What is GDP

What is GDP

GDP stands for Gross Domestic Product. It refers to the market value of final goods and services that are produced within the domestic territory of a country during the period of an accounting year. The depreciation is also included in the GDP.

The total GDP of a country is the contribution of each industry or sector in the economy. The ratio of GDP to the total population of the country is called the per capita GDP or mean standard of living.

GDP helps in deciding the economic progress and is used as a metric for international comparison. That’s why while determining national development, the GDP is considered the world's most powerful statistical indicator.

GDP AT MARKET PRICE AND FACTOR COST

GDP can be estimated both at market price and factor cost. The domestic product at market price can be calculated when the domestic product is estimated as the total market value of the final goods. These are the goods that are produced within the domestic territory of the country.

On the other hand, when the domestic product or income is estimated as the total of factor incomes ( the income that is generated within the domestic territory of a country), we get the domestic product at factor cost. Here, the term ‘cost' is used because factor incomes indicate factor cost to the producing units. There is no difference between gross domestic product at market price and factor cost so long as we are considering only a two-sector economy that includes (i)the producer sector and (ii) the household sector. But the difference emerges when the government sector is also included in it.

To raise the market price of the goods, the government imposes taxes (called indirect taxes). On the other hand, the subsidies that are provided by the government lower the market price of the goods.

Thus, the indirect taxes raised the market price while subsidies lowered the market price. By adding subsidies and deducting indirect taxes to the prevailing market price, one can easily estimate the true market price or the price that is received by the producers. After adjusting the market price for indirect taxes and subsidies, the difference between the GDP at market price and GDP at factor cost disappears.

Thus,

GDP_FC = Compensation of Employees + Rent + Interest + Profit + Depreciation (consumption of fixed capital)

And,

GDP_MP = Compensation of Employees + Rent + Interest + Profit + Depreciation + Net Indirect Taxes

Or

GDP_MP = GDP_FC + Net Indirect Taxes

Net Indirect Taxes = Indirect Taxes – Subsidies

NOMINAL AND REAL GDP

Nominal GDP

It refers to GDP at current prices. The market values of the final goods and services that are produced within the domestic territory of a country during the period of an accounting year, i.e., from 1^st April to 31^st March, is known as the nominal GDP. The prices of the current year are used to estimate the nominal GDP. These are the prices that are prevailing during the year of estimation.

Thus,

Nominal GDP = Q × P

Here, Q refers to the number of final goods and services that are produced during an accounting year.

And P refers to the prices that are prevailed during an accounting year.

Real GDP

It refers to GDP at constant prices. The market value of the final goods and services that are produced within the domestic territory of a country during the period of an accounting year, i.e., from 1^st April to 31^st March, is known as the real GDP. It is estimated by using the prices of the base year (the year of comparison). It is the year when the macro variables (like production and general price level) are believed to be within their normal range.

Thus,

Real GDP = Q × P*

Here, Q refers to the number of final goods and services that are produced during an accounting year.

And, P* refers to the prices that are prevailed during the base year.

In the above equation, P* is constant, which indicates that the real GDP will increase only when Q increases. Hence when there is a rise in the real GDP, the flow of goods and services will also increase in the economy. The availability of goods and services to the residents of a country will be greater when the level of real GDP is higher if the other things remaining constant. It implies that the quality of life should improve.

The index of real GDP always reflects a change in the level of output. On the other hand, the index of nominal GDP may or may not. That’s why in comparison to nominal GDP, real GDP is considered a better index of economic growth.

HOW TO CALCULATE REAL GDP FROM NOMINAL GDP?

Real GDP or GDP at constant prices can easily be calculated from nominal GDP or GDP at current prices by using the price index. We know that GDP at constant prices shows the real GDP of a country. It is estimated at the prices of base-year. Let us assume, the price index or base year prices are 100. So, the price index during the current year has doubled than the price index during the base year when the price level shoots up to 200 during the year of estimation.

GDP at constant prices or real GDP can be obtained if we divide the GDP at current prices by the price index of the current year and then multiply it by the price index of the base year, which is equal to 100.

Real GDP = (Nominal GDP ÷ Price Index) × 100

The nominal GDP can also be estimated by using the given formula if the real GDP and Price Index is given:

Nominal GDP = (Real GDP ÷ 100) × Price Index.

GDP AND WELFARE

Real GDP is considered as an index of the welfare of the people. The welfare of the people of a country is determined by the availability of goods and services per person. The level of output in the economy increases with a rise in the real GDP. Other things remaining constant, this condition implies the higher availability of goods per person. This helps in raising the level of welfare or social welfare. That’s why the planners and politicians in a country focus on the growth rate of GDP.

The higher the growth of GDP, the greater is the flow of goods and services. Also, the higher level of output is often associated with a higher level of employment. It is also associated with a higher level of productivity and efficiency in the economy. This tends to a rise in the purchasing power of the people, which causes a rise in aggregate demand. This leads to higher investment. Higher investment leads to yet another cycle of GDP growth. This another cycle again leads to an increase in the welfare of the people. Thus, there is a strong relationship between GDP growth and an increase in the level of welfare of the people. This relationship sets in motion a virtuous circle of economic prosperity, as follows:

LIMITATIONS

There are certain limitations that are related to the positive relationship between GDP and welfare. These are as follows:

1. Distribution of Income: There will not be a rise in social welfare if the distribution of income turns unequal. This unequal distribution of income is a huge problem in India. Here, starvation deaths are continuously rising and hitting the headlines more often than ever before in spite of rising in the per capita income. The main reason behind this situation is the rich are getting richer, and the poor are getting poorer.
2. Composition of GDP: Sometimes, the composition of GDP may not be welfare-oriented (for the welfare of the people). For example, there is not any direct increase in the welfare of people with an increase in the production of defense goods. Well, as we know, for creating a peaceful environment in the country, a strong defense system is a must. But, it has just an indirect contribution to social welfare. 
3. Non-monetary Exchange: In rural economies, the barter system is preferable to the monetary exchange. Farm labor is often paid in kind rather than cash. These transactions are not recorded during the calculation of the GDP, which causes underestimation of GDP. Hence this underestimation laid GDP as an inappropriate index of welfare.
4. Externalities: Those good and bad impacts of economic activity for which a person does not get any price or penalty are known as the externalities. As per their impact on the environment, these externalities can be positive as well as negative. For example, when a person maintains a beautiful garden and another person in his neighborhood enjoys it then this is the positive externality because it added welfare to the second person, but the first can not charge for it. On the other hand, the stubble burning by the farmers pollute the air. It harms the health of many people and causes loss to social welfare. But the farmers do not pay any penalty for it. So, this is an example of a negative externality. GDP fails to account for the impact of positive and negative externalities on social welfare. Hence, it makes the index of welfare inappropriate.

Thus, there is a need to pay some attention to the limitations of GDP as an index of welfare because there is a deep impact of these limitations on the growth of GDP as an index of welfare.

FREQUENTLY ASKED QUESTIONS

Q. How does GDP differ from NDP?

Ans. During the calculation of GDP, depreciation is included, while during the calculation of NDP, depreciation is not included.

Q. How to convert GDP into NDP?

Ans. To convert GDP into NDP:

GDP – Depreciation = NDP

Q. What is GDP Deflator? How to find a GDP deflector?

Ans. The GDP Deflector refers to the ratio between GDP at current prices and GDP at constant prices. It is the same as the price index, which shows a change in GDP that occurs due to the change in the price level. It can be expressed as follows:

GDP Deflator = (Nominal GDP ÷ Real GDP) × 100