What is GDP (Gross Domestic Product)

GDP stands for “gross domestic product” or “gross domestic product.” GDP is the monetary value of all final goods and services produced in a territory during a given period, usually one year.

By goods we mean all the finished products that reach the hands of the consumer (food, technology, clothing, etc.). By services we refer to the activities that we hire. For example, taxis, restaurants, educational or artistic activities, etc.

Thus, the GDP will be the sum of the cost of the total goods and services acquired by the inhabitants of a territory in a specific period.

The function of GDP is to measure the level of wealth of a country in a defined period. In other words, the GDP is used to diagnose whether the national economy is growing or if, on the contrary, it is facing a fall, which will influence the economic policies to be implemented. For this diagnosis, economists also use indicators such as GDP per capita, real GDP and nominal GDP.

GDP characteristics

The main characteristics of the gross domestic product are as follows:

  • It is a macroeconomic indicator: provides information on the behavior of the economy.
  • Its calculation is in charge of government entities: It is normally governed by the criteria defined by the International Monetary Fund (IMF).
  • Only consider legal production and business: this means that informal trade, the black market and illicit businesses (such as drug trafficking or arms trafficking) are not evaluated, among other things, because they do not leave a record.
  • It does not take into account the deterioration of resources, such as machinery or infrastructure. Therefore, it does not provide information on investment and reinvestment costs.

GDP per capita

GDP per capita means gross domestic product per person. It is the result of dividing the GDP by the number of inhabitants of a country.

For example, in 2018, Mexico’s GDP reached the figure of 1,220,699.48 million dollars. Dividing this number by the total number of inhabitants in that year, the Mexican GDP per capita was recorded at 9,673.44 dollars. In contrast, the GDP of the United States was 20,544,343.46 million dollars and the GDP per capita was 62,794.59.

However, the use of GDP per capita to measure social welfare has been highly questioned. This is because, by prorating the total figure of GDP by the total number of inhabitants, inequalities in the distribution of wealth are ignored.

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For example, if we compare the GDP per capita of Mexico in 2019 with the minimum wage, we will notice the former reached the figure of 10,275 dollars at the end of the year. However, the minimum wage is equivalent to 1,634 dollars per year.

See also: What is GDP per capita and Distribution of wealth.

nominal GDP

There are two different types of GDP, both necessary to understand the economic behavior of a country: nominal GDP and real GDP.

Nominal GDP is that which is calculated based on current prices or market prices of goods and services, which can be affected by inflation or deflation.

This means that nominal GDP is focused on price fluctuations rather than production.

For example, suppose that in year 1 a country produced 35 pieces of clothing at $2 per unit. Then, in year 2, production was 20 pieces, but prices were raised to $3.

To calculate both years, nominal GDP will take into account price variations in the market. The result will be the following:

  • Year 1: 350 pieces of clothing * $2 = 700 GDP.
  • Year 2: 280 pieces of clothing * $3 = 840 GDP.

As we can see, in year 2 the GDP would have had an increase of 20% compared to year 1. Now, does this mean that production has increased? To determine this we will need to calculate real GDP.

real GDP

Real GDP refers to the monetary value of final goods and services based on constant prices, that is, without taking into account price variations due to inflation.

To determine constant prices, analysts establish a base year. This means that they take the prices of a specific year as a reference and, based on this indicator, calculate the GDP of the desired period.

This makes it possible to compare the results and evaluate the growth of production itself, and not that of market fluctuations.

Thus, real GDP has the function of obtaining real values ​​of productive growth and its evolution over time, since inflation generates a distortion in the data.

For example, let’s go back to the previous example. A country produced in year 1 a total of 35 pieces of clothing at $2 per piece. In year 2, he produced 20 pieces at $3.

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To determine if there was an increase in production, real GDP will take year 1 as the base year, that is, it will use the price of year 1 as the constant price. The result will be the following:

  • Year 1: 350 pieces of clothing * $2 = 700 GDP.
  • Year 2: 280 pieces of clothing * $2 = 560 real GDP.

Comparing GDP in year 1 to GDP in year 2 at constant prices, we find a 20% drop in output. But, how to know what the real price variation has been between the base year and year 2? For that we will need to calculate the GDP deflator.

GDP deflator

GDP deflator is a cost index whose purpose is to calculate and measure price variations in relation to GDP. Recording these price variations makes it possible to better assess when the increase in GDP responds to economic growth or to inflation.

To calculate the GDP deflator, the following formula is used:

GDP deflator = (nominal GDP/real GDP)*100

For example, if we have the following data:

Year 1 (base year):

  • Nominal GDP: 700
  • Real GDP: 700

Year 2:

  • Nominal GDP: 840
  • Real GDP: 560

At first glance, it appears that year 2 had nominal GDP growth of 20%. Real GDP reveals that there was an inflation process. But, how do we know how much that inflation was and what was the real growth of the economy?

So, we need to estimate the GDP deflator for year 1 (which is the base year) and year 2 separately.

  • Base year GDP deflator = (700/700)*100 = (1)*100 = 100 [la operación sobre el año base siempre dará cien]
  • GDP deflator year 2 = (840/560)*100 = (1.5)*100 = 150%

This number obtained allows us to know that in year 2 there was an increase in prices with respect to the base year. To determine exactly what this variation has been, we calculate the difference between both deflators, which reveals a 50% increase in prices.

How to calculate GDP (formula)

GDP can be calculated based on three different methods or approaches: according to production or “value added”; according to the flow of expenses or income or according to the flow of income. Any of these methods should match on your end result. The use of one method or another will depend on the data available when making the calculation.

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According to production or value added

It is calculated by totaling the sales value of products, called “gross value added” (GVA) minus the value of raw materials, plus the difference between taxes and subsidies.

The formula to calculate GDP according to the flow of income is:

GDP = GVA + (Taxes – Subsidies)

The calculation of GDP according to production or value added is intended to avoid double counting of goods. This is because some of these are resources or “intermediaries” for obtaining final products.

For example, wheat flour is an intermediate resource for the manufacture of bread. If an analyst were to take wheat flour and the bread produced from that flour as end products, he would be doubling the goods and calculating GDP would be inefficient.

According to the flow of expenses

It is calculated based on the value of purchases or consumption made by end users.

The formula to calculate GDP according to production is as follows:

GDP = Compensation of workers + Gross operating surplus + (taxes – subsidies)

The GDP according to the flow of expenses allows knowing and evaluating the reasons why the GDP registers a fall when the internal consumption of the inhabitants of a country decreases.

According to income or income flow

It is calculated taking into account the total income resulting from the productive activity. The GDP according to income or sales flow makes visible the distribution of income among the productive agents.

Indeed, when the production is sold, income is generated in the companies and these are distributed through wages, which in turn represents income for the families.

The formula to calculate GDP according to cats is as follows:

GDP = C + I + G + (X – M)

where,

  • C = Consumption
  • I = Investment
  • G = Public spending
  • X = Exports
  • M = Imports

Difference between GDP and GNP

The difference between the GDP and the GNP lies in the fact that the GDP is limited to measuring the total production that takes place within the limits of the country, regardless of whether the producing agent is foreign.

Instead, the GNP or “gross national product” only measures national production, whether inside or outside the country’s territory.

Therefore, it excludes the accounting of the production of foreign companies within the national territory, but includes the accounting of national companies in foreign territory.

See also: Gross National Product (GNP)