GDP: its measurement and meaning

GDP, or Gross Domestic Product, is a measure of how big an economy is. Nominal GDP is expressed in current prices i.e. in the common dollars that we all know and love. Real GDP is expressed in constant prices i.e. in the dollar values of a particular year, which is known as the base period. Real GDP is in effect nominal GDP after adjustment for inflation. Changes in real GDP are often referred to as volume increases in GDP, and are a measure of economic growth.

Most economic analysts focus on real GDP because it shows the underlying strength of an economy. But let’s look first at nominal GDP.

A common belief is that nominal GDP is the total value of all goods and services produced in a country in a particular time period. But this isn’t strictly correct. We have to adjust the total value of output – which is called gross output – to make sure we aren’t double counting. For example, suppose a firm makes $100,000 worth of furniture in a year, but in doing this, it buys supplies worth $40,000 from other firms. Of the total sales of $100,000, the component that our furniture firm is responsible for – the firm’s value added – is $60,000. And this is what we want to include in GDP – the value added from each firm.

The goods and services that are purchased from other firms are referred to as intermediate consumption. So, summing over all the firms in the economy we have:

            GDP = gross output minus intermediate consumption

and we can see that GDP and value added are the same thing.

Now we can define GDP more formally: GDP is the total market value of goods and services produced within a given period after deducting the cost of goods utilised in the process of production.

In estimating nominal GDP, Statistics New Zealand uses firm level survey data to calculate gross output and intermediate consumption. The data is assembled at the industry level to produce estimates of value added by industry. Summing over the industries we get what is known as the production measure of GDP.

There are two other measures of GDP: the expenditure measure and the income measure. In theory, all three measures should be identical. In practice, we are likely to get three different values, although these values should be similar. The differences between the values will be largely due to measurement errors.

The expenditure measure is assembled from data on spending. This spending is on goods and services bought by final end users. It covers consumption, investment, and exports. We add these three components together, but then have an adjustment to make, since some of these goods and services will have been imported and not produced in New Zealand. So we subtract imports from our total for consumption, investment and exports. Now we have a measure of GDP. Note that we have excluded intermediate consumption from our measure by focusing on the final use of goods and services.

The income measure of GDP is derived from earnings data. It is basically earnings by salary and wage earners, profits, and indirect tax (which is the proportion of firms’ takings that is siphoned off into taxation). We can think of income GDP as the ‘gross profit’ of firms, which is then distributed through payments to workers, capital, and government. This gross profit is basically firms’ income minus payments to other firms. But these payments to other firms are intermediate consumption, so again we can see that our measure of GDP – this time the income measure – excludes intermediate consumption.

So much for nominal GDP. How do we get real GDP? In New Zealand, we have quarterly real series for the production and expenditure measures. Real production GDP for most industries is based on production indicators. For example, the real GDP production series for forestry and logging is based on changes in the volumes of roundwood removals and stocks of standing timber. This approach gives us an estimate of real gross output. If we assume that real intermediate consumption, as a proportion of real gross output, stays constant then real GDP will increase in line with real gross output. This assumption is in fact used for most industries.

The quarterly real expenditure measure is largely derived by adjusting nominal values for price changes.

GDP – production and expenditure measures

Annual average percent change

Source:   Statistics New Zealand

The chart shows annual average percent changes for the real production and expenditure measures. As you can see, there are some differences. Which should we use? Statistics New Zealand, which compiles the GDP measures, advises using the production measure for an accurate assessment of term changes. However, most forecasters base their forecasts on the expenditure measure, which provides a demand-side view of the economy.

Real GDP per capita is often used as an indicator of how well off a country is, since it is a measure of average real income in that country. However, it is not a complete measure of economic well-being. For example, GDP covers only market sector activities, and does not therefore include unpaid work. Neither does GDP take account of negative effects of economic activity, like environmental degradation. Deriving measures that do take account of these aspects of activity is currently a popular research topic around the world.