, or falling price levels, is a sign of a weak GDP and economic recession. When demand is low, companies cut prices to sell excess supply. Deflation also leads people to delay purchases and save their money, anticipating lower prices in the future. This slows down economic activity and GDP growth further. Most economies aim for stable low inflation to avoid the risks of both high inflation and deflation.

Monetary and fiscal policy aim to balance GDP growth and stable inflation. Interest rates are raised to curb inflation, while lowered to spur economic growth. Government spending and tax policies also aim for maximum GDP growth with stable prices. Policymakers try to achieve solid GDP growth with an inflation rate around 2% to 3% per year in most countries.

Does the Stock Market affect GDP?

Yes, the stock market and GDP are closely related. Changes in the stock market affect GDP, and GDP growth also influences the stock market. Stock market trading and investing are signs which state that it would lead to better economic growth.

The GDP also takes a hit if the stock market is down. There wouldn’t be any buying mentality among the people to improve the sales and in turn bring in revenue. Therefore, it is imperative that the stock market also stays strong to improve the GDP of the country.

How many percent of GDP is in the Indian Stock Market?

The percent of GDP in the Indian stock market would mean the amount of shares traded multiplied by its price. This is calculated by comparing with the GDP of the country at that point of time to know the percentage related to it.

This is done so that people can get an idea of the size of the stock market compared to the size of the economy. Stock market capitalisation of above 50% would mean that the economy is healthy. The current percentage of GDP in the Indian Stock market is 103.7%.

What is the difference between GDP and GNP?

GDP or Gross Domestic Product measures the total market value of all goods and services produced within a country’s borders in a given time period. It includes all production by both domestic and foreign producers as long as the production takes place within the country. GDP measures the total output by all people, businesses and government entities in a nation’s economy.

GNP or Gross National Product measures the total income earned by a nation’s permanent residents, regardless of whether they earn it domestically or abroad. It includes all income earned by citizens of a country while abroad. GNP measures the value of goods and services produced by citizens of a nation’s economy. Unlike GDP, it does not matter where the production takes place geographically. GNP aims to measure total national income and living standards.

The main difference comes down to a production-based approach (GDP) versus an income-based approach (GNP). GDP measures the location of production, while GNP measures the citizenship of producers. For most countries, GDP and GNP are very close in magnitude because the bulk of production and income for citizens takes place within national borders. But the difference becomes significant for countries with high proportions of foreign workers or corporations.

Arjun
Arjun Remesh

Head of Content

Arjun is a seasoned stock market content expert with over 7 years of experience in stock market, technical & fundamental analysis. Since 2020, he has been a key contributor to Strike platform. Arjun is an active stock market investor with his in-depth stock market analysis knowledge. Arjun is also an certified stock market researcher from Indiacharts, mentored by Rohit Srivastava.

Shivam
Shivam Gaba

Reviewer of Content

Shivam is a stock market content expert with CFTe certification. He is been trading from last 8 years in indian stock market. He has a vast knowledge in technical analysis, financial market education, product management, risk assessment, derivatives trading & market Research. He won Zerodha 60-Day Challenge thrice in a row. He is being mentored by Rohit Srivastava, Indiacharts.

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