Gross Domestic Product

Gross Domestic Product (GDP) is a total of the outputs recorded in a country’s national income accounts. It is the best-known of such totals, and estimates of its growth rate are widely used as indicators of the prospects of inflation or unemployment. GDP per capita (that is, divided by total population) is the most frequently used measure of a country's or region's level of economic development. For alternative measures, see Human Development Index.

History

Gross Domestic Product is the principal summary statistic of national income accounts. The current practice of national income accounting was developed during the Second World War by Richard Stone and James Meade at the instigation of John Maynard Keynes while they were working as civil servants in the British Cabinet Office. In his 1984 Nobel prize lecture , Richard Stone ascribes the origins of the concept to essays by William Petty in 1664 and Richard Gordon in 1802, and reproduces their estimates for the English economies of their times.

Definitions

Gross domestic product (GDP) can be defined as the total recorded value of the goods and services produced within an economy. The word "gross" indicates that no deduction is made for the loss of value due to the depreciation of assets, and the word "domestic" indicates that net income from abroad is not included. (If income from abroad is allowed for, gross domestic product becomes gross national product (GNP), and if depreciation is also allowed for, it becomes net national product or simply national income).

GDP can be defined as either the total recorded output of the economy’s producers, the total recorded expenditure of investors and consumers, or the total of all recorded payments of wages, interest and rent. The totals of these measures should all be, in principle, equal. GDP is normally stated as "GDP at market prices", which indicates that the prices used include the effects of indirect taxes and subsidies. In an alternative version that matches payments to the factors of production, indirect taxes (such as sales taxes) are deducted, and subsidies (which are the equivalent of negative sales taxes) are added back - and the adjusted total is then termed "GDP at factor cost". Published statistics normally include estimates of "GDP at constant prices", which are obtained by applying approximate price index adjustments to the recorded values of its components. Time-series data adjusted for these factors are commonly referred to as showing "real", as distinct from "nominal" changes of GDP. GDP statistics are normally published quarterly and are "seasonally adjusted" to remove seasonal influences (e.g. Christmas shopping in December or the production of home heating oil in September) by applying factors based upon previous seasonal patterns.

Limitations and adjustments

Household production

Among the economic activities that are not recorded in the national accounts is unpaid production within a country’s households. It has been estimated that for Britain such production amounts to over 40 per cent of GDP. That omission can in principle be corrected by using household surveys to estimate the amount of time that householders devote to productive work.

New technology

Another limitation of conventional GDP measures is the failure to adequately capture gains in productivity that occur when switching to a new technology. Because GDP is so dependent on prices, when new equipment is purchased, the cost is factored into GDP as higher capital expenditure, while the increase in output may be less observable. The economist William Nordhaus has used a study of the changing methods of generating light to suggest that failure to allow for changes in technology has led to significant underestimates of real GDP growth as well as overestimates of inflation . Additionally, it has been estimated that failure to take account of quality improvements has long resulted in underestimates of between 0.6 and 1.5 percentage points on real GDP growth in the United States. The effects of that failure can sometimes be mitigated by the use of "hedonic price indexes" (as described in the article on the price index) based upon studies of the different prices that people are willing to pay for available quality differences - as is becoming the practice in the United States for the treatment of some high-technology products.

Accuracy and reliability

The rate of change of GDP is a major factor influencing policy action to stabilise the economy (as noted in the article on macroeconomics). Errors in the calculation of GDP can damage the economy as businesses and consumers make adjustments to their behavior in response to an erroneous figure. (The damaging Lawson boom in the Britain in the late 1980s was largely attributable to such an error ). Since it takes time for action in response to news of the GDP growth rate to take effect, the regulatory authorities and commercial organisations tend to react to early estimates, which are often subject to substantial revision. (The average revision to Britain’s quarterly growth figures between 1961 and 2001 was 0.2 per cent as compared to an average growth rate of 0.6 per cent, but the discrepancy was much greater in the late 1970s when a 1.7 per cent year-to-year reduction in GDP was later revised to a rise of 2.7 per cent). Attempts have been made to assess the accuracy of the components of GDP statistics , but since GDP data is compiled from thousands of inputs, it is not possible to do a complete check. Some indication of its reliability is, however, possible by comparing GDP estimates that have been compiled in different ways. The United States GDP is calculated separately from incomes data and from production data, and the difference is termed the "statistical discrepancy" . Since the early 1990s that discrepancy has been substantial, with the real income measure growing faster than the real product measure. (In 1993 the statistical discrepancy peaked at 1% of GDP, and over 7 years the income measure grew at an average annual rate of 4.3% and the product side measure at 4.0%). Estimates of statistical discrepancies for other countries are available from an United Nations database . Different countries have adopted different practices in allowing for the statistical discrepancy in their published statistics.

GDP comparisons

Exchange rates

In order to provide the information necessary for the preferred method of making international comparisons of GDP, a number of international organisations cooperate to provide "purchasing power parity" (PPP) exchange rates. A PPP exchange rate is defined by them as "the number of currency units required to buy goods equivalent to what can be bought with one unit of the currency of the base country, usually the US dollar"., and are set out in detail in an United Nations handbook Data on PPP rates are published by the OECD . The alternative of using market exchange rates can produce grossly misleading comparisons. For example the OECD brief shows that using market exchange rates would overstate Japan’s 1999 GDP by almost 50 per cent compared to the GDP of the United States, and Switzerland’s GDP by over 30 per cent; giving the false impression that both had a higher GDP than the United States.

Accuracy and reliability

Comparisons using PPP exchange rates are in some cases still prone to substantial error. Because developing countries do not all compile their national accounts in accordance with internationally accepted standards , their statistics may not take account outputs like subsistence farming, which are significant within the economy but of a non-commercial nature. Additionally, the standard "basket" of purchased goods that is used to calculate GDP may vary from country to country based on custom, religion, and taste. These cultural differences can result in additional error when trying to make inter-country comparisons of GDP.

Other indicators

Because GDP does not take into account non-economic factors like public health, or the state of the environment, there have been several attempts to develop a more robust measure success resulting from government policies. The Human Development Index (HDI) published by the United Nations adds such measures as literacy and life expectancy, and the Index of Sustainable Economic Welfare (ISEW) published by Friends of the Earth, includes additions for welfare-producing services and deductions for pollution and environmental damage. The Genuine Progress Indicator (GPI) includes crime and income distribution, in addition to much of what is included in the ISEW. In all of such indicators, the choice of the factors to be included and of the relative weights to be attached to them are significantly influenced by the personal values and judgments of individuals who create those measurements.

See also

Francis Lequiller and Derek Blades Understanding National Accounts OECD 2006 [3]