# Gross Domestic Product (GDP)

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Gross domestic product (GDP) is one of the major aggregates in the national accounts.

# GDP and its components

## GDP as a measure of economic performance

When we have to judge whether an economy is doing well or not, it is natural to look at the total income earned by each individual.

Gross Domestic Product (GDP) is ONE measure of the income and expenditure of an economy. For an economic system as a whole, income must necessarily equal total expenditure because each transaction has a buyer and a seller and each franc of expenditure by a buyer represents one franc of income for a bidder.

The equality of income and expenditure can be illustrated through the flow of the economy. There are three views of GDP.

## The economic circuit (simplified)

Par simplicité, pas de gouvernement et pas de Reste du Monde (RdM)

## Definition of GDP

GDP is a measure of the income that has been generated by an economy. It is a measure that helps the economist judge a country's economic performance.

GDP is the value at market prices of all final goods and services produced within an economy over a certain period of time.

« value at market prices »: production is valued at market price. To be able to add apples and oranges, a common unit of measurement is needed. An alternative would be to value them at factor costs.
« of all final goods & services »: final because we want to avoid double counting intermediate goods (=> we consider value added = total production - purchases of intermediate goods). Of course all goods produced and traded legally on a market are included (self-consumption or products of the underground or illegal economy will not be included).
« products »: this implies that transactions in second-hand goods are not included in GDP because, in this type of transaction, nothing new has been produced to generate income in the economy (= simple redistribution of income). What is produced will not necessarily be sold either, as it may be stored for sale later, but will be included in the current year's GDP because it has generated income in the current year.
« within an economy »: this implies that what is produced outside the country's borders by nationals is not taken into account and that what is produced by foreigners within the country will be counted in the GDP.
« for a certain period »: usually a year, or a quarter (seasonal adjustment for quarterly data).

We speak of Gross Domestic Product, as opposed to Net Domestic Product, because we do not take into account the depreciation of the capital that was used to generate this output => ${\displaystyle NDP=GDP-depreciation}$ (or replacement of worn-out capital).

## Other measures

Other indicators can also be distinguished:

• GNP (Gross National Product): differs from GDP by the Balance of Factor Income Balance, BIFB (= return on capital or labour services).
• 'NIP (Net Internal Product): differs from GDP by the fact that the depreciation of capital needed for production is taken into account in the calculation of aggregate income. For the majority of countries, PIN ≈ (1-10%)GDP.
• 'NNP (Net National Product): makes the two modifications above = ${\displaystyle NNP\,-depreciation}$.
• 'NNP at factor cost or National Income: is NNP but instead of measuring production at market price it is measured at factor cost (best indicator of a country's productive capacity). Subsidies on production are added to the NNP and indirect taxes on production (VAT for example) are subtracted. This is called national income.

In principle, all these measures and their evolution are highly correlated.

## Switzerland's GDP

In 2006 the Swiss SBRF was CHF 41.6 billion. For Switzerland (a net exporter of capital and importer of labour services), the GNP is higher than the GDP. In countries such as Argentina or Barbados, on the other hand, GDP is 1% to 10% higher than GNP, because these countries are net importers of capital (income must be paid to the foreign owners of this capital, and therefore the balance of factor income balance (SBRF) is negative).

## The three lenses

The three lenses offer three interpretations of GDP as well as three ways of calculating it.

The production perspective: the value of the final annual production of residents in terms of flows = sum of the values added.

Income perspective: the total income of all members of the economy = distribution of the sum of value added among economic agents (wages + return on capital).

Expenditure perspective: the total expenditure devoted to the acquisition of the B&S produced by this economy = use of the product by the various groups of agents.

These three measures are necessarily equivalent (cf. FSO data 1990-2007).

## Production perspective

GDP = the sum of value added

The added value is the increase in the value of the products resulting from the production process. In the national accounts, the added value is obtained by balance :

Added Value = value of production - intermediate consumption

Intermediate goods and added value: GDP only includes the value of final goods!

Example - hamburger macdo :

• Price of the purchased meat (150 gr.) = 0.50 Frs (hp: no purchase of intermediate goods)
• Sale price hamburger = 2.00 Frs
• MacDo added value = 1.50 Frs
• The GDP is the sum of the added values, here 0.50 + 1.50 = 2.00 Frs (and not 2.50!) = value of the final goods (here only one).

## Income perspective

GDP = Σ of compensation of factors of production - production subsidies + indirect taxes + depreciation

As we have seen, if to GDP we add factor income from the rest of the world and subtract factor income paid to the rest of the world, we obtain the National Product (NP).

The NATIONAL product (e.g. GNP) includes all the production carried out by residents both inside and outside the territory. The criterion is therefore that of residence.

The '"INTERNAL product"' (e.g. GDP) covers all production carried out on the territory by both residents and non-residents. The criterion is therefore that of territory.

According to a number of economists, the national product is a better measure of a country's income, especially at a time of strong economic integration (movement of factors between countries) such as today (cf. video by J. Stiglitz).

## Expenditure perspective: the components of GDP

GDP = Production = Consumption + Investment + Public Expenditure + Trade Balance (= Exports - Imports)

Y ≡ C + I + G + X - M (${\displaystyle X-M}$ = Trade balance)

Y ≡ domestic demand (C + I + G - M) + external demand (X)

This is an accounting identity! Household production is the same as resident consumption plus non-resident net consumption.

${\displaystyle C}$ includes household expenditure on durable goods (cars, refrigerators ...), perishable goods (food) and services (health, lawyer, hairdresser ...).
${\displaystyle I}$ includes business and household investments (buildings)
${\displaystyle G}$ includes only public expenditure on goods and services (social transfers (unemployment, AHV, etc.) and interest on public debt are not included as they are not a counterpart of a good or service produced in the year).

## Expenditure perspective: an example

NB: these three alternative ways of calculating GDP give exactly the same result.

## PIB réel versus nominal

Le PIB nominal mesure la production domestique aux prix courants (ceux de l’année en question).

Le PIB réel mesure la production domestique à des prix constants (ceux d’une année de référence).

L’idée est d’avoir une mesure de ce qu’a été réellement produit dans l’économie et que les augmentations ou diminutions du PIB ne soient pas dues simplement à des effets prix (effets nominaux).

Exemple - Economie à 2 biens: hot-dog et hamburgers.

## Real and nominal GDP: calculations

The real increase in GDP is much less dramatic than the nominal increase, as there is a significant increase in prices during the period.

## Nominal vs. actual: more in general

In a simplified economy producing only two goods, hot dogs (good 1) and hamburgers (good 2), nominal GDP (or GDP at current prices) in ${\displaystyle t}$ is written :

${\displaystyle PIB_{t}=p_{1}^{t}\times q_{1}^{t}+p_{2}^{t}\times q_{2}^{t}}$

Sf the prices of hot dogs and hamburgers are respectively p10 and p20 in the initial (base) period, real GDP (or GDP at constant prices) in the year ${\displaystyle t}$ is :

${\displaystyle PIB_{t}{\text{réel}}=p_{1}^{0}\times q_{1}^{t}+p_{2}^{0}\times q_{2}^{t}}$

A change in nominal GDP may therefore be due to a change in prices (good 1 and/or good 2) and/or a change in quantities produced (good 1 and/or good 2):

${\displaystyle PIB_{t}=(\Delta p_{1}^{t}\times q_{1}^{t}+\Delta q_{1}^{t}\times p_{1}^{t})+(\Delta p_{2}^{t}\times q_{2}^{t}+\Delta q_{2}^{t}\times p_{2}^{t}}$)

But only a change in quantities can change real GDP :

${\displaystyle \Delta PIB_{t}{\text{réel}}=\Delta q_{1}^{t}\times p_{1}^{0}+\Delta q_{2}^{t}\times p_{2}^{0}}$

## The GDP deflator

The GDP deflator is the index by which nominal GDP must be divided to obtain real GDP. It is therefore given by :

GDP Deflator = ${\displaystyle {\frac {PIB\,nominal\,(=p_{1}^{t}\times q_{1}^{t}+p_{2}^{t}\times q_{2}^{t})}{PIB\,{\text{real}}\,(=p_{1}^{0}\times q_{1}^{t}+p_{2}^{0}\times q_{2}^{t})}}\times 100}$

And so:

Real GDP = math>\frac {PIB\, nominal}{\text{GDP deflator}} \times 100[/itex]

and, approximately,

% change nominal GDP ≈ % change real GDP + % change GDP deflator

In the previous example, between 2003 and 2005 prices increased by 140%.

