The gross domestic product, or GDP, is one of the most common measures on the state of the economy for any nation. Unfortunately, unless you took an Economics 101 class in college and managed to not fall asleep, you may not know exactly what the GDP is – or why it is important.
Simply stated, GDP is the total market value of all goods and services produced in a country for a given time period. The time period most often used is one year, which is then compared to past years as a way to measure the improvement or decline of a country’s economic situation. Some of the measurable items utilized in GDP calculations include the sales of automobiles, food, salon services, financial services, and movie tickets. Generally, the higher the number, the better the economy is doing.
If the GDP number drops below the point where it stood during the prior year, then it is assumed that the economy is lagging. If the GDP numbers decline for two or more quarters, economists believe the country is in a recession.
Methods of Calculating GDP
The general definition of GDP is rather simple – however, economists seldom like simplicity, and therefore there are three different ways to calculate GDP.
1. Production Method
The production approach to GDP is the market value of all final goods and services. Also called the “net product” method, it includes three statistics:
- Gross Value Added: Estimation of the gross value of various domestic economic activities.
- Intermediate Consumption: Determination of the cost of materials, supplies, and labor used to create goods and services.
- Value of Output: Deduction of the intermediate consumption from the gross value, which gives you the GDP. This is how you determine GDP via the production method.
Weakness of the Production Method
The major problem with the production method of measuring GDP is that there is no 100% accurate way to determine what is true production. Services like babysitting have no way of being measured, and therefore are not included – though it can be argued that a babysitter allows parents to go out and spend money on a service, like dinner at a restaurant, and therefore has a positive effect on the economy. Also, if you make baked goods or have a small garden, you are producing, but your output is likely not included in the GDP, especially if you do not sell your goods.
If you do sell your baked goods, that could be considered part of the underground economy. For example, if you pay a person cash under the table to fix your car, it does not count toward GDP, although a service has been rendered.
2. Income Approach
Many economists dislike the production method as a means to measure GDP as it does not include income. Rather, they believe that the money each family brings home is a better way to evaluate the economic strength of the country. Therefore, the income approach measures the annual incomes of all individuals in a country.
Incomes are culled from five different areas:
- Wages, salaries, and supplementary labor income
- Corporate profits
- Interest and miscellaneous investment income
- Farmers’ income
- Income from non-farm unincorporated businesses
Once these numbers are added, two further adjustments must be made to arrive at the GDP via this method. Indirect taxes, such as sales taxes at a convenience store, minus tax subsidies (tax breaks or credits) are added to arrive at market prices. Then, depreciation on various hard assets (buildings, equipment, etc.) is added to that to arrive at the GDP number. The idea behind the income method is to try to get a better handle on real economics activity.
Weakness of the Income Approach
A quick review of the items utilized in the income approach makes its weakness obvious: Production is not included, nor is saving or investment. When you sit with an investment advisor and invest money in a mutual fund, you are releasing money from your hands to get more back. That is economic activity, but it is not counted in the income approach. Similarly, increased production at factories can occur without higher wages, and because there is a delay from the time the increased production of goods hits the marketplace and sales are recorded, the increased income may not show up in the corporate profits until later.
3. Expenditure Approach
There are, in fact, other economic theorists who believe that neither the income approach nor the production method is sufficient. In theory, income is not generated to be hoarded. People might save and invest, but they will definitely purchase needed and desired goods. From this basic viewpoint, the expenditure approach was developed. This approach measures all expenditures by individuals within one year.
The components of this method are:
- Consumption as defined by purchases of durable goods, non-durable goods, and services. Examples include food, rent, gas, clothes, dental expenses, and hairstyling. The purchase of a new house, however, is not included as consumption. Consumption is the largest component of this method of determining GDP.
- Investment means capital investments, such as equipment, machinery, software, or digging a new coal mine. It does not mean investments in financial products, like stocks and mutual funds.
- Government Spending is the total of government expenditures on goods and services, including all costs of government employee salaries, weapons purchased by the military, and infrastructure costs. For example, the money spent on the war in Iraq is included, as is the money spent in the stimulus bill in 2008. Social Security and unemployment benefits, however, are not included.
- Net Exports are calculated by subtracting the value of imports from the value of exports. Exports are goods that are created in this country for other nations to consume, while imports are created in other nations and consumed domestically.
Weakness of the Expenditure Method
The weakness of this method is similar in nature to the weakness of the income approach. First, savings are not included in the equation – so savings accounts and stock investments are not accounted for. Also, deeply discounted and even free services from government, business, and nonprofit organizations are included. This presents a problem because the actual value of these services – not what is charged for them – is estimated. For this reason, the final GDP number is likely to be inaccurate.
