Money is one of humanity’s greatest inventions. It is both a tool and a measure. But unlike other measures that are confined to measuring a single dimension or quality, money has the capacity of assigning value to almost anything material or immaterial — physical objects, human labor, social status, information, obedience, loyalty etc.
GDP on the other hand is a gross measure of total output. It measures the value of finished goods and services ready to be used by consumers, business and government, similar to the “bottom line” (earnings) of an accounting statement, which determined the “value added” or the value of final use.
Today, economics employs a wide range of indispensable measuring tools, including GDP, the consumer price index, interest rate, money supply, exchange rate and the unemployment rate. While the general public may regard these tools as accurate measures of economic reality, economists recognize that they are in fact only rough, approximate indicators designed to reflect economic reality rather than accurately measuring it.
William Petty came up with a basic concept of GDP to defend landlords against unfair taxation during warfare between the Dutch and the English between 1652 and 1674. It is interesting to note that, though GDP is often used as an indicator of living standards, it may increase while real incomes for the majority decline. Similarly, GDP per capita is not a measure of personal income.
At the same time, all citizens would benefit from their country's increased economic production as it leads to an increase in consumption opportunities which in turn increases the standard of living. Though GDP is usually calculated on an annual basis, it can be calculated on a quarterly basis as well.
GDP includes all private and public consumption, government outlays, investments and exports minus imports that occur within a defined territory. Thus, GDP is a broad measurement of a nation’s overall economic activity. The major advantage of GDP per capita as an indicator of standard of living is that, it is measured frequently, widely, and consistently.
It is measured frequently in that, most countries provide information on GDP on a quarterly basis, allowing trends to be seen quickly. It is measured widely which implies that, some measure of GDP is available for almost every country in the world, allowing inter-country comparisons. It is measured consistently meaning, the technical definition of GDP is relatively consistent among countries.
GDP is not only the measure of the total of finished goods and services produced in the monetized segment of the economy valued on the basis of cost. But, its relative importance or benefit to human well-being without making any distinction between productive and destructive, essential and trivial, sustainable and unsustainable activities.
It can be argued that GDP per capita as an indicator standard of living can be proven through these factors:
More goods and services are available to consumers;
Consumers are in a better position to buy goods.
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GDP is not only the measure of the total of finished goods and services produced in the monetized segment of the economy valued on the basis of cost. But, its relative importance or benefit to human well-being without making any distinction between productive and destructive, essential and trivial, sustainable and unsustainable activities.
It can be argued that GDP per capita as an indicator standard of living can be proven through these factors:
More goods and services are available to consumers;
Consumers are in a better position to buy goods.
As one can imagine, economic production and growth, what GDP represents, has a large impact on nearly everyone within that economy. For example, when the economy is healthy, you will typically see low unemployment and wage increases as businesses demand labor to meet the growing economy.
A significant change in GDP, whether up or down, usually has a significant effect on the stock market. It's not hard to understand why: a bad economy usually means lower profits for companies, which in turn means lower stock prices. Investors really worry about negative GDP growth, which is one of the factors economists use to determine whether an economy is in a recession.
It can also be determined in three ways, all of which should, in principle, give the same result. They are the production (or output or value added) approach, the income approach, or the expenditure approach. The most direct of the three is the production approach, which sums the outputs of every class of enterprise to arrive at the total.
The expenditure approach works on the principle that all of the product must be bought by somebody, therefore the value of the total product must be equal to people's total expenditures in buying things.
The income approach works on the principle that the incomes of the productive factors ("producers," colloquially) must be equal to the value of their product, and determines GDP by finding the sum of all producers' incomes.
Production Approach;
This approach mirrors the OECD definition given above.
Estimate the gross value of domestic output out of the many various economic activities;
Determine the intermediate consumption, i.e., the cost of material, supplies and services used to produce final goods or services;
Deduct intermediate consumption from gross value to obtain the gross value added.
Gross value added = gross value of output – value of intermediate consumption.
Value of output = value of the total sales of goods and services plus value of changes in the inventories.
The sum of the gross value added in the various economic activities is known as "GDP at factor cost".
GDP at factor cost plus indirect taxes less subsidies on products = "GDP at producer price".
For measuring output of domestic product, economic activities (i.e. industries) are classified into various sectors. After classifying economic activities, the output of each sector is calculated by any of the following two methods:
By multiplying the output of each sector by their respective market price and adding them together;
By collecting data on gross sales and inventories from the records of companies and adding them together.
The gross value of all sectors is then added to get the gross value added (GVA) at factor cost. Subtracting each sector's intermediate consumption from gross output gives the GDP at factor cost. Adding indirect tax minus subsidies in GDP at factor cost gives the "GDP at producer prices".
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The income approach works on the principle that the incomes of the productive factors ("producers," colloquially) must be equal to the value of their product, and determines GDP by finding the sum of all producers' incomes.
Production Approach;
This approach mirrors the OECD definition given above.
Estimate the gross value of domestic output out of the many various economic activities;
Determine the intermediate consumption, i.e., the cost of material, supplies and services used to produce final goods or services;
Deduct intermediate consumption from gross value to obtain the gross value added.
Gross value added = gross value of output – value of intermediate consumption.
Value of output = value of the total sales of goods and services plus value of changes in the inventories.
The sum of the gross value added in the various economic activities is known as "GDP at factor cost".
GDP at factor cost plus indirect taxes less subsidies on products = "GDP at producer price".
For measuring output of domestic product, economic activities (i.e. industries) are classified into various sectors. After classifying economic activities, the output of each sector is calculated by any of the following two methods:
By multiplying the output of each sector by their respective market price and adding them together;
By collecting data on gross sales and inventories from the records of companies and adding them together.
The gross value of all sectors is then added to get the gross value added (GVA) at factor cost. Subtracting each sector's intermediate consumption from gross output gives the GDP at factor cost. Adding indirect tax minus subsidies in GDP at factor cost gives the "GDP at producer prices".
The second way of estimating GDP is to use "the sum of primary incomes distributed by resident producer units". If GDP is calculated this way it is sometimes called gross domestic income (GDI), or GDP (I). GDI should provide the same amount as the expenditure method described later. (By definition, GDI = GDP. In practice, however, measurement errors will make the two figures slightly off when reported by national statistical agencies.)
This method measures GDP by adding incomes that firms pay households for factors of production they hire - wages for labour, interest for capital, rent for land and profits for entrepreneurship. The US "National Income and Expenditure Accounts" divide incomes into five categories including:
Wages - Payments based on a certain amount of time. Usually based on the number of hours worked multiplied by an hourly rate of pay.
Salaries - Commonly paid in fixed intervals, for example, monthly payments of one-twelfth of the annual salary.
Supplementary labour income -Example free-of-cost health care, education, food, clothing, accommodation and servant facility.
Corporate profits - Interest and miscellaneous investment income
Farmers’ incomes - Income from non-farm unincorporated businesses
These five income components sum to net domestic income at factor cost.
Two Adjustments Must Be Made To Get GDP:
Indirect taxes minus subsidies are added to get from factor cost to market prices.Depreciation (or capital consumption allowance) is added to get from net domestic product to gross domestic product. Total income can be subdivided according to various schemes, leading to various formulae for GDP measured by the income approach. A common one is:
GDP = compensation of employees + gross operating surplus + gross mixed income + taxes less subsidies on production and imports.
GDP = COE + GOS + GMI + TP & M – SP & M
'Compensation of employees (COE) measures the total remuneration to employees for work done. It includes wages and salaries, as well as employer contributions to social security and other such programs.
'Compensation of employees (COE) measures the total remuneration 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 are 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; it is the income of all of the factors of production in society. It 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).
Total Factor Income Is Also Sometimes Expressed As:
Total factor income = employee compensation + corporate profits + proprietor's income + rental income + net interest
Yet another formula for GDP by the income method is:
GDP = R + I + P + SA + W
where R : rents
I : interests
P : profits
SA : statistical adjustments (corporate income taxes, dividends, undistributed corporate profits)
W : wages.
Total Factor Income Is Also Sometimes Expressed As:
Total factor income = employee compensation + corporate profits + proprietor's income + rental income + net interest
Yet another formula for GDP by the income method is:
GDP = R + I + P + SA + W
where R : rents
I : interests
P : profits
SA : statistical adjustments (corporate income taxes, dividends, undistributed corporate profits)
W : wages.
Expenditure Approach
The third way to estimate GDP is to calculate the sum of the final uses of goods and services (all uses except intermediate consumption) measured in purchasers' prices. In economics, most things produced are produced for sale and then sold. Therefore, measuring the total expenditure of money used to buy things is a way of measuring production.
This is known as the expenditure method of calculating GDP. Note that if you knit yourself a sweater, it is production but does not get counted as GDP because it is never sold. Sweater-knitting is a small part of the economy, but if one counts some major activities such as child-rearing (generally unpaid) as production, GDP ceases to be an accurate indicator of production.
Similarly, if there is a long term shift from non-market provision of services (for example cooking, cleaning, child rearing, do-it yourself repairs) to market provision of services, then this trend toward increased market provision of services may mask a dramatic decrease in actual domestic production, resulting in overly optimistic and inflated reported GDP. This is particularly a problem for economies which have shifted from production economies to service economies.
Similarly, if there is a long term shift from non-market provision of services (for example cooking, cleaning, child rearing, do-it yourself repairs) to market provision of services, then this trend toward increased market provision of services may mask a dramatic decrease in actual domestic production, resulting in overly optimistic and inflated reported GDP. This is particularly a problem for economies which have shifted from production economies to service economies.
Components Of GDP By Expenditure
GDP (Y) is the sum of consumption (C), investment (I), government spending (G) and net exports (X – M).
Y = C + I + G + (X − M)
GDP (Y) is the sum of consumption (C), investment (I), government spending (G) and net exports (X – M).
Y = C + I + G + (X − M)
Here Is A Description Of Each GDP Component:
C (consumption) is normally the largest GDP component in the economy, consisting of private (household final consumption expenditure) in the economy. These personal expenditures fall under one of the following categories: durable goods, non-durable goods, and services. Examples include food, rent, jewelry, gasoline, and medical expenses but does not include the purchase of new housing.
I (investment) includes, for instance, business investment in equipment, but does not include exchanges of existing assets. Examples include construction of a new mine, purchase of software, or purchase of machinery and equipment for a factory. Spending by households (not government) on new houses is also included in investment.
In contrast to its colloquial meaning, "investment" in GDP does not mean purchases of financial products. Buying financial products is classed as 'saving', as opposed to investment. This avoids double-counting: if one buys shares in a company, and the company uses the money received to buy plant, equipment, etc., the amount will be counted toward GDP when the company spends the money on those things; to also count it when one gives it to the company would be to count two times an amount that only corresponds to one group of products.
Buying bonds or stocks is a swapping of deeds, a transfer of claims on future production, not directly an expenditure on products.
G (government spending) is the sum of government expenditures on final goods and services. It includes salaries of public servants, purchases 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.
Other Examples Of GDP Component Variables
C, I, G, and NX(net exports): If a person spends money to renovate a hotel to increase occupancy rates, the spending represents private investment, but if he buys shares in a consortium to execute the renovation, 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 a hotel is a private home, spending for renovation would be measured as consumption, but if a government agency converts the hotel into an office for civil servants, the spending would be included in the public sector spending, or G.
If the renovation involves the purchase of a chandelier from abroad, that spending would be counted as C, G, or I (depending on whether a private individual, the government, or a business is doing the renovation), but then counted again as an import and subtracted from the GDP so that GDP counts only goods produced within the country.
If a domestic producer is paid to make the chandelier for a foreign hotel, the payment would not be counted as C, G, or I, but would be counted as an export.
Social, environmental and economic progress does not always go hand in hand with an increase in GDP. For example, if a country decides to cut down all its forests, it will dramatically increase its timber exports, thus increasing its GDP. If GDP were the only indicator of quality of life, this would mean that the population of this country would have greatly improved its well-being.
However, the deforestation would have a significant impact on the population’s quality of life in the mid and long term: loss of natural habitat, soil erosion and more. GDP definitely measures quantity, but not necessarily other aspects of production (such as distribution and potential impacts for the future).
Consequently, overall measures of economic and social well-being must also include distribution indicators in order to provide a more realistic picture of the living standards and quality of life of a society’s citizens. GDP and other economic measures need to be complemented with indicators covering other important domains in order to measure well-being.
Moving beyond economic performance, a more comprehensive, wide-ranging approach is needed when trying to define and measure quality of life. While it remains very difficult to provide an overall definition with specific measurable indicators, quality of life definitely includes more than just economic production and GDP figures.
Based on academic research and several initiatives, the following 8 dimensions/domains have been defined as an overarching framework for the measurement of well-being. Ideally, they should be considered simultaneously, because of potential trade-offs between them:
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Material living standards are measured on the basis of three sub-dimensions: income, consumption and material conditions (deprivation and housing). Income is an important indicator as it has an impact on most of the other indicators in the framework.
Consequently, overall measures of economic and social well-being must also include distribution indicators in order to provide a more realistic picture of the living standards and quality of life of a society’s citizens. GDP and other economic measures need to be complemented with indicators covering other important domains in order to measure well-being.
Moving beyond economic performance, a more comprehensive, wide-ranging approach is needed when trying to define and measure quality of life. While it remains very difficult to provide an overall definition with specific measurable indicators, quality of life definitely includes more than just economic production and GDP figures.
Based on academic research and several initiatives, the following 8 dimensions/domains have been defined as an overarching framework for the measurement of well-being. Ideally, they should be considered simultaneously, because of potential trade-offs between them:
- Productive or main activity
- Health
- Education
- Leisure and social interactions
- Economic and physical safety
- Governance and basic rights
- Natural and living environment
- Overall experience of life
Material living standards are measured on the basis of three sub-dimensions: income, consumption and material conditions (deprivation and housing). Income is an important indicator as it has an impact on most of the other indicators in the framework.
There are several different indicators within this sub dimension, taken from both national accounts and household surveys (net national income, household disposable income). The same is true for consumption, within which some aggregated indicators are taken from national accounts (household consumption per capita, total consumption per capita), and other indicators for households are taken from the Household Budget Survey.
Material conditions (deprivation and housing) provide important complementary information to these money-based approaches. A number of activities fill up citizens’ lives every day, the most prominent one being their work. Indicators measuring both the quantity and the quality of jobs available (working hours, balancing work and non-working life, safety and ethics of employment) are some of the indicators used to measure this aspect of quality of life.
Health is an essential part of the quality of life of citizens. Poor health can affect the general progress of society. Physical and/or mental problems also have a very detrimental effect on subjective well-being. Health conditions are mainly measured using objective health outcome indicators such as life expectancy, infant mortality, the number of healthy life years, but also more subjective indicators, such as access to healthcare and self-evaluation of one’s health.
Health is an essential part of the quality of life of citizens. Poor health can affect the general progress of society. Physical and/or mental problems also have a very detrimental effect on subjective well-being. Health conditions are mainly measured using objective health outcome indicators such as life expectancy, infant mortality, the number of healthy life years, but also more subjective indicators, such as access to healthcare and self-evaluation of one’s health.
In our knowledge-based economies, education plays a pivotal role in the lives of citizens and is an important factor in determining how far they progress in life. Levels of education can determine the job an individual will have. Individuals with limited skills and competences are usually excluded from a wide range of jobs and sometimes even miss out on opportunities to achieve valued goals within society.
They also have fewer prospects for economic prosperity. Currently, available indicators of education that are relevant for quality of life are a population’s educational attainment, the number of early school leavers, self-assessed and assessed skills and participation in life-long learning.
The power of networks and social connections should not be underestimated when trying to measure the well-being of an individual, as they directly influence life satisfaction. This measured in terms of how often citizens spend time with people at sporting or cultural events or if they volunteer for different types of organisations.
The power of networks and social connections should not be underestimated when trying to measure the well-being of an individual, as they directly influence life satisfaction. This measured in terms of how often citizens spend time with people at sporting or cultural events or if they volunteer for different types of organisations.
In addition, the potential to receive social support and the frequency of social contacts are indicators included in the framework under this dimension. Security is a crucial aspect of citizens’ lives. Being able to plan ahead and overcome any sudden deterioration in the economy and wider environment has an impact on quality of life.
Safety is measured in terms of physical safety (e.g. the number of homicides per country) and economic safety. The ability to face unexpected expenses and having or not having arrears are therefore used as proxy variables.
The right to get involved in public debates and influence the shaping of public policies is an important aspect of quality of life. Moreover, providing the right legislative guarantees for citizens is a fundamental aspect of democratic societies. Good governance depends on the participation of citizens in public and political life (for example, involvement in political parties, trade unions etc.).
The right to get involved in public debates and influence the shaping of public policies is an important aspect of quality of life. Moreover, providing the right legislative guarantees for citizens is a fundamental aspect of democratic societies. Good governance depends on the participation of citizens in public and political life (for example, involvement in political parties, trade unions etc.).
It is reflected also in the level of trust of citizens in the country’s institutions, satisfaction with public services and the lack of discrimination. Gender discrimination measured in terms of the unadjusted pay gap is the only indicator included in this sub-dimension at the moment, but more indicators will be developed in the future.
Exposure to air, water and noise pollution can have a direct impact on the health of individuals and the economic prosperity of societies. Environment-related indicators are very important for assessing quality of life. Both subjective (individuals’ own perceptions) and objective (the amount of pollutants present in the air) indicators are included.
Overall assessment of one’s life is measured using three sub-dimensions: life satisfaction (cognitive appreciation), affect (a person’s feelings or emotional states, both positive and negative, typically measured with reference to a particular point in time) and eudaemonics (a sense of having meaning and purpose in one’s life, or good psychological functioning.).
This is in line with the OECD guidelines on Measuring Subjective Well-Being. Measuring quality of life for different populations and countries in a comparable manner is a complex task, and a scoreboard of indicators covering a number of relevant dimensions is needed for this purpose.
Further, GDP is very useful for measuring market production (expressed in money units). However, although it was not intended as an indicator of social progress, it has been considered to be closely linked to the well-being of citizens.
Adam Smith, David Ricardo and the other great founders of modern economics made remarkable contributions to our understanding of the wealth of nations, but did not have effective measurements to apply their concepts with precision. This changed dramatically with the development of quantitative economic measures after World War I.
During the Great Depression, GDP was developed as an indicator of market activity. It was also developed as a war-planning tool during the Second World War, when the primary objective of government was to stimulate industrial production. Based on its utility during the war, it became an official instrument of US economic policy in 1946.
Originally intended as an index of industrial growth, growth of GDP came to be regarded as synonymous with an improvement in a nation’s economic health and the welfare of its people. Its creator, Simon Kuznets, warned the US Congress about its limitations as early as 1934.
Why Is GDP So Important To Economists And Investors?
The income approach, which is sometimes referred to as GDP(I), is calculated by adding up total compensation to employees, gross profits for incorporated and non incorporated firms, and taxes less any subsidies. The expenditure method is the more common approach and is calculated by adding total consumption, investment, government spending and net exports.
Though the value of most currencies are closely tied to the economy of the country, economic growth is often seen as essential for economic prosperity, and indeed is one of the factors used as a measure of prosperity.
Further, GDP is very useful for measuring market production (expressed in money units). However, although it was not intended as an indicator of social progress, it has been considered to be closely linked to the well-being of citizens.
Adam Smith, David Ricardo and the other great founders of modern economics made remarkable contributions to our understanding of the wealth of nations, but did not have effective measurements to apply their concepts with precision. This changed dramatically with the development of quantitative economic measures after World War I.
During the Great Depression, GDP was developed as an indicator of market activity. It was also developed as a war-planning tool during the Second World War, when the primary objective of government was to stimulate industrial production. Based on its utility during the war, it became an official instrument of US economic policy in 1946.
Originally intended as an index of industrial growth, growth of GDP came to be regarded as synonymous with an improvement in a nation’s economic health and the welfare of its people. Its creator, Simon Kuznets, warned the US Congress about its limitations as early as 1934.
“The welfare of the nation can scarcely be inferred from a measurement of national income.” - Simon KuznetsThree decades later he asserted the need for distinguishing between quantity and quality of growth, costs and return, short and long run.
Why Is GDP So Important To Economists And Investors?
The income approach, which is sometimes referred to as GDP(I), is calculated by adding up total compensation to employees, gross profits for incorporated and non incorporated firms, and taxes less any subsidies. The expenditure method is the more common approach and is calculated by adding total consumption, investment, government spending and net exports.
Though the value of most currencies are closely tied to the economy of the country, economic growth is often seen as essential for economic prosperity, and indeed is one of the factors used as a measure of prosperity.
