Brief guide to GDP and its calculation, to make you understand what we are talking about

What is GDP? How is it calculated? How is inflation viewed? Here are some basic answers to make you understand what we are talking about.

Gross Domestic Product (GDP) is a macroeconomic quantity that measures the value of all final goods and services produced in a country over a specific period of time, usually a year. It is a widely used indicator to evaluate the vitality of economic activity and, if calculated as GDP per capita, it can give a very vague idea of ​​citizens' well-being. Only vague, because the distribution of wealth is missing.

GDP is said to be internal because it only takes into account what is produced within the national territory, regardless of the nationality of the companies or workers who produce it. If, on the other hand, we want to consider only what is produced by national companies or workers, even if they operate abroad, we must use the gross national product (GNP), which is obtained by adding the net income from abroad to the GDP.

GDP is said to be gross because it does not take into account the depreciation of fixed capital, i.e. the machines, plants and infrastructures that are consumed in the production process. If we subtract the value of depreciation from the GDP, we obtain the net domestic product (PIN), which represents the part of the product available for consumption or investment.

GDP can be calculated in three equivalent ways:

– Adding up the value of final goods and services, i.e. those intended for final consumption and not for further transformation. For example, bread is an end good, while flour is an intermediate good.
– Adding up the added value of each company or productive sector, i.e. the difference between the value of production and the cost of the intermediate goods used. For example, the baker's added value is given by the difference between the price of bread and the cost of flour, energy and other inputs.
– By adding up the income generated by the productive activity, i.e. workers' wages, company profits and taxes paid to the State.

GDP can be expressed in nominal or real terms. Nominal GDP is calculated using current prices for goods and services, while real GDP is calculated using base year prices. Real GDP makes it possible to eliminate the effect of inflation and to compare the purchasing power of an economy over several years.

What are the components of GDP

GDP can be divided into four main components, which correspond to the different destinations of the goods and services produced:

– Private consumption (C) is the expenditure made by households to purchase goods and services to satisfy their needs. It includes both the consumption of durable goods (such as cars, furniture, household appliances) and that of non-durable goods (such as food, clothing, fuel) and that of services (such as health, education, transport).
– Investment (I) is the expenditure made by firms to purchase capital goods (such as machinery, equipment, software) or to increase inventories. Investment serves to increase the productive capacity of an economy and to replace consumed fixed capital.
– Public consumption (G) is the expenditure made by the public administration to provide collective (such as defence, security, justice) or individual (such as health, education, social assistance) goods and services. Public consumption does not include cash social benefits (such as pensions, subsidies, transfers), which are considered part of household income.
– The net export balance (XM) is the difference between the value of goods and services sold abroad (exports) and the value of goods and services purchased from abroad (imports). The net export balance measures the contribution of foreign trade to national production.

The relationship between GDP and its components can be expressed by the following formula:

GDP = C + I + G + (X – M)

How government spending affects GDP

the explanation I am about to give is very rough and approximate, take it as a first hint and an invitation to deepen. Government spending has a direct and indirect effect on GDP. The direct effect is given by the fact that public consumption is a component of GDP and therefore an increase in public spending leads to an increase in GDP, other conditions being equal. The indirect effect is given by the fact that public spending can influence the other components of GDP through the so-called fiscal multiplier.

The fiscal multiplier is the ratio between the change in GDP and the change in public spending. It depends on the households' marginal propensity to consume, i.e. on the fraction of additional income that households allocate to consumption. If the marginal propensity to consume is high, it means that households tend to spend a large part of the additional income deriving from the increase in public spending, generating additional demand and production. If, on the other hand, the marginal propensity to consume is low, it means that households tend to save a large part of the additional income, reducing the multiplier effect.

The fiscal multiplier also depends on the degree of openness of the economy, ie the weight of exports and imports on GDP. If the economy is very open, it means that part of the additional demand generated by public spending is directed towards the purchase of foreign goods and services, reducing the balance of net exports and therefore the GDP. If, on the other hand, the economy is not very open, it means that the additional demand is concentrated on domestic goods and services, increasing the GDP.

Finally, the fiscal multiplier also depends on financial market conditions and monetary policy. If the financial market is efficient and monetary policy is accommodating, this means that businesses can easily access credit to finance investments and that interest rates are low, favoring household demand for durable goods. If, on the other hand, the financial market is in crisis and monetary policy is restrictive, this means that businesses have difficulty obtaining loans and that interest rates are high, discouraging the demand for durable goods.

What are real GDP and nominal GDP

Real GDP is GDP calculated using prices in a base year, i.e. a base year chosen as a starting point for comparing the prices of goods and services over different years. Real GDP makes it possible to eliminate the effect of inflation, ie the general increase in prices, and to measure only the variations in the quantities produced.

Nominal GDP is GDP calculated using current prices, i.e. the prices actually charged in the market in a given year. Nominal GDP takes into account both changes in the quantities produced and changes in prices.

To move from nominal GDP to real GDP, a price index is used, i.e. an indicator that measures the average price trend of a basket of goods and services representative of national production. The price index most commonly used to deflate GDP is the GDP deflator si

The formula for calculating real GDP from nominal GDP and the GDP deflator is as follows:

Real GDP = (Nominal GDP / GDP Deflator)

The GDP deflator is not exactly “inflation”, ie the consumer price index, for a number of reasons. We recall that the CPI measures the purchase cost of a specific basket of goods representative of the consumption of an average urban household.

Differences of the CPI with the GDP deflator:

• the GDP deflator reflects changes in the price of a much larger set of goods than the CPI;
• the basket of goods of the CPI remains unchanged for a certain number of years, while the set of goods to which the GDP deflator refers changes according to what is produced in the economic system in each year;
• the CPI includes the prices of some imported goods, the GDP deflator only includes the prices of domestically produced goods.

The fact that the CPI also includes imported goods in its basket and the GDP deflator does not mean that the difference between these two values ​​allows us to understand when an increase in prices is due to external or internal factors: if the shock is from external rise, from imported inflation, the CPI will rise before the GDP deflator.

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The article Brief guide to GDP and its calculation, to make you understand what we are talking about, comes from Scenari Economici .

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This is a machine translation of a post published on Scenari Economici at the URL https://scenarieconomici.it/breve-guida-al-pil-e-al-suo-calcolo-per-farvi-capire-di-cosa-si-parla/ on Thu, 27 Jul 2023 19:35:33 +0000.