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Determining GDP
Product approach
Usually in this approach the economy is broken down into classes of enterprise: agriculture, construction, manufacturing, etc. Their outputs are estimated largely on the basis of surveys which businesses fill out. To avoid "double-counting" in cases where the output of one enterprise is not a final good, but serves as input into another enterprise, either only final goods outputs must be counted, or a "value-added" approach must be taken, where what is counted is not the total value output by an enterprise, but its value-added: the difference between the value of its output and the value of its input.
Depending on how gross value added has been calculated, it may be necessary to make an adjustment to it before it can be considered equal to GDP. This is because GDP is the market value of goods and services – the price paid by the customer – but the price received by the producer may be different than this if the government taxes or subsidises the product. For example, if there is a sales tax:
If taxes and subsidies have not already been computed as part of GVA, we must compute GDP as:
Expenditure method
In contemporary economies, most things produced are produced for sale, and sold. Therefore, measuring the total expenditure of money used to buy things is a way of measuring production. This is known as the expenditure method of calculating GDP. Note that if you knit yourself a sweater, it is production but does not get counted as GDP because it is never sold. Sweater-knitting is a small part of the economy, but if one counts some major activities such as child-rearing (generally unpaid) as production, GDP ceases to be an accurate indicator of production.
Components of GDP by expenditure
GDP (Y) is a sum of Consumption (C) , Investment (I) , Government Spending (G) and Net Exports (X - M) .
Here is a description of each GDP component:
- C (consumption) is normally the largest GDP component, consisting of private household expenditures in the economy. These personal expenditures falls under one of the following categories: durable goods, non-durable goods, and services. Examples include food, rent, jewelry, gasoline, and medical expenses but does not include the purchase of new housing.
- I (investment) includes business investment in plant, equipment, inventory, and structures, and does not include exchanges of existing assets. Examples include construction of a new mine, purchase of software, or purchase of machinery and equipment for a factory. Spending by households (not government) on new houses is also included in Investment. In contrast to its colloquial meaning, 'Investment' in GDP does not mean purchases of financial products. Buying financial products is classed as 'saving', as opposed to investment . This avoids double-counting: if one buys shares in a company, and the company uses the money received to buy plant, equipment, etc., the amount will be counted toward GDP when the company spends the money on those things; to also count it when one gives it to the company would be to count two times an amount that only corresponds to one group of products. Buying bonds or stocks is a swapping of deeds, a transfer of claims on future production, not directly an expenditure on products.
- G (government spending) is the sum of government expenditures on final goods and services. It includes salaries of public servants, purchase of weapons for the military, and any investment expenditure by a government. It does not include any transfer payments, such as social security or unemployment benefits.
- X (exports) represents gross exports. GDP captures the amount a country produces, including goods and services produced for other nations' consumption, therefore exports are added.
- M (imports) represents gross imports. Imports are subtracted since imported goods will be included in the terms G , I , or C , and must be deducted to avoid counting foreign supply as domestic.
Note that C , G , and I are expenditures on final goods and services; expenditures on intermediate goods and services do not count. (Intermediate goods and services are those used by businesses to produce other goods and services within the accounting year. )
According to the U.S. Bureau of Economic Analysis, which is responsible for calculating the national accounts in the United States, :In general, the source data for the expenditures components are considered more reliable than those for the income components ."
Examples of GDP component variables
C , I , G , and NX (net exports): If a person spends money to renovate a hotel to increase occupancy rates, the spending represents private investment, but if he buys shares in a consortium to execute the renovation, it is saving. The former is included when measuring GDP (in I ), the latter is not. However, when the consortium conducted its own expenditure on renovation, that expenditure would be included in GDP.
If a hotel is a private home, spending for renovation would be measured as c onsumption, but if a government agency converts the hotel into an office for civil servants, the spending would be included in the public sector spending, or G .
If the renovation involves the purchase of a chandelier from abroad, that spending would be counted as C , G , or I (depending on whether a private individual, the government, or a business is doing the renovation), but then counted again as an import and subtracted from the GDP so that GDP counts only goods produced within the country.
If a domestic producer is paid to make the chandelier for a foreign hotel, the payment would not be counted as C , G , or I , but would be counted as an export.
Income method
Another way of measuring GDP is to measure total income. If GDP is calculated this way it is sometimes called Gross Domestic Income (GDI), or GDP(I). GDI should provide the same amount as the expenditure method described above. (By definition, GDI = GDP. In practice, however, measurement errors will make the two figures slightly off when reported by national statistical agencies.)
Total income can be subdivided according to various schemes, leading to various formulae for GDP measured by the income approach. A common one is:
- Compensation of employees (COE) measures the total remuneration to employees for work done. It includes wages and salaries, as well as employer contributions to social security and other such programs.
- Gross operating surplus (GOS) is the surplus due to owners of incorporated businesses. Often called profits, although only a subset of total costs are subtracted from gross output to calculate GOS.
- Gross mixed income (GMI) is the same measure as GOS, but for unincorporated businesses. This often includes most small businesses.
The sum of COE , GOS and GMI is called total factor income; it is the income of all of the factors of production in society. It measures the value of GDP at factor (basic) prices. The difference between basic prices and final prices (those used in the expenditure calculation) is the total taxes and subsidies that the government has levied or paid on that production. So adding taxes less subsidies on production and imports converts GDP at factor cost to GDP(I).
Total factor income is also sometimes expressed as:
Yet another formula for GDP by the income method is:
where R : rents
I : interests
P : profits
SA : statistical adjustments (corporate income taxes, dividends, undistributed corporate profits)
W : wages
Note the mnemonic, "ripsaw".The production boundary
Not all useful human activity is counted in GDP. Indeed, not everything that economists recognise as "production" is counted in GDP. The economists who compile GDP readily admit even the latter point. However, it raises several questions: What does GDP actually measure? Is it a useful figure? Does it mean what most people think it means?
The economists who compile national accounts speak of a "production boundary" that delimits what will be counted as GDP.
"One of the fundamental questions that must be addressed in preparing the national economic accounts is how to define the production boundary – that is, what parts of the myriad human activities are to be included in or excluded from the measure of the economic production."
All output for market is at least in theory included within the boundary. Market output is defined as that which is sold for "economically significant" prices; economically significant prices are "prices which have a significant influence on the amounts producers are willing to supply and purcha
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