Lastly, some services are counted based on their costs, but that value can be substantially higher than is estimated or reported. For example, when a major infrastructure collapse happens, such as the result of 9/11 or the tornadoes in Alabama, medical and building costs go up. This creates a temporary increase in infrastructure costs, which increases the final GDP number. This skews the numbers by representing a spike – but not a growth curve that is sustainable. Consider this: When you buy a new house, you may spend a lot of money on new furniture – but you do not buy new furniture every month.
Why GDP Matters
However you decide to measure the GDP of a country, it is a major economic indicator and a chief factor in examining a country’s economic health. When the GDP is growing, a country is generally improving economically: Companies are hiring, and people are working. It is like using the Dow Jones Industrial Average to measure the stock market. The DJIA provides a quick read of the market, while the GDP provides a quick read of the economic health of a country.
Often, the GDP numbers are used to determine whether we are in a recession or an expansion (a growing economy). If a country experiences two consecutive quarters of declining GDP, it is in a recession. If the country shows increasing GDP numbers over two quarters, then it is expanding. Aside from measuring economic growth within a country, GDP is also used as a benchmark to measure the economies of competing countries.
The top 10 countries by a measure of GDP are:
- United States
- United Kingdom
The Problems With GDP
When it comes to measuring the economic standing of a country, GDP has several problems and opponents. The primary problem is that GDP is a measure of generality. The Dow Jones Industrial Average presents a similar problem: It is the average of 30 companies, which is a pittance in comparison to the total amount of companies trading on the stock exchange. Even the S&P 500 is only an average of 500 companies. Using an average figure omits many other factors that may tell a different story, and it likely excludes pertinent information that should be included.
Economists label items that fit this description “externalities,” and they fall into the following categories:
- Recessionary Hangovers. There are times when a country is out of a recession, according to GDP, but in actuality is still in a recession. For instance, according to economists using GDP as a measure, the recession in the United States ended in 2009. However, as of 2012, the unemployment rate has remained above 8% for 30 straight months, reaching as high as 10% in 2009. That is a functional recession. If the goal is to measure economic health, then you cannot count 8% unemployment as healthy, particularly when drops in the unemployment rate for two quarters straight are because of people dropping out of the job search.
- Credit-Based Spending. Another problem is that spending on goods and services does not always come from income generated. Both the American public and the government routinely spend money on credit, and the effects of chronic debt are not factored into GDP. During the run up to the mortgage crisis, millions of Americans got home equity loans. These monies were used for everything from renovations, college tuition, new cars, vacations, and more. All those expenditures counted toward positive GDP growth, but the country was not in a healthy state. When the housing bubble burst, the effects of that debt spending hit the nation hard – and the GDP numbers did not reflect that hidden time-bomb. This can be seen on a national level if you consider that Italy is in the top 10 list of worldwide GDP, but is currently embroiled in a nationwide debt crisis.
- Underground Economy. From economic calamities like the housing bubble, we get high unemployment and an increase in what is called the “underground economy.” If you pay cash “under the table” for a good or service to someone who does not have a formal business or does not report the income, this contributes to the underground economy. This economic activity is not included in the GDP.
- Non-monetary Economy. GDP numbers omit production and services where no money comes into play. Bartering is no longer a large part of the American economic model, but does increase in severe recessions. Exchanges of goods for services and vice-versa are not recorded, resulting in skewed GDP figures.
- Sustainability of Growth. The effect that production – particularly industrial production – has on the environment has become a concern, as maximizing short-term output may be unsustainable and can cause long-term damage. For instance, a logging company could make a huge output in the harvesting of trees, but if they over-harvest, replenishing the forest’s supply of quality lumber could become problematic or impossible, affecting future GDP. Other examples include over-fishing a body of water, or over-farming a tract of land. A country may achieve a temporarily high GDP from abusive usage of natural resources or by improper allocations of investments.
It is best to view the GDP numbers as a quick snapshot of which direction the country is heading when it comes to economic growth and stability. The measure is not as accurate as it could be, nor is there any way to truly capture all the dynamic forces that affect the economy. Depending on what method a politician, pundit, or economist uses, you can get very different views of the economy.
However, becoming caught up in spin or methodology is counterproductive for most people who wish to understand GDP and utilize it as a simple read of a country’s economic health. Let economists and the pundits interviewing them wade into the weeds – the average person on the street should keep it simple. The production method is the one that is used most often, and is one of the benchmarks upon which every president has been evaluated for the last 50 or so years. It may not be perfect, but if you accept its limitations, then you understand that the limitations are the same for all presidents. Therefore, it is a decent way to look at the country to see if it is getting stronger, or if there are serious weaknesses.
(photo credit: Bigstock)