GDP (Gross Domestic Product): Definition, Types, and History

GDP Definition
GDP (Gross Domestic Product): Definition, Types, & History

GDP (Gross Domestic Product) is the total valuation of the goods and services sold by a country during a certain period. GDP is seen as an indicator of the economic opportunities and prosperity of a country. The GDP of a country helps to identify the overall output of the country in terms of goods and services. The countries with higher GDPs have higher economic growth. Countries with lower GDP have lesser economic growth. GDP is considered one of the world’s most trusted indicators for making broader economic decisions. GDP is calculated both quarterly and annually depending on the country’s policy. The value of GDP projects an overall picture of the economy and gets an estimate of economic growth.

The earliest form of GDP was developed by William Petty, the famous English economist. William Petty was a charter member of the Royal Society and a former member of the Parliament of England. William was the first person that figures out a way to calculate GDP.. 

The modern form of GDP was developed by Simon Kuznets in 1934 at the US Congress. Simon Kuznets was an economist at the National Bureau of Economic Research when he presented the formulation of GDP in his report to congress. 

GDP got accepted worldwide majority after 1944. The acceptance of GDP came after Bretton Woods Conference. At Bretton Woods Conference, delegates from 44 allied nations took part. The main aim of this conference was to stabilize the world economy after world war 2. International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD) were created during this conference. 

There are four main types of GDP calculation methods: Nominal, Actual, Real, and Potential GDP.

GDP is considered the most important statistical parameter to determine the standard of living of a country. The GDP growth rate is an important element in determining the success of economic policies implemented in a country over a while. These kinds of parameters are important for governments to determine any upcoming threats of recession or inflation.. A country’s GDP is used by investors to make decisions regarding investing in that country.

What is GDP?

GDP is the total market value of a country that is used to estimate the overall economic strength and stability over a particular period. GDP estimates the overall monetary value of goods and services of a country. GDP is used by policymakers and central banks to analyze a country’s economic valuation.

The GDP is calculated by government agencies such as the Ministry of Statistics and Programme Implementation. In the case of India, GDP is calculated by the Central Statistics Office, which obtains various kinds of data such as annual surveys of industries, IPI (Industrial production index), and CPI(Consumer price index) from state governments & federal agencies to estimate GDP. There are different methods like nominal and real to calculate GDP. These data slightly differ but are approximately the same. For example, nominal GDP is calculated using the present market cost, whereas real GDP is estimated based on cost adjusted concerning inflation. 

History of GDP

GDP was first conceptualized at the end of the 18th century. The term GDP was introduced only after the 1940s, but the need to calculate the value of output was already present before its introduction. During the mid-1600s, William Petty, a British economist, gave a method to analyze the data of land, population and income expenditure. The biggest problem at that time was that there was no common definition of national income, which led to confusion about what to include in the national income. But the core idea was clear that national income is how much income is available to spend. 

The earlier form of GDP, which was known as national income, was not clear at that time. For example, Russia did not include the income generated through services in its national income data. 

The concept of GDP was further enhanced by Charles Davenant in 1695, GDP can help us identify the contributions by all of the sectors of the country he explained this through his works. His first pamphlet came in 1695, “An Essay Upon Ways and Means of Supplying the War”. 

Although his works are completely forgotten nowadays, England’s government was able to estimate the potential for greater output and tax revenues, which was a significant contributing element in the country’s recurrent wars with France because of the country’s consolidated national income figures.

The modern form of GDP was given by Simon Kuznets in 1934. Simon later won the Nobel Prize for this contribution after he presented his first report at the US national Congress in January 1934. The observation of this data was that the national economy of the United States halved from 1929 to 1932. His report was a great success and even during times of recession, his report was a bestseller. Around more than 40,000 copies were sold. Even the data was used by then-President Roosevelt when he was announcing the recovery policy.

The system of estimating GDP has become more and more complex over time. This is because of the complicated methods used for the estimation of the GDP, not only the methods but the economy has become more complex. For instance, unlike goods, sometimes it is difficult to estimate the output of some kinds of sophisticated services.

What are the 4 types of GDP?

