Gross domestic product

Many economists point out that the use of GDP as an indicator for determining the welfare of countries is an erroneous practice and leads to great misconceptions. An indicator based on a fundamentally incomplete picture of social and natural systems, within the framework of human and economic coverage. GDP will not cover characteristic products and long-term prospects - the growth of natural resources and the growth of natural resources of exclusive products. The calculation methodology encourages the degradation of natural resources by counting the increase in the cost of living as income, although this undermines the basis of income similarity in the future and leads to the degradation of the ecosystem, taking into account inclusion on the planet. Saturation of the environment and the state of health of people, their satisfaction with life. An example here is India, which ranks third in the world in terms of GDP, but at the same time is one of the poorest countries in the world.

Also, when calculating GDP, the shadow economy is not taken into account, which can significantly distort economic growth indicators.

Despite this, the economic policy of most countries of the world is largely determined by the goal of increasing GDP. Leading economists, politicians, entrepreneurs and the media regularly talk about GDP growth as if it represents progress in general or an increase in the welfare of society. According to critics, GDP growth in the modern world has become something of a “magic formula” for solving all problems.

The concept of GDP was first proposed in 1937 in a report to the U.S. Congress in response to the Great Depression, conceived of and presented by an economist at the National Bureau of Economic Research, Simon Kuznets.8

At the time, the preeminent system of measurement was GNP. After the Bretton Woods conference in 1944, GDP was widely adopted as the standard means for measuring national economies, although ironically, the U.S. continued to use GNP as its official measure of economic welfare until 1991, after which it switched to GDP.8

Beginning in the 1950s, however, some economists and policy-makers began to question GDP. Some observed, for example, a tendency to accept GDP as an absolute indicator of a nation’s failure or success, despite its failure to account for health, happiness, (in)equality, and other constituent factors of public welfare. In other words, these critics drew attention to a distinction between economic progress and social progress.

However, most authorities, like Arthur Okun, an economist for President John F. Kennedy’s Council of Economic Advisers, held firm to the belief that GDP is an absolute indicator of economic success, claiming that for every increase in GDP, there would be a corresponding drop in unemployment.9

Investors watch GDP since it provides a framework for decision-making. The “corporate profits” and “inventory” data in the GDP report are a great resource for equity investors, as both categories show total growth during the period; corporate profits data also displays pre-tax profits, operating cash flows, and breakdowns for all major sectors of the economy.

Comparing the GDP growth rates of different countries can play a part in asset allocation, aiding decisions about whether to invest in fast-growing economies abroad—and if so, which ones.

One interesting metric that investors can use to get some sense of the valuation of an equity market is the ratio of total market capitalization to GDP, expressed as a percentage. The closest equivalent to this in terms of stock valuation is a company’s market cap to total sales (or revenues), which in per-share terms is the well-known price-to-sales ratio.

Just as stocks in different sectors trade at widely divergent price-to-sales ratios, different nations trade at market-cap-to-GDP ratios that are literally all over the map. For example, according to the World Bank, the U.S. had a market-cap-to-GDP ratio of 195% for 2020, while China had a ratio of just over 83% and Hong Kong had a ratio of 1,769%.7

However, the utility of this ratio lies in comparing it to historical norms for a particular nation. As an example, the U.S. had a market-cap-to-GDP ratio of 142% at the end of 2006, which dropped to 79% by the end of 2008.7 In retrospect, these represented zones of substantial overvaluation and undervaluation, respectively, for U.S. equities.

The biggest downside of this data is its lack of timeliness; investors only get one update per quarter, and revisions can be large enough to significantly alter the percentage change in GDP.

Most nations release GDP data every month and quarter. In the U.S., the Bureau of Economic Analysis (BEA) publishes an advance release of quarterly GDP four weeks after the quarter ends, and a final release three months after the quarter ends. The BEA releases are exhaustive and contain a wealth of detail, enabling economists and investors to obtain information and insights on various aspects of the economy.1

GDP’s market impact is generally limited, since it is “backward-looking,” and a substantial amount of time has already elapsed between the quarter-end and GDP data release. However, GDP data can have an impact on markets if the actual numbers differ considerably from expectations.