# GDP as a welfare measure

## Technical Reviews of National Accounts

The reliability of the data depends on the degree of sophistication of the statistical apparatus (and other possible internal priorities: see the case of China, The Economist, 01.03.2008). Sometimes indirect rather than direct estimates are preferred because of a lack of accounting data.

The national accounts do not take into account the "weight" of underground activities and undeclared work. Moreover, it records production (flows) rather than wealth (stocks).

It is an indicator of quantitative rather than qualitative changes and does not take into account the wealth produced and consumed by the individual (self-consumption) or voluntary work (cf. FSO, 01.11.2004, on the estimation of unpaid work in Switzerland).

## GDP as a measure of well-being

GDP is also used by economists to measure the well-being of individuals in an economy.

Dividing GDP by population gives the average income of individuals in a society. This is often used as a proxy for the level of well-being and development of an economy.

In principle a higher GDP per capita indicates a higher standard of living and a higher stage of development.

Problem: This is clearly not an ideal indicator because it focuses on only part of what influences the quality of life of individuals and the level of development of countries. According to some economists, alternative measures of well-being should be developed that take into account factors other than GDP (cf. The Economist, 17.09.2009).

Example => Human Development Index (United Nations Human Development Index); Green GDP in China, etc.

## GDP per capita cannot capture everything

${\displaystyle HDI=1/3\,Life\,expectancy\,index\,+1/3\,Education\,achievement\,index\,+1/3\,GDP\,per\,capita\,index}$

What about environmental depreciation (environmental capital)? What about the value of leisure time? What about income inequality? ... Shouldn't these factors also be taken into account when assessing quality of life?

## Measuring Social Well-Being

This is leading some economists to think about a new way of measuring quality of life (e.g. Stiglitz: see his video + article) that:

1. takes into account the depreciation of environmental capital
2. is based on the concept of "national" rather than "domestic" (more appropriate in a globalized world)
3. considers income inequality (going to the limit to Rawls' ideas: the level of well-being of a society = the level of well-being of the lowest)
4. and considers the value of leisure

The problem is that the introduction of these concepts is not trivial. It is necessary to be able to give an economic value to 1), 3) and 4), which is not obvious, and it is necessary to construct reliable and internationally comparable data series .

Pending a better indicator, GDP per capita continues to be used as a measure of the level of well-being .

The problem is that the accounting framework used to measure quality of life (GDP) is not without consequences for the objectives that politicians and government set themselves. Very little weight will be given to increasing inequality, environmental degradation, etc., if the measure of a country's success is GDP.

On the other hand, it has also been argued that GDP per capita is an indicator that is very highly correlated with many other variables influencing quality of life. In general, it is in the richest countries that we have enough resources to invest in environmental protection, that we find relatively high levels of education and health, that we can afford to pay attention to workers' free time, that inequalities are less striking, and so on.

# Summary

GDP is the value of output at market prices of all goods and services produced within an economy over a certain period of time.

There are other definitions of aggregate income that take into account, for example, the depreciation of capital with which income is produced (NDP), or the output of nationals across borders (GNP).

GDP can be broken down into four components: consumption, investment, government expenditure and trade balance...

The difference between nominal and real GDP is given by price developments in the economy.

The GDP deflator measures the change in the price level in an economy.

GDP per capita is a good measure of the level of development or quality of life in an economy.

But it is far from a perfect measure because it does not take into account leisure time, the impact on the environment, income inequality and so on.