The gross domestic product (GDP) of a nation is an estimate of the total value of all the goods and services it produced during a specific period, usually a quarter or a year. Its greatest use is as a point of comparison: Did the nation’s economy grow or contract compared to the previous period measured?
There are three different methods (Expenditure, Income and Production) which can be used to measure the GDP of a country. All of these methods in theory should sum to the same amount.
1. Expenditure method
The expenditure approach is where you add up all the various types of spending which occurs within an economy. There are 4 different types.
Consumption is all the spending that households do on goods and services. For example, the number of apples a household purchases; the amount of money spent on healthcare; the amount of money spent purchasing new cars and the money spent on pizza are all examples of consumption spending.
Investment is the spending that firms do machinery and equipment to operate their businesses. Examples of investment spending would be a mining company purchases a truck to transport coal; It companies purchasing new computers and the purchase of a new plane for an airline company.
Government Spending (G)
Government spending is the spending that the government conducts within an economy. Examples of government spending include spending on defence; spending on health care; the building of roads and education spending.
Net Exports (NX)
Net exports is defined at the purchases of domestically produced goods by foreigners subtracted from the purchases of internationally produced goods by local residents. In essence, it is the value of what is sent overseas minus the value of stuff that comes here.
If an airline company operating in the USA purchases a new plane from France, this would be considered an import for the USA and an export for France. This would cause the net exports to decrease for the USA whilst causing the net exports to increase for France.
An interesting case is where a foreign student from China comes and studies at a school in the USA. This is considered an export from the USA to China since the USA is producing a service (education) which is essentially being “sent” to a Chinese student who is from the Chinese economy. Thus, China is importing education from the USA.
Therefore, if we add up these 4 components we get:
GDP = C + I + G +NX
This is also called the demand approach to calculating GDP since all these components are demands for goods and services. It is looking at the demand side of the economy.
For example, using the input-output tables for Australia you can calculate the GDP for Australia in the year 2018 with:
where GDP is measured in millions of dollars.
2. Income Method :
The income approach starts with the income earned from the production of goods and services. Under the income approach, we calculate the income earned by all the factors of production in an economy.
Factors of production are the inputs which go into producing final product or service. Thus, the factors of production for business are – Land, Labour, Capital and Management within the domestic boundaries of a country.
In this approach, we calculate income from each of these Factor of production which includes the wages got by labour, the rent earned by land, the return on capital in the form of interest, as well as business profits earned by management. Sum of All these incomes constitutes national income and is a way to calculate GDP.
Formula : Net National Income = Wages + Rent + Interest + Profits
To make it gross, we need to do two adjustments – Add depreciation of capital & Add Net Foreign Factor Income. NFFI is (income earned by the rest of the world in the country – income earned by the country from the rest of the world)
GDP (Factor Cost) = Wages + Rent + Interest + Profits+ Depreciation + Net Foreign Factor Income
This basically is the sum of final income of all factors of production contributing to a business in a country before tax.
Now if we add taxes and deduct subsidies, then it becomes GDP at Market cost.
GDP (Market Cost) = GDP (Factor Cost)+ (Indirect Taxes – Subsidies)
3. Production Method:
The production method (or value-added) is where we calculate the total value of all goods produced in the economy minus the value of intermediate goods.
Consider an economy which produces steel and cars. Suppose the economy produces 100 units of steel which it sells for $1 and it produces 10 cars, using 5 units of steel, which it sells for $100.
As the production of steel requires no intermediate inputs, the value added from the production of steel is $100.
The production of cars produces $1000 worth of cars using $50 of steel. Therefore, the value added is $950.
The total value-added/GDP of the economy is thus $1050. Alternatively, we could have added the total amount spent on the cars $1000 and total spend on steel $100 giving $1100 and then subtracted the $50 of intermediate inputs to also get $1050.
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