What Is Gross Domestic Product?

Gross domestic product, or GDP, is the overall monetary value of all the complete or final services and goods that a nation can produce within its domestic boundaries in a specific period. In other words, it is the monetary/market value of final goods and services produced by a nation in a given period.

GDP Growth

The gross domestic product acts like a growth scorecard of a country's economic health. GDP growth depicts that there is an increase in the volume of services and products that a nation can consume and produce from one period of time to another.

There are two main ways to increase gross domestic product growth:

1. Increasing the size of the workforce
2. Increasing the productivity level, or the output per hours worked

This helps a nation to achieve a higher level of economic growth and is useful in measuring the standard of living of a nation. 

Mathematically, the growth rate can be estimated as:

Growth rate = (GDP (t) - GDP (t-1) / GDP (t -1)) * 100

Consider the case where GDP in period t is $110 and GDP in period (t-1) is 100. Now, substitute the given values in the “growth rate” formula written above.

That is:

Growth rate = (($110 - $100) / $100) * 100

Growth rate = 10%

The growth rate is a crucial indicator of the economic growth of a nation that helps to compare different nations of the world with each other.  

Types of Gross Domestic Product

There are two main types of gross domestic product:

1. Real GDP
2. Nominal GDP

Real gross domestic product is the GDP adjusted for inflation. Nominal gross domestic product, on the other hand, measures GDP in current prices, without adjusting for inflation.

Ways to Measure Gross Domestic Product

There are three prime methods to measure the GDP of a nation:

1. The expenditure approach
2. The value-added approach
3. The income approach

The Expenditure Approach

The “expenditure approach” is the most widely used. This is because it measures the total spending or expenditure by all the sectors of the nation on their domestic economy. It is also known as the “spending approach."

This approach is based on aggregating the final value of all the products and services that a country can produce by using all its resources optimally. The expenditure approach is primarily concerned with the demand of the products and services of an economy. The following formula shows the expenditure approach of measuring GDP: 

Expenditure approach = Consumption expenditure + Investment expenditure + Government expenditure + (Exports - Imports)

Here,

Consumption expenditure is what the household sector spends in the economy to meet their basic requirements.

Investment expenditure is what firms and potential investors spend in the economy to gain a higher future return and profit. This helps them to expand their business operations. 

Government expenditure is related to the expenditure that the ruling political party of the nation makes in their economy to raise the welfare of citizens as a whole or a targeted group of persons. 

Exports refers to the activities in which domestically produced products and services are being sold to consumers living outside domestic borders.

Imports refers to the activities in which products and services that are produced outside the country are bought so that the domestic consumers can consume the product or service.

The term (exports - imports) can also be called net exports.

The Value-Added Approach

This approach adds the value of every production stage until the product is finally made and ready to be consumed by consumers. In other words, it is measured by tallying the value added by each firm operating in the economy. It is also known as the output or inventory method. The following formula shows the value-added approach to measure GDP:

Value-added approach = Gross value of output - Value of intermediate consumption

Here, 

The gross value of output can be stated as the total value of output in the market and the value of intermediate consumption is the value of inputs used.

An important point to note here is that the the value of the intermediate consumption must be subtracted so that you don't double count a product.

The Income Approach

The income approach represents a kind of middle ground between the two other approaches. It is measured by aggregating the price earned by the production factors of the economy. The following formula shows the income approach of measuring GDP:

Income approach = Wages + Rents + Interest rate earned + Profits + Indirect business tax + Depreciation on fixed assets + Statistical discrepancy - Net factor income from abroad

Here,

Wages refers to the income of laborers in the economy that help companies produce the final output by supplying their labor services.

Rent is the sum of money that an asset holder will receive on a regular basis by lending its productive asset in the market.  

The interest rate earned is the income that a person is entitled to receive on a regular basis for the sum of money that he/she either saves or lends in the economy. 

Profits are the income of firms and businesses that operate in the market. 

Indirect business tax is the tax that is passed on to the customers by raising the price of the product. This is the income of the government ruling in the economy.

Depreciation of fixed assets is the reduction in the value of the fixed asset each year when it is used by firms to meet their business activities in an economy. 

Statistical discrepancy is the variation between the two statistics that must be equal.  

Net factor income from abroad is the variation between the factor income earned from abroad and factor income paid abroad. It is abbreviated as NFIA.

What is not Included in GDP?

Several goods are excluded from GDP estimation, including:

• Sales of foreign goods in domestic boundaries
• Sales of used products
• Illegal sales of products and services (black market)
• Transfer payments made by the government
• Intermediate goods
• Goods produced outside domestic boundaries

What is National Income?

The term “income” is probably one of the most persistent terms used in economics. In simple terms, national income is determined by adding the income earned by all the residents of a nation by involving themselves in legal activities. It is one of the most commonly used tools to know about the economic condition of a country and can be used to evaluate the status of the country as compared to other countries. Furthermore, it helps to estimate the well-being and the happiness of countries and their citizens.

However, keep in mind that the 'income level' is not the exclusive measure of the well-being of a country and its citizens. It is important to also account for inflation, or real GDP.

Ways of Measuring National Income

The income of a single person is easy to determine and estimate, but for a nation, estimation of its aggregate income is a complex task. There are four main ways of calculating the income of a nation:

1. Gross Domestic Product (GDP)
2. Net Domestic Product (NDP)
3. Gross National Product (GNP)
4. Net National Product (NNP)

All of these are ways of measuring national income, but all are different from one another. They each tell a different story about the income of a nation in their specific way.

1. GDP

As discussed above, the GDP, calculated using all three approaches, gives the same result. So, the expenditure approach, value-added approach, and income approach all will give a result that is consistent with measuring the national income of the nation. This is because the GDP of a nation gives a true picture of its national income.

2. NDP 

The net domestic product (NDP) is a measure to estimate the national income of a nation via measuring the value of the economic output of a nation after adjusting for the depreciation rate. It is calculated with the following formula:

NDP = GDP - Depreciation on fixed capital

3. GNP

GNP = Consumption defrayal + Investment defrayal + Government defrayal + Exports + Income attained by domestic residents from overseas investments - Income attained by foreign residents from domestic investments

4. NNP

The term NNP is known as the GNP, the total value of finished products and services produced in a nation by its citizen irrespective of their location, minus the depreciation of the existing capital stock. That is:

NNP = GNP - Depreciation

Common Mistakes

1. Some people assume that a higher income corresponds with a better life and more utility. However, this is only true up to a specific income level. A few types of research have discovered that beyond a certain income level, additional income is not necessarily related to a higher quality of life. All things considered, economic growth and other non-income factors (like the equity of income, level of education, and medical care) all more firmly correspond with a more joyful society.

2. The poorest nations on the planet may seem less fortunate than they truly are if we consider only their official figures. For example, if a large portion of the labor force works in the informal sector, their salaries won't be reflected in the country's gross domestic product. Thus, some countries will seem more modest than they would be if all financial activities were incorporated.

Context and Real-life Applications of GDP

GDP is an important concept in the macroeconomics branch of economics. Students, professors, and economists study economics to understand the behavior of the economy and solve economic problems, such as scarcity. It is also an indicator for the future progress of the nation.  Other concepts, like standard of living, GDP deflator, and more are also linked to GDP.