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Defination of Gross Domestic Product - GDP
Background:
GDP is a gross measure of market activity. It represents the monetary value of all the goods and services produced by an economy over a specified period. This includes consumption, government purchases, investments, and the trade balance (exports minus imports). The GDP is perhaps the greatest indicator of the economic health of a country. It is usually measured on a yearly basis, but quarterly stats are also released. The Commerce Department releases an "advance report" on the last day of each quarter. Within a month it follows up with the "preliminary report" and then the "final report" is released another month later.
The GDP is presented in two ways:
- "current dollars" which represent actual prices in every period.
- "constant dollars" which abstract from changing prices over time.
The "current dollar GDP" equals the market value of goods and services produced. Meanwhile the "constant dollar GDP", also known the real GDP, represents the quantity of economic output, which is used in measuring the overall rate of economic growth.
What it means for Investors:
The most recent GDP figures have a relatively high importance to the markets. GDP indicates the pace at which a country's economy is growing (or shrinking). If GDP growth fails to meet or beat the market expectations stocks can temporarily pay the price.
Traditionally, the U.S. Economy's average growth rate has been between 2.5 - 3%. Economists believe that this range represents the sustainable long-run growth rate of output.
Strengths:
· GDP is considered the broadest indicator of the economic output and growth. · pay close attention to increasing inventories as it can indicate that growth is slowing, or consumer demand is changing.
Weaknesses:
· The data is not very timely because it is released quarterly unlike many economic indicators which are released monthly.
A region's gross domestic product, or GDP, is one of several measures of the size of its economy. The GDP of a country is defined as the market value of all final goods and services produced within a country in a given period of time. It is also considered the sum of value added at every stage of production of all final goods and services produced within a country in a given period of time. Until the 1980s the term GNP or gross national product was used in the United States. The two terms GDP and GNP are almost identical. The most common approach to measuring and understanding GDP is the expenditure method:
GDP = consumption + investment + government spending + (exports - imports)
"Gross" means depreciation of capital stock is not included. With depreciation, with net investment instead of gross investment, it is the net domestic product. Consumption and investment in this equation are the expenditure on final goods and services. The exports minus imports part of the equation (often called cumulative 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 (or government) 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
The components of GDP
Each of the variables C, I, G and NX (where GDP = C + I + G + NX as above):
•C is private consumption in the economy. This includes most personal expenditures of households such as food, rent, medical expenses and so on but does not include new housing.
•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. Spending by households on new houses is also included in Investment. '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 a 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 military, 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.
•X is gross export. GDP captures the amount a country produces, including goods and services produced for overseas consumption, therefore exports are added.
•M is gross import. 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.
•NX are "net exports" in the economy: gross exports - gross imports. There is a fixed relation: NX = X - M.
It is important to understand the meaning of each variable precisely in order to:
•Read national accounts.
•Understand Keynesian or neo-classical macroeconomics
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.).
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:
GDP = Compensation of employees + Gross operating surplus + Gross mixed income + Taxes less subsidies on production and imports
•Compensation of employees (COE) measures the total remunerations 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 is 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).
Another formula can be written as this:
GDP = R + I + P + SA + W
R = rents
I = interests
P = profits
SA = statistical adjustments (corporate income taxes, dividends, undistributed corporate profits)
W = wages
Cross-border comparison
The level of GDP in different countries may be compared by converting their value in national currency according to either
•current currency exchange rate: GDP calculated by exchange rates prevailing on international currency markets
•purchasing power parity exchange rate: GDP calculated by purchasing power parity (PPP) of each currency relative to a selected standard (usually the United States dollar).
The relative ranking of countries may differ dramatically between the two approaches.
•The current exchange rate method converts the value of goods and services using global currency exchange rates. This can offer better indications of a country's international purchasing power and relative economic strength. For instance, if 10% of GDP is being spent on buying hi-tech foreign arms, the number of weapons purchased is entirely governed by current exchange rates, since arms are a traded product bought on the international market (there is no meaningful 'local' price distinct from the international price for high technology goods).
•The purchasing power parity method accounts for the relative effective domestic purchasing power of the average producer or consumer within an economy. This can be a better indicator of the living standards of less-developed countries because it compensates for the weakness of local currencies in world markets. The PPP method of GDP conversion is most relevant to non-traded goods and services.
There is a clear pattern of the purchasing power parity method decreasing the disparity in GDP between high and low income (GDP) countries, as compared to the current exchange rate method. This finding is called the Penn effect
Criticisms and limitations
GDP is widely used by economists to follow how the economy is moving, as its variations are relative quickly identified. However, its value as an indicator for the standard of living is considered to be limited. An alternative for this purpose is the United Nations' Human Development Index in which the GDP is a contributing factor in its calculation. Criticisms of how the GDP is used include:
