You probably know the term GDP from television and newspapers. You also probably know that it is a number that expresses the wealth of a country. A high GDP means that the country is rich and a low one means that it is poor.
But, how do you measure GDP?
The IMF defines GDP as:
“the monetary value of final goods and services—that is, those that are bought by the final user—produced in a country in a given period of time (say a quarter or a year)”1
This value can be measured in three ways: By income, production or expenditure. Today we are going to see the expenditure approach, which is the most reliable and commonly used of the three.
GDP = C + I + G + (X – M)
Let’s explain the variables one by one:
Consumption: Consumption are purchases made by the general population. Every time you buy something you are contributing to the growth of the GDP through this variable.
Investment: The investment refers to expenses incurred by companies, such as buying machinery or building a new factory.
Government: Governments also demand resources to perform their duties, thus contributing to GDP growth with their spending. This is one of the reasons why some economists propose to increase government spending in times of recession. If people stop buying because the situation is difficult (-C) then the government should compensate this deficit with their own purchases (+G).
Exports: Purchases made by people from other countries also count as demand for the products produced in the country. Exports are especially important when the local market is limited (eg: Country X is ideal for producing a certain product, but the local people are not interested in buying it, however, it is a product in high demand in the country Y where it isn’t easy to acquire).
It is worth mentioning that tourism counts as an export. Tourists use money earned in their home country to demand products of the country where they are.
Imports: Imports are the only variable in the formula that subtracts from the GDP. Because people are using wealth produced in their country to buy products from other nations, giving that wealth to them. When you import a product that money goes M to instead of C.
There are different ideas about the effects of a trade deficit (when a country imports a greater value than it exports) in the economy of a country, but most economic schools agree that it isn’t necessarily negative to maintain a moderate deficit.
WHAT ISN’T INCLUDED IN THE GDP?*
Auto Consumption / Production: When you grow a potato and then eat it that production and consumption of wealth is not counted towards the GDP. In fact, producing your own products is theoretically negative for the GDP because you stop buying things from the market when you can meet that needs by yourself.
Underground Economy: The underground economy is anything that is not reported to the government. From criminal activities to simple transactions that are not registered to avoid taxes. Several countries estimate the size of their underground economy and then add it to the official figures, although these figures are not very accurate due to their nature.
Natural Resources: GDP only measures the wealth produced by people. The natural wealth of a nation does not enter into the calculation, this brings the problem that governments are encouraged to plunder natural resources to increase their GDP.
*In most cases. Some goverments try to estimate the value of these activities.
REAL AND NOMINAL GDP
There is a small distinction to make when measuring a country’s GDP, and that is the price of stuff. GDP measured using current prices is called nominal GDP, however, using this measure has the problem of being easily affected by inflation (the general increase in prices).
To prevent inflation from giving us a distorted view of the economy we use real GDP, measured using a deflator. The deflator is the measure of the level of prices of a reference year (eg: 2005 prices) that are used in subsequent years.
In the following article we will take a look at the GDP of different nations worldwide.