There are mainly four ways in which the value of GDP can be calculated. They include nominal GDP, real GDP, actual GDP, and potential GDP.

1. Nominal GDP

Nominal GDP is the total sum of all the goods and services at the market price as purchased by the consumer. All these goods and services should be manufactured or produced inside the country for a particular period. The value of goods and services used in nominal GDP is not under the effect of inflation, because of this unreal GDP growth increases. So, nominal GDP is not a better option when used for comparing GDP growth between consequent years. In simple words, we can say that Nominal GDP is the total monetary value of goods and services sold in a year. 

2. Real GDP

Real GDP is a little different from nominal GDP as it takes into account the changes in prices due to inflation. So, to calculate real GDP, first, we need the value of nominal GDP, and then this value is divided by the GDP deflator. The GDP deflator helps us to take into account inflation. The GDP deflator is known as the general price index. Statisticians use a lot of methods to find GDP deflators. For example, if the nominal GDP for a particular year is $20,000 and the inflation is around 15%. The GDP deflator becomes 1.15, and to calculate the value of Real GDP, we would divide the nominal GDP by 1.15 ($2000/1.15=$17391.3).

The value of Real GDP is less than Nominal GDP in case of positive inflation. This data on GDP is much more meaningful when calculating the GDP growth rate. The real GDP gives us the actual value of the total outcome. In the case of inflation, the normal GDP growth rate always increases, which might be meaningless.

3. Actual GDP

Actual gross development product is similar to the other types of GDP. Actual GDP measures the total value of goods and services produced in a country. It gives the idea of the economy at the current time. 

4. Potential GDP

Potential gross development product represents the total outcome of the market in terms of the monetary value of goods and services sold in a particular period. The assumption that potential GDP takes into account is that it assumes the highest level of productivity. During the calculation of the potential gross development product, ideal economic conditions are assumed. This index is used by policymakers to make decisions regarding economic policies. For example, it means that there is a low demand for services and goods in the market, and the employment rate is low if the potential GDP is greater than the real case the real GDP is less than the potential GDP, the goods and services are sold more than the sustainable value, because of which inflation or pricing increases occur.

In actuality, on occasions, the Real GDP is higher than the Potential GDP, this indicates a higher demand as compared to the supply. And when this imbalance occurs, there is a huge rise in inflation. In this case, even the central bank can interfere by increasing the interest rate to bring the market back to normal.

There are a lot of ways to calculate potential GDP, depending on different economists. But in various general kinds of forecasts, unemployment rates are used to calculate the potential GDP. 

There are more ways to calculate GDP, like GDP per capita, GDP expenditure approach, GDP purchasing power parity, etc., apart from these four. But the above four methods are normally used for GDP calculation. 

 What are the 3 ways to calculate GDP?

There are three different ways to calculate GDP as mentioned below:

3 ways to calculate GDP
3 Ways to calculate GDP

1. Expenditure Approach

The expenditure method of calculating GDP combines four major data: consumption, investment, government spending, and net exports. The value of GDP achieved from the expenditure method is nominal GDP, which can be converted into real GDP by dividing the nominal GDP by the GDP deflator. The expenditure method tells us about the demand of the market. The spending increases when the demand increases. So, the core Idea behind this method is that whenever the spending increases, there is a rise in GDP. The expenditure method has four main components: GDP calculation, consumer expenditure, government expenditure, investments of the country, and net exports (calculated by subtracting the total imports from total exports).

The formula for calculating GDP based on expenditure is:

(Nominal) GDP = Consumer Spending + Investments + Government’s spending + {Total exports − Total imports}

  • Consumer spending includes goods and services purchased by the citizens of the country, like cars, bikes, and food products. These products can be divided into two categories: durable products and nondurable products. Durable products generally have a lifespan of more than three years, like washing machines, refrigerators, etc. Non-durable includes edible items, articles of clothing, and services.
  • Government spending includes all kinds of expenditures done for public welfare, like the construction of roads, bridges, hospitals, and schools. Salaries to government workers are included in this component.
  • Investment spending is the most vital component of the expenditure method. It includes money used for buying assets like land, equipment, etc., by organizations.
  • Net export is the value of total imports subtracted from total exports. This value is positive when a country’s total exports are higher than its total imports. For countries like Saudi Arabia (a major exporter of crude oil), this component constitutes a big part of their GDP.

2. Income Approach 

The income method for the calculation of GDP uses the net income generated by all the goods and services. Four major revenue sources are considered while calculating GDP based on income, including total national Income, total sales tax, depreciation of assets, and net foreign factor income. By evaluating all these revenue sources, we can get an idea about the country’s overall production over time.

Furthermore, the estimations of taxes and depreciations are added.

The formula for calculating GDP based on income is:

(Income Based)GDP = Total National Income + Total Sales Tax + Depreciation of assets + Net Foreign Factor Income

  • Total National Income is the total income earned from the production of goods and services.
  • Total sales tax is the amount of tax earned by the government which is imposed on the production of goods and services. This makes up a large component of the GDP.
  • Depreciation of assets is the money used for various kinds of government-owned assets.
  • Net foreign factor income is a complex component of the GDP as it’s difficult to analyze it. The value of net foreign factor income is calculated by subtracting income earned by foreign individuals and companies in the domestic country from net income generated by the individuals or organizations of the domestic country in a foreign country.

3. Production Approach

GDP based on production subtracts the value of some goods and services from the economy’s total output.

This method is the opposite of the expenditure method.

The formula for GDP based on production is:

(Production method)GDP = Sum of the value of all goods and services – the value of intermediates

What impact does GDP have on our economy?

GDP impacts an economy’s investments, growth, and citizens’ income. Higher GDP growth is considered a positive event in the economy. Increasing GDP increases the monetary status of the economy and the people involved in it. 

A higher GDP is a result of more spending. More spending can lead to a smoother flow of the economy as businesses net increased profits. Higher business profits can lead to more jobs which further helps economic growth.

Higher GDP rates could attract foreign investments, as well as higher GDP, represents an economy that is growing. Foreign direct investments target growing economies as there is more potential for growth.

What happens if GDP increase?

The increase in GDP benefits the citizen as the income per person increases. Also, the relative standard of living improves. The organizations hire more people as the net cash flow in the market increases.

But, this increase in the GDP value should not be directly related to economic prosperity, because events like wars, terrorist attacks and natural disasters would also increase the GDP. So to obtain the actual rise in the economy GPI(Genuine Progress Indicator) is used, which includes some other variables for calculation. For the general public, the GDP can give misleading ideas about the economy, so in order to resolve this, the Genuine Progress Indicator was designed in 1995. The value of GDP is still used by economists, politicians and media to estimate the overall growth of the nation. So, when the GDP increases, the people earn more money, they spend more, the industries earn more and more tax is paid.

What happens if GDP decreases?

When the GDP falls, it creates an alarming situation for the economy because the employment percentage drops immediately. The cash flow is reduced making businesses suffer. The demand and supply balance is disturbed, due to which small business owners become helpless. For example, during the COVID-19 pandemic, all of the major economies suffered. Governments took loans of billions of dollars to stabilize the economy. Unemployment rates increased, and businesses went bankrupt as the GDP rate was declining at an alarming rate. In severe cases like wars and bubble burst GDP decline can even trigger a recession. In such cases the general trade declines resulting in lesser tax collection. Because of this governments suffer to manage public services like schools, hospitals and construction activities etc. 

Does GDP affect the Standard of Living of each country?

Gross domestic product (GDP) is an indicator of a society’s standard of living, but it is only a rough marker since it does not directly account for things like leisure time, environmental quality, health and education, non-market activities, changes in income inequality, increased variety, advances in technology, or the value that society may place on certain types of output (whether positive or negative). Whether or not these components can be purchased from a third party, they are all included in the quality of living since they have an impact on people’s pleasure.

What are the factors in the Standard of Living that GDP fails to account for?

GDP is not a perfect scale always and it fails to account for six main factors in the standard of living. Let us take a look at each of them in detail.

1. Externalities

GDP often fails to account for externalities. The rise in Gross Domestic Product may be attributed to the expansion of various economic activities, such as urbanization and industrialization. When there is a higher rate of industrialization, there is also a higher rate of certain social concerns, such as the pollution of air, water, and soil, as well as deforestation. Problems with housing, a rise in the number of accidents on the roads, and other issues are also caused by urbanization. When calculating GDP, this drop in welfare is disregarded, which leads to a general decline in people’s standard of living. Therefore, we might claim that using GDP as a measure of well-being can be problematic due to the presence of externalities.

2. Wealth Distribution

GDP is an average metric, thus it does not represent the wealth and income differences that exist within a community. These gaps are often adversely connected with the health of that society. When there is a major imbalance in the distribution of wealth, this may rise to conflicts, which in turn can bring about change that is sometimes violent and other times (finally) beneficial. During the so-called Gilded Age in the late 19th century in the United States, when there was a great discrepancy in the distribution of wealth, important legislation was enacted to combat monopolies, trusts, and cartels.

As a result of this, one of the things that we should now be looking at as a metric of economic success is the Gini coefficient, which assesses the disparity of wealth or income. And the current distribution of wealth seems to be much more unequally distributed than it was during the Gilded Age.

3. Non-monetary Economy

The Gross Domestic Product doesn’t really take into account any transactions that cannot be quantified using monetary units. The fact that there are numerous transactions that, despite the fact that they are non-monetary, contribute to the expansion and development of the nation is one of the primary limitations of using GDP as an indication of a country’s standard of living. Due to a lack of genuine data, many non-monetary acts that take place inside the economy and are done out of love and compassion are not appraised in terms of their monetary value. Therefore, non-market transactions that boost economic well-being, such as the services provided by housewives and social workers, are not included in the computation of GDP. These transactions take place outside of the market. As a result, GDP is an underestimate of welfare and may not be an accurate reflection of a country’s well-being.

4. Sustainability of Growth

sustainable economic growth refers to actions within the economy that work to increase both the standard of living and the general well-being of society. Additionally, the term “sustainable economic growth” refers to a pace of economic development that may be sustained without causing substantial issues in the future. The current expansion of the economy might, in the long run, result in the depletion of resources and the emergence of environmental issues. The creation of a sustainable economy takes into account future requirements and places restrictions on the extraction of natural gas, cattle, fish, and other resources. A sustainable expansion of the economy helps to forestall further warming of the planet.

Utilizing resources but also protecting them is necessary for maintaining economic viability. To guarantee the organization’s continued viability over the long term, it is essential that both the people and material resources be maintained. For an economy to be economically sustainable, it is necessary to make efficient use of its resources, to recover and recycle as much waste as possible in order to reduce the amount of waste produced and to devise plans to protect and take care of the surrounding environment while operating a business. To ensure sustainability over the long term, externalities need to be protected in the here and now so that the value of natural resources may be realized in the future. When making choices dealing to externalities like the environment, it is necessary to have a strategy for sustainable economic development that has been put into place to assure growth while also preserving the quality of life. GDP fails to account for sustainable growth and it is a major drawback.

 5. Non-market Transactions

Transactions that don’t take place on a formal market aren’t accounted for in official statistics, aren’t taxed and aren’t overseen by the government. As a result, this activity does not contribute to the GDP of the country in question.

It’s important to note that the value created by non-market transactions is not reflected in GDP numbers despite its importance. The GDP does not account for the value of domestic labor, which is done alone inside a single home. The GDP doesn’t account for the time you spend helping your mom with the kids or doing housework like washing the dishes or painting rooms. These deals aren’t included in GDP since they aren’t conducted on a public market but rather in private settings like the home.

What are the limitations of GDP?

The biggest limitation of GDP is that it is only a measurement of the size of the country’s economy; it does not represent the country’s prosperity. When measuring development, if one focuses just on GDP and economic gain, then one misses the negative impacts that economic expansion has on society, such as the change in climate and the increase in income disparity. It is time that we recognize the limits of GDP and broaden our measure of progress so that it takes into consideration the quality of life in a community.

What do the critics say about GDP?

