What is GDP and How to Calculate Gross Domestic Product
When you hear about the word GDP, what comes into mind? World economics, right? Well GDP is one of the major indicators of how sophisticated and economically vibrant country is. More developed countries have very large GDPs compared to third world countries. The population of a country can fairly determine how large its GDP will be.
What is GDP?
GDP stands for Gross Domestic Production. It refers to the value of money in your local currency of all goods and services in your country in a certain period of time. This is very important in the running of development projects and the organization of a country’s economy. In many countries, gross domestic product is calculated quarterly and then for the whole year.
Economically developed countries such as Germany, United States of America, China, and many others are usually concerned about their GDP in order to know if it is suitable to pump money into the economy or not to supply excess money into the economy. Normally, an increase in GDP is an indicator of increased development in a country. That is why knowing how to calculate GDP is very crucial for any person who is interested in economics.
In addition, GDP is not an aspect that works for countries alone. GDP also matters largely to a business owner. Growth in GDP in the country your business is located in means that you can pump more money/capital into the business.
Types of GDP
GDP is measured in different ways depending on the variables used. There are basically four types of GDP figures that economists calculate. They defer according to the prices of goods that are used to calculate GDP;
- Actual GDP – this is the measure of the value of economic activities at a specific time and interval. Here, the current pricing is used to calculate the value of GDP.
- Real GDP – this is the calculation of GDP using the previous year’s prices as the base price. This makes a Real GDP calculation suitable for tracking economic growth of a country. This method also caters for inflation, therefore, it has accuracy compared to other types.
- Nominal GDP – this is the total value of goods and services produced at the current time. This method does not, however, take into account the effect of inflation on GDP calculation.
- Potential GDP – This type of GDP is just a gauge of how an economy would be if all the base factors for economic production were maximum. It takes into account how the size of the economy would look like if employment across all sectors would be 100%, stable production prices, and a stable currency.
How to Determine Gross Domestic Product
Calculating GDP is not an impossible task. Although the extent and size of information that you need to collect before calculating the GDP is the real task. Data collection in small countries such as Luxembourg can take you a long while and that is why many analysts depend on government-provided data to calculate. In order for you to determine gross domestic product, there are three relevant ways that you can use. They include:
- Expenditure Method
- Income Method
- Production Method
The above-mentioned methods are used by economists worldwide to calculate the GDP of their countries. GDP in most countries is calculated on a quarterly basis and the figures are used to calculate annual GDP.
GDP is very crucial because it’s the real-time measure of whether economic activities have increased or reduced. This way, if a government notices a slump in economic activities, it can pump money to revitalize it.
The expenditure method is the most widely used method by economists to calculate GDP. In this method, you calculate GDP by the good and services offered to people in terms of how they are purchased. In other instances, some good or services are produced but not sold. This means that the goods or services are produced but not sold meaning that the producers have kind of bought the goods and services from themselves. These methods therefore include;
How to Calculate GDP Using Expenditure Method
For you to get the gross domestic product you need to know the components that will help you to get GDP. They include:
- GDP (Y) – Gross Domestic Product
- Consumption (C) – consumption includes all goods consumed within a country’s economy in the private sector. This also includes durable goods – goods that are more than three years old.
- Investment (I) – this is the sum of all investments that is spent on capital equipment, inventory, and housing.
- Governments Spending (G) – Government spending includes the total expenditure by the country’s central government in the year. This can range from salaries, expenditure on infrastructure, education, etc.
- Total Exports (X-M) – This is the net exports or a country’s total exports less total imports
- Therefore, the method used to calculate GDP using the expenditure method is;
- GDP = C + I + G + NX
This method includes the value of goods produced and services provided to calculate the GDP of a country. This method is a bit exhaustive compared by the expenditure methods since the provision of services is a major part of the economy and it needs to be included when calculating GDP.
How to Calculate GDP Using the Income Method
When using the income method to calculate GDP, there are various variables that should be collected;
- Total National Income – The sum of all the rent, wages, interest, and profits
- Sales Tax – this is the figure for consumer tax that is imposed on the sale of goods and services.
- Net Foreign Factor Income – This is the difference between the total income that a country’s citizens and companies generate in foreign countries compared to the total amount that citizens in foreign countries generate.
- Depreciation – This is the cost allocated to a tangible asset i.e. buildings over their economically viable life.
When you want to calculate GDP using the income method, the following formula is applied;
GDP = Total National Income + Sales Tax + Depreciation + Net + Foreign Income Factor
The production method is rarely used because of its lack of exhaustiveness. This is because it takes only a small aspect of production in its calculation. The production method uses the sum of value added to a product during the production process. It, therefore, used value addition as its base for GDP.
This method is highly critiqued since it leaves out a large section of the economy such as the services sector, imports, and exports, government spending, etc.
Drawbacks of GDP Calculation Methods
The methods that have been explained above are not completely exhaustive since they do not include the black-market which is a very major source of income for a significant part of a population. The black market is very large and untaxed in many countries and therefore it is impossible to include it in the calculation of GDP.
Another drawback of GDP calculation is that it does not gauge whether poverty levels have increased or reduced. Therefore, GDP can indicate the increase in economic activity in a country without indicating whether the country’s Human Development Index is really improving.