What Is Gdp?

Table of Contents

Introduction 3

What is GDP? 4

GDP Measurements Approaches 5

Expenditure Approach 5

Income Approach 6

Real vs. Nominal GDP 6

GDP Shortfalls 7

Conclusion 10

References 11

Introduction

Economy and politics are strongly related because politicians need to make decisions that would affect the people of their countries. Economy, on the other hand, describes the status of the people in a certain country. Therefore, economical measurement tools are heavily used by politicians for decision making. These tools would also work like alerts for a change in the economy status that would help in conducting proactive decisions. GDP is a strong example of such tools.

Moreover, for any investor or creditor, it is important to know the economical status of the party that he is going to credit or invest his money with, and the environment that he will invests his money in. For the first case, financial statements are used to reflect the economical status of the company. However, when it comes to measure the financial and economical status of the environment, such as a country, a region or even a nation, the role of economical status measurement tools or indicators show its importance. One of the most important tools is GDP.

In the following papers we will take a tour in the world of GDP where we will start by defining GDP. Then we will show the two approaches in which we can measure GDP. Finally we will show the shortfalls of GDP and we will demonstrate this using two example countries, Germany as an Industrialized country vs. Saudi Arabia as a developing country.

What is GDP?

Gross Domestic Products, or GDP, is defined by economics as "the total market value of all final goods and services produced in a country in a given time period". We will stop at important parts of the definition to clarify the meaning of GDP.

Gross means before subtracting the depreciation of capital. The opposite of "gross" is net, which means after subtracting the depreciation of capital. This word is important as it means that for our calculations we are looking for the gross amount not the net amount of either expenditure or income.

One key phrase in the definition is "final goods", which means the goods that are consumed by the end user, wither the end user is a person or an organization, and does not require any further processing.

Another key phrase in the definition is "produced in a country". GDP will only consider the goods and services produced inside the country. It will not consider any goods or services produced outside the country boarders even if it is owned by one of its citizens. For example, even though Toyota is a Japanese corporation, its products are calculated in the U.S. GDP because Toyota cars are produced in the U.S.

GDP is calculated quarterly. Each quarter's GDP is compared against the previous quarter's GDP. If there is a positive difference, it means that the economy has enhanced over the past three months. If the difference is negative, it is considered as an alert that the economy is facing troubles and needs to be taking care of. If the difference is zero, then that would mean that the economy was stable during the past three months. Three consecutive decreases in the quarterly measured GDP would indicate a possibility of a recession period that a country would enter. It is not always good to have a high GDP because it might be an indicator of inflation which can be solved via different means like increasing taxes rates.

GDP Measurements Approaches

GDP measures the economy of a certain country. To calculate it, we need first to know the main components in any economy from where we can get the GDP inputs. The economy consists of four main parties: households, firms, governments and the rest of the world. These parties trade in two markets: Factor market and Goods market. Each party may either gain an income from one of the markets (income) or spent at one of the markets (expenditure). All these actions would flow in a cycle called the circular flow of expenditure and income represented in figure 1.

Figure 1: The Circular Flow of Expenditure and Income

Because the value of aggregate production equals aggregate expenditure and aggregate income, there are two approaches of calculating the economy of a country: Expenditure Approach and Income Approach. In theory, both approaches should produce the same result. Each country uses a different approach according to what they think of as the best reflection of its economy.

Expenditure Approach

Calculating the GDP using the expenditure approach means that we add up what everyone spends. The expenditure approach works on the principle that all of the product must be bought by somebody, knowing the amount of money spent on buying the products results in know the amount of products. The expenditure method is used more common and is calculated by adding total consumption expenditure, investment, government spending and net exports. The formula used to calculate GDP using income approach is:

GDP = C + I + G + (X - M)

Consumption (C) means the amount of money spent on purchasing consumables like food, rent, jewelry, gasoline and medical expenses. Investments (I), means the amount of money used in new investments and not the money used for enhancing or exchanging existing assets. Examples include the construction of a new mine, purchasing a new software, etc. Government Spending (G) includes all the expenditures made by the governments like buying defensive weapons, investments or governments' employees' salaries. Net Exports (X - M), is the gross exports