The major criticism of GDP is that it depends on official statistics, therefore it does not take into account the scale of the underground economy, which might be large in certain countries. This means that GDP does not account for the existence of the underground economy.

Is there a relationship between GDP and Inflation?

The relationship between GDP & inflation has been one of the most researched topics in economics. Inflation is a phenomenon in which the prices of goods and services increase. During inflation, goods become costly, and the value of money is reduced. 

The GDP is closely related to inflation, As per economists, the growth rate of GDP should be between 2% to 3%. GDP increases too much, and it greatly impacts people’s purchasing power. Inflation increases when GDP increases, the value of the currency decreases, and the purchasing power of people declines,  which would ultimately results in lesser demand for goods and services.

The increase in inflation can have devastating effects on the economy, the effects of inflation are not straight, for example, 8% inflation is more than twice devastating when compared to 4% inflation.

Most people argue that 0% inflation is favorable for the country. But in actuality, it is very hard to attain 0% inflation. Generally, the laborers’ wages are increased to feel satisfied. And when wages are increased, inflation increases as the value of money is reduced, as now everyone has more money. Economists generally suggest that 2% to 3% inflation is favorable for the economy’s overall growth.

Does the stock market affect GDP?

Yes, the stock market is dependent on GDP through the supply and demand balance of the market. As the health of the economy of a country changes, the balance between demand and supply changes simultaneously, and the listed companies can observe a lesser or higher demand for their products. A fluctuation in the economy increases or decreases the performance of the company, and hence its share prices would rise or fall.

Whenever there is an increase in the stock prices, it shows that the investors are hopeful about the company and are investing their money for better results. This causes an increase in the economy, and the GDP  increases. 

Investors do not want to invest in a share if they find out that the company is not performing well. This leads to a decrease in the share price, which ultimately causes a loss to the economy. So, whenever there is a fall in the stock market, the GDP  decreases.

In addition to that, foreign investors do not want to invest in an economy that is either stagnant or shrinking. So growing GDP is required to attract investors.

How many percentages of GDP are in the Indian Stock Market?

The stock market of a country is compared to the GDP of the country to get an idea about the size of the stock market relative to the economy. In the case of India, in 2020, the percentage of market cap was around 97.29%, while the world average is around 99.07%. The current percentage of the Indian Stock Market concerning GDP is 112.4%. Last year this percentage was around 95%.

A stock market capitalization of more than 50% is considered as big enough for the economy.

This percentage is used to determine whether the market is overvalued or undervalued.

Formula = (Market Capitalisation/GDP)x100

Generally, when the stock market capitalization is above 100%, the stock is considered overvalued; when the percentage is below 50%, it is considered undervalued.

What is the difference between GDP and GNP?

GDP and GNP are both economic indicators that are used to give the overall picture of the financial stability of a country. Both of them calculate the value of goods and services, but the way of calculation is different.

The full form of GDP is Gross Domestic Product, whereas the full form of GNP is Gross National Product. The main difference between both is how the goods and services are included. In the case of GDP, we include all the products and services produced inside the country in a particular duration of time. For GNP, All the goods and services owned by the citizens of the country are included, even if these goods are produced outside the country.

In simple terms, GDP only includes assets that are produced inside the country. Whereas GNP  includes the overseas activities performed by its citizens.

The countries use GDP as an indicator for economic activities, GNP was followed by the USA before 1991, but now even America follows GDP. 

The GNP does not include the contributions made by foreign individuals in a country. For example, if an Indian citizen living in the USA sends his money back to India, this activity will not be included in the GNP of the USA, but it will be included in the GDP of the USA just because the GDP  includes the contributions made by foreign individuals living inside the country.

However, both of these terms seem a lot different, but in actuality, the data obtained by estimating both GDP and GNP is almost the same. For example, the GDP of India was 2,660 billion USD, and the GNP was 2,635 billion USD. The GNP/GDP percentage of India was 99.1%. Similarly, for America, it was around 101.6%.  The GNP is sometimes referred to as GNI(Gross National Income). However, both of them are theoretically the same. But actually, GNI is based on national income, and GNP is based on national expenditure.

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