What is the GDP?
The gross domestic product, or GDP, is the total value of a nations goods and services produced within a preset period of time. Usually, GDP is measured on a calendar year basis. More precisely, GDP can be calculated by adding up the following components: consumption, investment, government spending, and net exports, or the spread between imports and exports.
Consumption includes personal items such as food, utilities, rent, clothing, fuel, and financial services received by individuals. It is important to note that housing purchase costs are NOT included in this category. This is by far the largest component of GDP.
Investments refer to capital expenditures which would include costs associated with building new factories, business machinery expenses, new home purchases, business inventory changes. One important note to make on investments is that stock and bond purchases are not considered in this category as they do not add to the GDP, or any actual output.
The Government spending category includes state and local governments as well as the federal government. This category is the second largest component of the gross domestic product. Items such as school teacher salaries and pensions, congressman and senator salaries, and military goods are a few of the major components.
Finally, net exports is simply the difference between the amount of goods we export and import every year. This would account for all foreign consumption of our goods, or output from our economy.
Different types of GDP measurements:
You may have heard the terms "real" GDP growth or "nominal" GDP growth and wondered what the difference was. The difference lies in the fact that nominal GDP does not take into account price changes, or inflation, while real GDP does. Nominal GDP measures the aggregate prices of goods based on current prices while real GDP, also referred to as constant price GDP, represents gross domestic product in constant dollars. This means that real GDP will measure the value of output in terms of prices from a base year.
For example, let's say that the economy produced 10 billion dollars worth of cars in 2006. Since this will be our basis year, real and nominal GDP will be the same, 10 billion dollars. However, in 2007, 12 billion dollars worth of automobiles were produced using 2007 prices. Additionally, the number of cars produced in 2007 priced at 2006 levels would result in a output of 11 billion dollars.
Using this example, you can see the following: 2006 nominal and real GDP are 10 billion dollars. For 2007, the nominal GDP is 12 billion dollars while the real GDP is 11 billion.
This enables us to calculate the real GDP growth rate which would be (11 billion - 10 billion) / 10 Billion = 10%.
The nominal GDP growth rate would then be (12 billion - 10 billion) / 10 billion, or 20%.
The nominal growth rate does not help us in determining the true growth in output as it has inflation baked into it. That is why many economists rely on real GDP to determine the true growth rate of the economy.
Another important ratio that is derived using real and nominal GDP is the GDP Deflator. It can be calculated using the following formula: (Nominal GDP / Real GDP) / 100 (converts to %). The GDP deflator is key because it allows us to measure how much a year over year change in the base level of GDP (2006 to 2007 in our example) is due to inflation.
The GDP deflator is similar to the consumer price index in that it measures inflation; however, it has a distinct advantage. CPI measures a fixed basket of goods and services while the GDP deflator takes into account a much broader variety of goods and services, especially new ones that are introduced into the economy.