As a productive individual, you would surely like to find out how much you have produced at the end of the day. Same for the economy; the economy is busy with a lot of things like production, selling, buying, and all kinds of business activities. To determine how much the economy has produced, we put a value on all the completed works in the economy. This value is what economists refer to as the Gross Domestic Product (GDP). In simple terms, this GDP tells us how rich or productive an economy is. But, to be able to use GDP to tell how rich an economy is, it has to be measured first. This is why we are here. Interested? Then keep on reading!
How do Economists Use Changes in GDP to Measure Economic Performance?
Economists use changes in GDP to measure economic performance. But what does this mean? As an individual or a firm measures their income or expenditures, the country wants the same thing, and this is what economists use the GDP for. Changes in the GDP will show whether the economy is performing well or poorly. Wait, what is GDP? It is the value of an economy's annual total output of goods and services. Essentially, it measures the value of everything the economy produced in a given year.
GDP is the value, in monetary terms, of an economy's annual total output of goods and services.
Economists use changes in GDP to measure economic performance.
By measuring output in monetary terms, economists are able to easily assess the long-term growth of the economy and the health of the economy at specific time intervals and develop policies according to the assessed health of the economy.
Take a look at the example below, which will help you understand the GDP.
Let's consider a simple economy that produces cars and planes. A car costs $30,000 and a plane costs $300,000. In year one, the economy produces 3 cars and 2 planes. In year two, the economy produces 2 cars and 3 planes.
From the above example, we can construct the following table:
| Year | Annual Output | Market Value |
| 1 | 3 cars and 2 planes:\((\$30,000\times3)+(\$300,000\times2)\) | \(\$690,000\) |
| 2 | 2 cars and 3 planes:\((\$30,000\times2)+(\$300,000\times3)\) | \(\$960,000\) |
Table 1. National Economic Output Example
Table 1 shows that the GDP in year one was $690,000, whereas the GDP in year two was $960,000. This shows a positive economic performance from year one to year two.
Types of GDP
There are two main types of GDP. These are nominal GDP and real GDP. Nominal GDP is the monetary value of the total annual goods and services produced in an economy using current prices. It uses the prices in the year for which the GDP is being measured.
Since economists must be able to compare economic performance without being fooled by the difference in prices, they use constant prices in measuring real GDP. Real GDP is the monetary value of the total annual goods and services produced in an economy using constant prices.
Nominal GDP is the monetary value of the total annual goods and services produced in an economy using current prices.
Real GDP is the monetary value of the total annual goods and services produced in an economy using constant prices.
What is Not Included in Measured GDP?
Measured GDP takes into account all transactions involving final goods. This means that not all business activities are taken into consideration when measuring GDP. For now, it is more convenient to indicate what is not included in measured GDP. The transactions economists do not include when measuring GDP are referred to as non-production transactions. These are transactions that are not tied to the production of final goods.
Non-production transactions are transactions that are not tied to the production of final goods.
There are two main types of non-production transactions:
purely financial transactions and secondhand sales.
First, let's look at purely financial transactions.
- Public transfer payments - payments made by the government directly to households or individuals for social welfare purposes. These are not tied to production, hence would bloat the GDP if included in the measurement.
- Private transfer payments - these are monies exchanged between individuals. For instance, if a parent gives their children some money as gifts, these do not contribute to the production and are not included in the measurement of the GDP.
- Stock market transactions - these are shares of the same company that are simply changing hands. The output generated by the shares is included in the GDP. This means the shares are already valued. Therefore, to include the value of the transaction would be measuring the value of the shares multiple times, which would bloat the measured GDP.
Secondhand sales are the other category of transactions not included in the measured GDP. These are sales made after a product has been originally sold. For instance, if you sell a pair of Nike Jordans to your friend after buying them three weeks ago, this would not be included in the measured GDP.
Nominal GDP
Nominal GDP is GDP measured at current prices. GDP is the monetary value of the annual total goods and services produced in an economy. In the case of nominal GDP, that monetary value is measured using the prices at the time.
Nominal GDP is the monetary value of the total annual goods and services produced in an economy using current prices.
Nominal GDP can be useful in determining the value of aggregate output in the economy in the year of measurement. It is a quick way to sum up all economic activity in a year and put a value on it. But this is just about where its usefulness ends.
The value of money changes as time goes on due to inflation. Therefore, the value of $1 in one year may not be equal to the value of $1 in another year. This makes it necessary to have a uniform price when measuring GDP. This way, we can compare GDP across years and determine how well the economy is truly performing. This is where real GDP comes in.
Fig. 1 - The value of money changes due to inflation
Real GDP uses constant prices to measure the value of the total annual goods and services produced in an economy.
