Understanding Gross Domestic Product (GDP): Macroeconomics Essentials
1.1 Macroeconomics vs. Microeconomics
Microeconomics focuses on how decisions are made by individuals and firms and the consequences of those decisions. One product, one price, a single market.
Macroeconomics examines the aggregate behavior of the economy – how the actions of all the individuals and firms in the economy interact to produce a particular level of economic performance as a whole. Aggregate production, price index, economy as a whole.
1.2 Gross Domestic Product (GDP)
- The most frequent measure of an economy’s output.
- Intended to measure how much is produced in a given period, aggregating the quantities of all the goods produced into a single number. This is a flow variable (as opposed to a stock variable).
- More precisely, it is the market value of the final goods and services produced domestically (within a country) in a given period of time (usually one year).
Value Added Method
GDP = sum of value added
- In practice, the valuation of GDP relies on the value added by each firm.
- Value added = Value of production – value of intermediate goods.
Example: Grain, Flour, and Bread
- Value added of farmers = €25 – €0 = €25
- Value added of mills = €50 – €25 = €25
- Value added of bakery = €100 – €50 = €50
- GDP = 25 + 25 + 50 = €100
Firms create value added by transforming raw materials into products. A final purchase includes the value added at each stage of the production and sales.
1.3 Nominal and Real GDP
- If we want to compare GDP over time, we need to eliminate the effect of price change (inflation) on the nominal GDP (GDP measured at the current year price).
- To do so, we fix the prices at a given base year, so that any variation in GDP is only due to a change in the quantities produced.
GDP Deflator
- Nominal GDP: GDP evaluated at current price.
- Real GDP: GDP evaluated at base year price.
- GDP deflator: (Nominal GDP / Real GDP) * 100
GDP deflator is a price index taking value 100 in the base year. It tells us the rise in nominal GDP that is attributable to a rise in prices rather than a rise in the quantities produced.
Nominal GDP to Real GDP
- Nominal GDP is converted to real GDP as follows: Real GDP year t = (Nominal GDP year t / GDP deflator year t) * 100
- Conversely, we can convert real GDP into nominal GDP as follows: Nominal GDP year t = (Real GDP year t * GDP deflator year t) / 100
Real GDP Growth Rate
(or economic growth, always with real GDP)
GDP growth rate = ((GDP t – GDP t-1) / GDP t-1) * 100
GDP Per Capita
GDP per capita = GDP / Country population
- GDP per capita (per person, by head) tells us the average production, income, and expenditure of the people in the economy.
- GDP is the best single measure of the economic well-being in a society.
1.4 Output, Expenditure, and Income Approaches to Measure GDP
a) Output Method
GDP = sum of value added
- In practice, the valuation of GDP relies on the value added by each firm (Revenues – value of intermediate goods).
- Firms create value added by transforming raw materials into products. A final purchase includes the value added at each stage of the production and sales.
GDP from the output approach measures the sum of the value added created through the production of goods and services within the economy. This approach provides the first estimate of GDP and can be used to show how much different industries (for example, agriculture) contribute within the economy.
b) Expenditure Method
GDP = sum of expenditures to purchase the production.
The expenditure approach relies on the principle that every product must be bought by somebody. Therefore, the value of the total product must be equal to people’s total expenditures in buying things. At the aggregate level, production = expenditure.
GDP = C + I + G + (NX)
- C: Household consumption
- I: Gross investment
- G: Government expenditure
- NX: Net exports (or Exports – Imports)
c) Income Method
GDP = sum of incomes earned from economic activity (Total payment to factors of production, including profits). At the aggregate level, production = incomes.
The revenue generated by the sales of goods is distributed between workers and owners of capital. GDP from the income approach measures the total income generated by the production of goods and services within the economy.
1.5 Why Do We Measure GDP?
- GDP per capita tries to measure the standard of living in an economy on the rationale that all citizens would benefit from their country’s increased economic production.
- GDP is not a perfect measure of happiness or quality of life, however. It is a measure of how well the economy is doing, but it fails to capture:
- Leisure time
- Non-market economy (important in developing economy)
- Product improvement – think of computers…
- Quality of life / environment
- Inequality / satisfaction
- However, GDP is well correlated with several indicators of wellbeing (health, education).