The welfare of a nation can scarcely be inferred from a measurement of national income as defined by the GDP.
- Simon Kuznets, American economist
To examine Kuznets' argument in more detail, we first need to understand the Gross Domestic Product (GDP) exactly. We also need to explore other types of national income measures we can use to understand economic growth and welfare in a country's macroeconomy.
Gross domestic product (GDP) measures total economic activity (total output or total income) in a country's economy. We can define the economy's total output as the total market value of all final goods and services produced in a specific period.
Measuring total output and income is important as they allow us to evaluate a country's economic performance over time and make comparisons between different countries' economic performance.
There are three ways of measuring the total economic activity of a country:
Evaluating expenditure : adding up all spending in a country's economy over a period of time (usually one year.)
Evaluating income : adding up all income earned in a country's economy over a certain period.
Evaluating output : adding up the total value of final goods and services produced in a country's economy over a period of time.
Real and nominal gross domestic product
When evaluating the macroeconomy, it’s important to distinguish between real and nominal GDP. Let's study those differences.
Nominal Gross Domestic Product
Nominal GDP measures GDP, or total economic activity, at current market prices. It measures the value of all goods and services produced in the economy in terms of the current prices in the economy.
We calculate the nominal GDP by adding the value of total expenditure in the economy through the following formula:
Where
(C): Consumption
(I): Investment
(G): Government spending
(X): Exports
(M): Imports
Real Gross Domestic Product
On the other hand, real GDP measures the value of all goods and services produced in the economy whilst considering price changes or inflation. In an economy, prices are likely to change over time. When comparing data over time, it’s important to look at real values to gain a more objective insight.
Let’s say the economy’s output (nominal GDP) has increased from one year to another. This could either be because the output of goods and services in the economy has increased or because price levels have increased due to inflation. An increase in prices would indicate that the output of goods and services has not increased, even though the nominal value of GDP is higher. This is why it’s important to distinguish between nominal and real values.
We calculate real GDP using the following formula:
The price deflator is the measure of average prices in one period compared to average prices during the base year. We calculate the price deflator by dividing nominal GDP by real GDP and multiplying this value by 100.
Gross Domestic Product per capita
GDP per capita measures the GDP of a country per person. We calculate it by taking the total value of GDP in the economy and dividing it by the country’s population. This measurement is useful for assessing the GDP output of different countries as population size and population growth rates vary between countries.
The output of both Country X and Country Y is £1 billion. However, Country X has a population of 1 million people and Country Y has a population of 1.5 million people. Country X’s GDP per capita would be £1,000, whilst Country Y’s GDP per capita would only be £667.
Gross Domestic Product in the UK
Figure 1 below shows GDP over the past seventy years in the UK. It was equal to around £1.9 trillion in 2020. As we can see, GDP was growing at a steady rate until 2020. We may infer that this drop in GDP in 2020 could be due to the COVID-19 pandemic impacting the supply of labour and increasing unemployment.
Fig. 1 - GDP Growth in the UK. Created with data from the UK Office for National Statistics, ons.gov.uk
Gross National Product (GNP) and Gross National Income (GNI)
As we now know, GDP is the value of all outputs (goods and services produced) in a country over a certain period.
The GDP’s output is domestic. The output includes everything produced in the country, regardless of whether a foreign company or an individual produced it.
On the other hand, in Gross National Product (GNP) and Gross National Income (GNI), the output is national. It includes all income of a country’s residents.
Put in simple terms:
| GDP | Total value of all goods and services produced in a country over a certain period. |
| GNP | Total income of all businesses and residents in a country regardless of whether it is sent abroad or circulated back into the national economy. |
| GNI | Total income received by the country from its businesses and residents regardless of whether they are located in the country or abroad. |
Let’s say that a German company sets up a production facility in the United States and sends back part of its profits to Germany. The production’s output will be part of the US GDP, but it’s part of Germany's GNI because it includes income received by German residents. This will be subtracted from US GNP.
We use this formula to calculate GNP and GNI:
We also know income from abroad minus income sent abroad is also as net income from abroad.
Economic growth and Gross Domestic Product
Economic growth is the sustained increase in the economy’s output over a certain period, usually one year. We refer to it as the percentage change in real GDP, GNP, or the real GDP per capita over a period of time. Thus, we can calculate economic growth with the formula:
Let’s say Country X’s real GDP in 2018 was £1.2 trillion and in 2019 it increased to £1.5 trillion. In this case, the country's GDP growth rate would be 25%.
GDP growth rates can also be negative.
For the A-levels, it’s important to understand the difference between a decrease in real GDP growth and a negative real GDP. A decrease in real GDP growth would suggest that the growth rate of a country’s GDP is falling over time, even though the growth rate might still be positive. In other words, it doesn’t imply that the real output is shrinking, it’s just growing at a slower rate.
On the other hand, a negative real GDP would imply that the economy’s growth rate is negative. In other words, the economy’s real output is shrinking. If a country is experiencing a sustained negative real GDP, it could be indicative of a recession.
Purchasing power parity
GDP, GNP, GNI, and GDP growth provide a good basis for understanding how a country’s economy is doing compared to previous years and to other countries. However, if we want to think in terms of economic welfare and living standards, it is important to consider additional metrics like the purchasing power parity (PPP.)
Purchasing power parity is an economic metric used to measure and compare the buying power of different countries’ currencies. It evaluates different countries’ currencies by constructing a standardised basket of goods and analysing how the price of this basket compares between countries. It is usually measured based on a country’s local currency in terms of US dollars (USD).
A PPP exchange rate is an exchange rate between currencies that equalises the buying power of a country’s currency to the USD. For example, in Austria, the purchasing power of €0.764 is equivalent to the purchasing power of $1 dollar.¹
Purchasing power is therefore determined by the cost of living and inflation in a certain country, whilst purchasing power parity equalises the purchasing power of two different countries’ currencies. This is important because different countries have varying price levels in their economies.
As a result, in poorer countries, one unit of a currency (1 USD) has greater purchasing power when compared with higher-price countries, as the costs of living are lower. PPP and PPP exchange rates allow us to get a more accurate comparison of economic and social welfare across countries because they consider price levels and costs of living.
GDP is an important tool that helps measure total output and income, which allows us to do a basic evaluation of a country’s economic performance. However, it’s also important to consider other economic welfare factors when using it as a comparison tool between different countries’ economic performance.
Gross Domestic Product - Key takeaways
- There are three methods of calculating GDP: the income, output, and expenditure approach.
- Nominal GDP is the measure of GDP, or total economic activity, at current market prices.
- Real GDP measures the value of all goods and services produced in the economy whilst considering price changes or inflation.
- GDP per capita measures the GDP of a country per person. We calculate it by taking the total value of GDP in the economy and dividing it by the country’s population.
- GNP is the total income of all businesses and residents regardless of whether it is sent abroad or circulated back into the national economy.
- GNI is the total income received by the country from its businesses and residents regardless of whether they are located in the country or abroad.
- We calculate GNP by adding net income from abroad to GDP.
- Economic growth is the sustained increase in the output of the economy over a certain period of time, usually one year.
- Purchasing power parity is an economic metric used to measure and compare the buying power of different countries currencies.
- A PPP exchange rate is an exchange rate between currencies that equalizes the buying power of a country's currency to the USD.
- PPP and PPP exchange rates allow us to get a more accurate comparison of economic and social welfare across countries by considering price levels and costs of living.
sources¹OECD, Purchasing power parities (PPP), 2020.
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