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Gross domestic product (GDP)  

Gross domestic product (GDP)

The gross domestic product (GDP) or gross domestic income (GDI), a basic measure of an economy's economic performance, is the market value of all final goods and services produced within the borders of a nation in a year. Gross domestic product (GDP) can be defined in three ways, all of which are conceptually identical. First, it is equal to the total expenditures for all final goods and services produced within the country in a stipulated period of time (usually a 365-day year). Second, it is equal to the sum of the value added at every stage of production (the intermediate stages) by all the industries within a country, plus taxes less subsidies on products, in the period. Third, it is equal to the sum of the income generated by production in the country in the period—that is, compensation of employees, taxes on production and imports less subsidies, and gross operating surplus (or profits).

The most common approach to measuring and quantifying Gross domestic product (GDP) is the expenditure method:

GDP = consumption + gross investment + government spending + (exports - imports), or,
GDP = C + I + G + (X - M).

"Gross" means that depreciation of capital stock is not subtracted out of GDP. If net investment (which is gross investment minus depreciation) is substituted for gross investment in the equation above, then the formula for net domestic product is obtained. Consumption and investment in this equation are expenditure on final goods and services. The exports-minus-imports part of the equation (often called net exports) adjusts this by subtracting the part of this expenditure not produced domestically (the imports), and adding back in domestic area (the exports).

Economists (since Keynes) have preferred to split the general consumption term into two parts; private consumption, and public sector (or government) spending. Two advantages of dividing total consumption this way in theoretical macroeconomics are:

  • Private consumption is a central concern of welfare economics. The private investment and trade portions of the economy are ultimately directed (in mainstream economic models) to increases in long-term private consumption.
  • If separated from endogenous private consumption, government consumption can be treated as exogenous, so that different government spending levels can be considered within a meaningful macroeconomic framework.

Measuring GDP

Components of GDP: Each of the variables C (Consumption), I (Investment), G (Government spending) and X - M (Net Exports) (where GDP = C + I + G + (X - M) as above)

(Note: * GDP is sometimes also referred to as Y in reference to a GDP graph)

  • C (Consumption) is private consumption in the economy. This includes most personal expenditures of households such as food, rent, medical expenses and so on but does not include new housing.
  • I (Investment) is defined as investments by business or households in capital. Examples of investment by a business 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. The distinction is (in theory) clear: if money is converted into goods or services, it is investment; but, if you buy a bond or a share of stock, this transfer payment is excluded from the GDP sum. That is because the stocks and bonds affect the financial capital which in turn affects the production and sales which in turn affects the investments. So stocks and bonds indirectly affect the GDP. Although such purchases would be called investments in normal speech, from the total-economy point of view, this is simply swapping of deeds, and not part of real production or the GDP formula.
  • 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) is gross exports. GDP captures the amount a country produces, including goods and services produced for other nations' consumption, therefore exports are added.
  • M (Imports) is 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.

Examples of GDP component variables

Examples of C, I, G, and NX(net exports): If you spend money to renovate your hotel so that occupancy rates increase, that is private investment, but if you buy shares in a consortium to do the same thing 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.

For example, if a hotel is a private home then renovation spending would be measured as Consumption, but if a government agency is converting the hotel into an office for civil servants the renovation spending would be measured as part of public sector spending (G).

If the renovation involves the purchase of a chandelier from abroad, that spending would also be counted as an increase in imports, so that NX would fall and the total GDP is affected by the purchase. (This highlights the fact that GDP is intended to measure domestic production rather than total consumption or spending. Spending is really a convenient means of estimating production.)

If a domestic producer is paid to make the chandelier for a foreign hotel, the situation would be reversed, and the payment would be counted in NX (positively, as an export). Again, GDP is attempting to measure production through the means of expenditure; if the chandelier produced had been bought domestically it would have been included in the GDP figures (in C or I) when purchased by a consumer or a business, but because it was exported it is necessary to 'correct' the amount consumed domestically to give the amount produced domestically.

Types of GDP and GDP growth

  1. Current GDP is GDP expressed in the current prices of the period being measured.
  2. Nominal GDP growth is GDP growth in nominal prices (unadjusted for price changes).
  3. Real GDP growth is GDP growth adjusted for price changes.

Calculating the real GDP growth allows economists to determine if production increased or decreased, regardless of changes in the purchasing power of the currency.

GDP income account

Another way of measuring GDP is to measure the total income payable in the GDP income accounts. In this situation, Gross Domestic Income (GDI) is sometimes used rather than Gross Domestic Product. This should provide the same figure 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.)

The formula for GDP measured using the income approach, called GDP(I), is:

    GDP = Compensation of employees + Gross operating surplus + Gross mixed income + Taxes less subsidies on production and imports

  • 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, and 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).

You can not GDP framework tell whether final goods and services that were produced during a particular period of time are a reflection of real wealth expansion, or a reflection of capital consumption.

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