Subject 1. Gross Domestic Product

Gross Domestic Product (GDP) is the total market value of all domestically produced final goods and services for a particular year. Its five key factors are: market value, final goods and services, produced, within a country, during a specific time period.

  • Only final goods and services count; GDP includes goods and services purchased by final users. Intermediate goods purchased for resale or for the production of another good or service are excluded, to avoid double-counting. Their value is embodied in the value of the goods purchased by the end user.

  • GDP is a flow variable; it measures the market value of production that flows through the economy.

  • Financial transactions and income transfers (e.g., social security and welfare payments) are excluded because they represent exchanges, not productions, of goods and services. GDP counts transactions that add to current production.

  • GDP counts only goods and services produced domestically, whether by citizens or foreigners.

  • It includes only goods produced during the current period. Thus, sales of used goods are not counted in GDP. However, sales commissions count toward GDP because they involve services provided during the period.

Government services and household production are estimated and included in the GDP. Activities occurring in the underground economy, although sometimes productive, are not included in GDP.

Nominal and Real GDP

When comparing GDP across time periods, we confront a problem: the nominal value of GDP may increase as the result of either expansion in the quantities of goods produced or higher prices. Since the former will improve our living standards, we have to adjust the nominal values (nominal GDP, or money values) for the effects of inflation to get real values (real GDP).

A price index is used for the adjustment. It measures the cost of purchasing a market basket or bundle of goods at a point in time relative to the cost of purchasing the identical market basket during an earlier reference period (e.g., a base year).

Consumer price index (CPI) (not included in the required reading) is an indicator of the general level of prices. It attempts to compare the cost of purchasing the market basket bought by a typical consumer during a specific period with the cost of purchasing the same market basket during an earlier period. The CPI is better at determining how rising prices affect the money income of consumers. The CPI is more widely used for price changes over time.

The GDP deflator is a price index that reveals the cost during the current period of purchasing the items included in GDP relative to the cost during a base year. Because the base year is assigned a value of 100, as the GDP deflator takes on values greater than 100, it indicates that prices have risen. It is a broader price index than the CPI since it is better at giving an economy-wide measure of inflation. It is designed to measure the change in the average price of the market basket of goods included in GDP. In addition to consumer goods, the GDP deflator includes prices for capital goods and other goods and services purchased by businesses and governments. The GDP deflator also allows the basket of goods to change as the composition of GDP changes, while the CPI is computed using a fixed basket of goods.

We can use the GDP deflator together with nominal GDP to measure the real GDP (GDP in dollars of constant purchasing power).

Real GDPi = Nominal GDPi x (GDP Deflator for base year/ GDP Deflator for year i)

Suppose the nominal GDPs in 1992 and 2010 were $6244 and $8509 billion dollars, respectively. This amount has increased by 36.3%. The GDP deflator for 1992 and 2010 was 100 and 112.7, respectively. The real GDP in 2010, therefore, should be:
Nominal GDP in 2010 x GDP deflator in 1992 / GDP deflator in 2010
= 8509 x 100 / 112.7
= $7550 billion dollars
Measured in terms of 1992 dollars, the real GDP in 2010 was only 20.9% higher than that in 1992.

User Contributed Comments 7

You need to log in first to add your comment.
Tommy: good notes! Very concise and compact.
olympria: If it is confusing as to which deflator is the numerator/denominator, just remember that from a Nominal GDP you have to "remove" this year's inflation and so you will divide this year's deflator, and you have to "consider/include" the comparing year's inflation (otherwise it would just remove ALL inflation from the very beginning) and so you will multiply the comparing year's deflator.
This makes it easier for me than memorising which deflator is divided and which is multiplied.

This actually helped me even in the Portfolio Management formula of removing the std deviation from the risk premium and including the std deviation of the required asset/portfolio to get its respective risk premium.
Hermalia: Thank you olympria.
MrFortei: Can someone please explain how the real GDP in 2010 was calculated to be only 20.9% higher than that in 1992?
unknown: @MrFortei It is (7750-6244)/6244=0,209
IatLs: What is the 'underground economy'?
: @lATLs it is goods and services not reported to the government.So tax collection is not possible