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Short guide to GDP: what is it, and why is it important

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What is GDP? How is it calculated? How is inflation considered? Here are some basic answers to help you understand what we are talking about.

Gross domestic product (GDP) is a macroeconomic quantity that measures the value of all final goods and services produced in a country over a given period of time, usually a year. It is a widely used indicator for assessing the vitality of economic activity and, when calculated as GDP per capita, can give a very vague idea of the well-being of citizens. Only vague, because the distribution of wealth is missing.

GDP is said to be domestic because it takes into account only what is produced within the national territory, regardless of the nationality of the firms or workers who make it. If, on the other hand, we want to take into account only what is produced by domestic firms or workers, even if they operate abroad, we have to use gross national product (GNP), which is obtained by adding net foreign earnings to GDP.

GDP is called gross because it does not take into account the depreciation of fixed capital, that is, the machines, equipment, and infrastructure that are consumed in the production process. If we subtract the value of depreciation from GDP, we get net domestic product (NIP), which represents the part of the output available for consumption or investment.

GDP can be calculated in three equivalent ways:

  • by adding up the value of final goods and services, that is, those intended for final consumption and not for further processing. For example, bread is a final good, while flour is an intermediate good.
  • Summing the value added of each enterprise or production sector, that is, the difference between the value of production and the cost of intermediate goods used,. For example, the baker’s value added is the difference between the price of bread and the cost of flour, energy, and other inputs.
  • Adding up the income generated by productive activity, that is, workers’ wages, firms’ profits, and taxes paid to the state,.

GDP can be expressed in nominal or real terms. Nominal GDP is calculated using the current prices of goods and services, while real GDP is calculated using prices in a base year. Real GDP makes it possible to eliminate the effect of inflation and compare the purchasing power of an economy in different years.

What are the components of GDP?

GDP can be divided into four main components, which correspond to the different uses of the goods and services produced:

Private consumption (C) is the spending by households to purchase goods and services to meet their needs. It includes both the consumption of durable goods (such as cars, furniture, and appliances) and nondurable goods (such as food, clothing, and fuel) and services (such as health, education, and transportation).
Investment (I) is spending by firms to purchase capital goods (such as machinery, equipment, and software) or to increase inventories. Investment is used to increase the productive capacity of an economy and replace consumed fixed capital.
Public consumption (G) is spending by the government to provide collective goods and services (such as defense, security, and justice) or individual goods and services (such as health, education, and social welfare). Public consumption does not include social cash benefits (such as pensions, subsidies, and transfers), which are considered part of household income.
The net export balance (X-M) is the difference between the value of goods and services sold abroad (exports) and the value of goods and services purchased abroad (imports). The balance of net exports measures the contribution of foreign trade to domestic output.

The relationship between GDP and its components can be expressed by the following formula:

GDP = C + I + G + (X – M)

How government spending affects GDP

The explanation I am about to give is very rough and crude. Take it as a first hint and an invitation to go deeper. Government spending has a direct and indirect effect on GDP. The direct effect is given by the fact that government consumption is a component of GDP, so an increase in government spending leads to an increase in GDP, other things being equal. The indirect effect is given by the fact that government spending can influence the other components of GDP through the so-called fiscal multiplier.

The fiscal multiplier is the ratio of the change in GDP to the change in government spending. It depends on the marginal propensity of households to consume, that is, the fraction of additional income that households allocate to consumption. If the marginal propensity to consume is high, it means that households tend to spend most of the additional income from increased government spending, generating additional demand and output. On the other hand, if the marginal propensity to consume is low, it means that households tend to save much of the additional income, reducing the multiplier effect.

The fiscal multiplier also depends on the degree of openness of the economy, that is, the weight of exports and imports in GDP. If the economy is very open, it means that some of the additional demand generated by government spending spills over into the purchase of foreign goods and services, reducing the net export balance and thus GDP. On the other hand, if the economy is not very open, it means that additional demand is concentrated on domestic goods and services, increasing GDP.

Finally, the fiscal multiplier also depends on financial market conditions and monetary policy. If the financial market is efficient and monetary policy is accommodative, it means that firms can easily access credit to finance investment and interest rates are low, boosting household demand for durable goods. On the other hand, if the financial market is in crisis and monetary policy is tight, it means that businesses have difficulty borrowing and interest rates are high, discouraging demand for durable goods.

What are real GDP and nominal GDP?

Real GDP is GDP calculated using the prices of a base year, which is a reference year chosen as a starting point for comparing the prices of goods and services in different years. Real GDP makes it possible to eliminate the effect of inflation, that is, general price increases, and measure only changes in quantities produced.

Nominal GDP is GDP calculated using current prices, that is, the prices actually charged in the market in a given year. Nominal GDP takes into account both changes in quantities produced and changes in prices.

To move from nominal GDP to real GDP, a price index is used, which is an indicator that measures the average price trend of a basket of goods and services representative of national output. The price index most commonly used to deflate GDP is the GDP deflator, that is

The formula for calculating real GDP from nominal GDP and the GDP deflator is as follows:

Real GDP = (Nominal GDP / GDP Deflactor)

The GDP deflator is not exactly “inflation,” that is, the consumer price index, for a number of reasons. Recall that the CPI measures the purchase cost of a given basket of goods, representative of the consumption of an average urban household.

Differences between the CPI and the GDP deflator:

  • the GDP deflator reflects price changes in a much larger set of goods than the CPI.
  • the CPI’s basket of goods remains unchanged for a number of years, while the set of goods to which the GDP deflator refers changes depending on what is produced in the economic system in each year.

The CPI includes the prices of some imported goods, while the GDP deflator includes only the prices of domestically produced goods.
The fact that the CPI includes, in its basket, imported goods and the GDP deflator does not mean that the difference between these two values makes it possible to capture when a price increase is due to external or internal factors; if the shock is from an external increase, from imported inflation, the CPI will rise before the GDP deflator.

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