Gross domestic product

Gross domestic product (GDP) is defined by the Organization for Economic Co-operation and Development (OECD) as "an aggregate measure of production equal to the sum of the gross values added of all resident, institutional units engaged in production (plus any taxes, and minus any subsidies, on products not included in the value of their outputs)."^[2]

GDP estimates are commonly used to measure the economic performance of a whole country or region, but can also measure the relative contribution of an industry sector. This is possible because GDP is a measure of 'value added' rather than sales; it adds each firm's value added (the value of its output minus the value of goods that are used up in producing it). For example, a firm buys steel and adds value to it by producing a car; double counting would occur if GDP added together the value of the steel and the value of the car.^[3] Because it is based on value added, GDP also increases when an enterprise reduces its use of materials or other resources ('intermediate consumption') to produce the same output.

The more familiar use of GDP estimates is to calculate the growth of the economy from year to year (and recently from quarter to quarter). The pattern of GDP growth is held to indicate the success or failure of economic policy and to determine whether an economy is 'in recession'.

Determining GDP

GDP can 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.^[7]

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".

Income approach

The second way of estimating GDP is to use "the sum of primary incomes distributed by resident producer units".^[2]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:

Wages, salaries, and supplementary labour income
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 + T_{P & M} – S_{P & 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.
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^[9]

Yet another formula for GDP by the income method is:^{[citation needed]}

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.^[2]

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.

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)

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.
X (exports) represents gross exports. GDP captures the amount a country produces, including goods and services produced for other nations' consumption, therefore exports are added.
M (imports) represents gross imports. Imports are subtracted since imported goods will be included in the terms G, I, or C, and must be deducted to avoid counting foreign supply as domestic.

A fully equivalent definition is that GDP (Y) is the sum of final consumption expenditure (FCE), gross capital formation (GCF), and net exports (X – M).

Y = FCE + GCF+ (X − M)

FCE can then be further broken down by three sectors (households, governments and non-profit institutions serving households) and GCF by five sectors (non-financial corporations, financial corporations, households, governments and non-profit institutions serving households). The advantage of this second definition is that expenditure is systematically broken down, firstly, by type of final use (final consumption or capital formation) and, secondly, by sectors making the expenditure, whereas the first definition partly follows a mixed delimitation concept by type of final use and sector.

Note that C, G, and I are expenditures on final goods and services; expenditures on intermediate goods and services do not count. (Intermediate goods and services are those used by businesses to produce other goods and services within the accounting year.^[10] )

Economic growth

Economic growth is the increase in the market value of the goods and services produced by an economyover time. It is conventionally measured as the percent rate of increase in real gross domestic product, or real GDP.^[1] Of more importance is the growth of the ratio of GDP to population (GDP per capita, which is also called per capita income). An increase in growth caused by more efficient use of inputs is referred to asintensive growth. GDP growth caused only by increases in inputs such as capital, population or territory is called extensive growth.^[2]

In economics, "economic growth" or "economic growth theory" typically refers to growth of potential output, i.e., production at "full employment". As an area of study, economic growth is generally distinguished fromdevelopment economics. The former is primarily the study of how countries can advance their economies. The latter is the study of the economic development process particularly in low-income countries.

Growth is usually calculated in real terms – i.e., inflation-adjusted terms – to eliminate the distorting effect ofinflation on the price of goods produced. Measurement of economic growth uses national income accounting.^[3] Since economic growth is measured as the annual percent change of gross domestic product (GDP), it has all the advantages and drawbacks of that measure.

Measuring economic growth

Main article: Gross domestic product

Economic growth is generally calculated from data on GDP and population provided by countries' statistical agencies, although independent scholarly estimates are also available.