GDP is the measure of the market worth of the output of a given country for a particular period. The output comprises of goods and services made available in that country. There are three formulas used to calculate GDP, but no matter which formula one chooses the results will be the same.
The first formula is the expenditure formula because it uses the figures computed from the sales of items. In this formula, the worth of output is gauged by the amount of money people had used to pay for the items they have. Here is formula (Taylor, 2006):
GDP=Gross consumption + Gross investment + Government spending + (eX-i)
Variables and Formulas of calculating GDP
Exports are also included because the items are made locally, but the imports are subtracted because they are made from other countries. The Income formula refers to the incomes earned by the people who participate in the manufacturing of goods in terms of wages, salaries and bonuses. The returns earned by organizations and profits made in the agricultural and non-agricultural sectors (Moffat, n.d).
The second method of calculating GDP uses the amounts spent by individuals to buy items, but this method can be misleading because sometimes we make items for our own use. For instance, when we obtain foodstuffs from our own gardens and cook our own food we do not pay for anything, thus the GDP may be misguided. Here is the formula used in this method:
(GDP) Y = C + I + G + (x-m)
Y represents the total consumption; C represents consumption, which is the biggest variable in any given economy. It is comprised of the expenses paid by individuals when purchasing goods and services such as clothing, food and Medicare services among many others.
Investment (I) consists of the costs incurred by people when they venture into businesses, such as when they purchase equipments and purchasing of new houses by individuals. Stocks, bonds and other financial products are excluded from investments, but are rather expressed as savings. Taylor (2006) points out that this is necessary to prevent double entries because if they were calculated as investment a clash would occur when the savings are used to buy other things.
Government spending (G) comprises of the salaries paid to civil servants and the money that is designated to the military. The items and services that are purchased by the government are also included in this variable. However, the money that is spent on pensioners and the people without jobs is not included in this variable.
X represents exports and comprises the goods and services produced locally and later shipped to other countries. For instance, if a given country exports oil products to another country then the profits earned in that trade would be included. Imports (m) are subtracted because they are obtained from other countries.
The third method of calculating GDP involves calculating the remunerations provided by employers to employees such as salaries wages and the money deducted for social security from the salaries and wages. The method further incorporates the profits earned by organizations and the profits earned by minor enterprises, such as barbershops and food joints. Here is the expression used in this argument (Taylor, 2006):
GDP = COE (compensation of employees) + GOS (gross operating surplus) + GMI (gross mixed income) + Taxes subtract subsidies on manufacturing and imports (Tp&m – Sp&m).
The prices that consumers are willing to pay to obtain goods and services determine the overall output in a country. This enhances output in general because if the prices are high manufacturers will increase their output with the aim of gaining more returns and thus GDP will go up. Alternatively, if the prices of goods and services decline general output will come down because the producers will also reduce the rate of production and hence GDP will reduce.
Importance of GDP
GDP is used to gauge the wellness of an economy, but this does not mean that a healthy GDP is represented by a higher GDP figure. When GDP is high it suggests that the population of the country in question are spending a lot of cash to pay for goods and services, and this could cause inflation to go up because the local currency has depreciated in value. Alternatively, GDP should not be lower to cause a zero inflation rate because that is not healthy (Moffatt, n.d).
This is to say that GDP should not be very little or excess. In other words in as much as we hate inflation we need it in small amounts. It is just like the fats in our bodies: too much of it is not healthy, but we cannot survive without it because it is a precious element in body functions and the same applies for inflation and GDP.
This is because GDP is supposed to be balanced between high and low rates. Governments rely on the reports concerning GDP when they are making decisions that are most likely to affect the economy, such as unemployment.
Investors use GDP to dictate when the economy of a given nation is ripe to attract investments. This is achieved by evaluating the way people spend their money and the things that are preferred the most such as in real estate. It is not only foreign investors who use GDP, but also local investors such as financial institutions and people who invest in shares.
This is because an increase in GDP would mean that the interest rates would also increase, which in return might be an advantage or a disadvantage to them. This is because in business world an investor must have a clear vision of the future to prepare for the changes that might affect him/her (Taylor, 2006).
Differences between Nominal and Real GDP
GDP is further divided into two: nominal and real GDP. Real GDP calculates the general output of a country by using the output of a given year as its base period, especially in a decade. For instance, if we were to calculate real GDP for the last decade, that is, from 2001 to 2010, we would have to use one of the years as the base period such as 2002.
This means that the output of that particular year would be used to give an impression of the output of that decade. Moffatt (n.d.) argues that this could be misleading because the output could have reduced or increased in the years that followed due to inflation. Likewise, nominal GDP is calculated by gauging the output of a given nation including inflation and deflation. This is the most reliable GDP because it projects the output the way it is in reality, especially when it is presented on a quarterly basis.
The following table displays the list of ten countries for the year 2010 and their respective GDP – real growth rate presented on yearly basis (Central Intelligence Agency, 2010).
RankCountryGDP – Real Growth Rate (%)