Gross domestic product: Encyclopedia II - Gross domestic product - Definition

Gross domestic product - Definition

GDP is defined as the total value of goods and services produced within a territory during a specified period (or, if not specified, annually, so that "the UK GDP" is the UK's annual product), regardless of ownership. 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 adjusts this value for the effects of inflation in order to estimate 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.

GDP measures only final goods and services, that is those goods and services that are consumed by their final user, and not used as an input into other goods. Measuring intermediate goods and services would lead to double counting of economic activity within a country. This distinction also removes transfers between individuals and companies from GDP. 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 affect the GDP figure, but not as a $20m receipt, the auctioneer's fees would appear in GDP as consumption expenditure, because this is a final service.

The most common approach to measuring and understanding GDP is the expenditure method:

Consumption and investment in this equation are the expenditure on final goods and services. The exports minus imports part of the equation (often called net exports) then adjusts this by subtracting the part of this expenditure not produced domestically (the imports), and adding back in domestic production not consumed at home (the exports).

Economists (since Keynes) have preferred 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 GDP can be expressed as:

Gross domestic product - The components of GDP

Each of the variables C, I, G, and NX :

• C is private consumption (or Consumer expenditures) in the economy. This includes most expenditures of households such as food, rent, medical expenses and so on.
• I is defined as business investments in capital. Examples of investment by a business include construction of a new mine, purchase of software, or purchase of machinery and equipment for a factory. 'Investment' in GDP 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 government expenditures on final goods and services. It includes salaries of public servants, purchase of weapons for the millitary, and any investment expenditure by a government. It does not include any transfer payments, such as social security or unemployment benefits. The relative size of government expenditure compared 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:

• Read national accounts.
• Understand Keynesian or neo-classical macroeconomics.;

Gross domestic product - 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. However, when the consortium conducted its own expenditure on renovation, that expenditure would be included in GDP.

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 involves the purchase of a chandelier from abroad, that spending would also be counted as an increase in imports, so that NX would fall 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 chandelier 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 means of expenditure; if the chandelier you produced had been bought domestically it would have been included in the GDP figures (in C or I) when purchased by a consumer or a business, 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.).

Gross domestic product - Difference from Aggregate expenditure

An alternative 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"). GDP counts these changes in inventory levels as investment.

Gross domestic product - The GDP Income account

Another way of measuring GDP is to measure the total income payable in the GDP income accounts. This should provide the same figure as the expenditure method described above.

The formula for GDP measured using the income approach, called GDP(I), is:

• Compensation of employees (COE) measures the total remuneration to employees for work done. It includes wages and salaries, as well as employer contributions to social security and other such programs.
• Gross operating surplus (GOS) is the surplus due to owners of incorporated businesses. Often called profits, although only a subset of total costs are subtracted from gross output to calculate GOS.
• Gross mixed income (GMI) is the same measure as GOS, but for unincorporated businesses. This often includes most small businesses.

The sum of COE, GOS and GMI is called total factor income, and measures the value of GDP at factor (basic) prices.The difference between basic prices and final prices (those used in the expenditure calculation) is the total taxes and subsidies that the Government has levied or paid on that production. So adding taxes less subsidies on production and imports converts GDP at factor cost to GDP(I).

Adapted from the Wikipedia article "Definition", under the G.N U Free Docmentation License. Please also see http://en.wikipedia.org/wiki