Real GDP is the monetary value of the total annual goods and services produced in an economy using constant prices.
Why are we using constant prices? Because it is the quantity of output that really matters, not the money it costs.
For instance, in year 1, a bottle of water costs 20 cents. In year 2, a bottle of water costs 25 cents. While the money to buy the water has increased, the water remains the same and will satisfy the same number of people it satisfied in year 1.
Read our article on Inflation and the Effects of Inflation to see how inflation works in practice!
Take a look at our article on Nominal GDP vs Real GDP for a detailed comparison of the two metrics!
GDP Formula
To arrive at the formula for calculating the GDP, we must first understand the three ways of measuring GDP. These three ways of measuring GDP are the value-added approach, the spending or expenditure approach, and the income approach.
The Value Added Approach to Measured GDP
The value-added approach looks at production in the form of value created or added. The economy consists of three main agents in this approach: the government, businesses, and households. Therefore, the GDP is measured by simply summing up the value added by the government, businesses, and households.
Under the value-added approach, GDP is measured by summing up the value added by the government, businesses, and households.
The value created or added is the value of the output produced by each of the economic agents.
The Expenditures Approach to Measured GDP
The expenditures approach of measured GDP puts together all the spending on final goods and services in the economy during the year in question. These expenditures are grouped into four main types of aggregate spending. These are personal consumption (C), gross investment expenditures (Ig), government spending on goods and services (G), and net exports (Xn).
The expenditures approach of measured GDP puts together all the spending on final goods and services in the economy during the year in question.
Putting all the metrics together, the GDP formula under the expenditures approach is:
\(GDP=C+I_g+G+X_n\)
The Income Approach to Measured GDP
The income approach of measured GDP puts together all income earned by households and the government during the year in question. The specific things the income approach considers include employee compensation, rent, proprietors' income, corporate profits, taxes on production, taxes on imports, net foreign factor income, consumption of fixed capital, and statistical discrepancy.
The income approach of measured GDP puts together all income earned by households and the government during the year in question.
Note that we can break these down to get the national income and other metrics that are accounted for to get the GDP.
When we sum up the employee compensation, rent, proprietors' income, corporate profits, taxes on production, and taxes on imports, these make up the national income.
We then subtract the net foreign factor income, add the consumption of fixed capital, then add the statistical discrepancy to finally arrive at the GDP.
Read our article on the Income Approach, where we explain all these metrics in more detail!
GDP Examples
Let's look at an example where we calculate the GDP. Consider the example given below.
The expenditures in the economy of Country X are presented in Table 2 below.
| Expenditure Category | Amount in $ billion |
| Personal Consumption (C) | 15,000 |
| Gross Domestic Private Investment (Ig) | 5,000 |
| Government Spending on Goods and Services (G) | 10,000 |
| Net Exports (Xn) | 2,500 |
Table 2. Expenditures in an Economy Example
What is the GDP of Country X?
Using the formula:
\(GDP=C+I_g+G+X_n\)
We have:
\(GDP=15,000+5,000+10,000+2,500=32,500\)
Therefore, the GDP of Country X is $32,500 billion.
Now, let's try our hands on another example.
The incomes in the economy of Country X are presented in Table 3 below.
| Income Category | Amount in $ billion |
| National income | 27,250 |
| Net foreign factor income | 2,500 |
| Consumption of fixed capital | 8,250 |
| Statistical discrepancy | -500 |
Table 3. Incomes in an Economy Example
What is the GDP of Country X?
Using the formula:
\(GDP=\hbox{national income}-\hbox{net foreign factor income}+\hbox{consumption of fixed capital}+\hbox{statistical discrepancy}\)
We have:
\(GDP=27,250-2,500+8,250-500=32,500\)
Therefore, the GDP of Country X is $32,500 billion.
As you can see, the two examples used the expenditure and income approaches and arrived at the same GDP. This is because the two approaches should arrive at the same answer in theory. However, measurement errors and misreporting create some minor discrepancies in practice. And that is why economists add the statistical discrepancy to account for this difference.
Measured GDP - Key takeaways
- GDP is the value, in monetary terms, of an economy's annual total output of goods and services.
- Nominal GDP is the monetary value of the total annual goods and services produced in an economy using current prices.
- Real GDP is the monetary value of the total annual goods and services produced in an economy using constant prices.
- The expenditure approach of measuring GDP sums up personal consumption (C), gross investment expenditures (Ig), government spending on goods and services (G), and net exports (Xn).
- The income approach of measuring GDP sums up employee compensation, rent, proprietors' income, corporate profits, taxes on production, and taxes on imports, consumption on fixed capital, statistical discrepancy, then subtracts net foreign factor income.
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