Because GDP provides a direct indication of the health and growth of the economy, businesses can use GDP as a guide to their business strategy. Government entities, such as the Fed in the U.S., use the growth rate and other GDP stats as part of their decision process in determining what type of monetary policies to implement.

If the growth rate is slowing, they might implement an expansionary monetary policy to try to boost the economy. If the growth rate is robust, they might use monetary policy to slow things down to try to ward off inflation.

Real GDP is the indicator that says the most about the health of the economy. It is widely followed and discussed by economists, analysts, investors, and policy-makers. The advance release of the latest data will almost always move markets, although that impact can be limited, as noted above.

Although GDP is a widely used metric, there are other ways of measuring the economic growth of a country. While GDP measures the economic activity within the physical borders of a country (whether the producers are native to that country or foreign-owned entities), gross national product (GNP) is a measurement of the overall production of people or corporations native to a country, including those based abroad. GNP excludes domestic production by foreigners.

Gross national income (GNI) is another measure of economic growth. It is the sum of all income earned by citizens or nationals of a country (regardless of whether the underlying economic activity takes place domestically or abroad). The relationship between GNP and GNI is similar to the relationship between the production (output) approach and the income approach used to calculate GDP.

GNP uses the production approach, while GNI uses the income approach. With GNI, the income of a country is calculated as its domestic income, plus its indirect business taxes and depreciation (as well as its net foreign factor income). The figure for net foreign factor income is calculated by subtracting all payments made to foreign companies and individuals from all payments made to domestic businesses.

In an increasingly global economy, GNI has been put forward as a potentially better metric for overall economic health than GDP. Because certain countries have most of their income withdrawn abroad by foreign corporations and individuals, their GDP figure is much higher than the figure that represents their GNI.

For example, in 2019, Luxembourg had a significant difference between its GDP and GNI, mainly due to large payments made to the rest of the world via foreign corporations that did business in Luxembourg, attracted by the tiny nation’s favorable tax laws.4 On the contrary, in the U.S., GNI and GDP do not differ substantially. In 2019, U.S. GDP was $21.7 trillion while its GNI was $21.7 trillion also.56

Adjustments to GDP

A number of adjustments can be made to a country’s GDP to improve the usefulness of this figure. For economists, a country’s GDP reveals the size of the economy but provides little information about the standard of living in that country. Part of the reason for this is that population size and cost of living are not consistent around the world.

For example, comparing the nominal GDP of China to the nominal GDP of Ireland would not provide much meaningful information about the realities of living in those countries because China has approximately 300 times the population of Ireland.

To help solve this problem, statisticians sometimes compare GDP per capita between countries. GDP per capita is calculated by dividing a country’s total GDP by its population, and this figure is frequently cited to assess the nation’s standard of living. Even so, the measure is still imperfect.

Suppose China has a GDP per capita of $1,500, while Ireland has a GDP per capita of $15,000. This doesn’t necessarily mean that the average Irish person is 10 times better off than the average Chinese person. GDP per capita doesn’t account for how expensive it is to live in a country.

Purchasing power parity (PPP) attempts to solve this problem by comparing how many goods and services an exchange-rate-adjusted unit of money can purchase in different countries—comparing the price of an item, or basket of items, in two countries after adjusting for the exchange rate between the two, in effect.

Real per-capita GDP, adjusted for purchasing power parity, is a heavily refined statistic to measure true income, which is an important element of well-being. An individual in Ireland might make $100,000 a year, while an individual in China might make $50,000 a year. In nominal terms, the worker in Ireland is better off. But if a year’s worth of food, clothing, and other items costs three times as much in Ireland than in China, however, then the worker in China has a higher real income.

The income approach represents a kind of middle ground between the two other approaches to calculating GDP. The income approach calculates the income earned by all the factors of production in an economy, including the wages paid to labor, the rent earned by land, the return on capital in the form of interest, and corporate profits.

The income approach factors in some adjustments for those items that are not considered payments made to factors of production. For one, there are some taxes—such as sales taxes and property taxes—that are classified as indirect business taxes. In addition, depreciation—a reserve that businesses set aside to account for the replacement of equipment that tends to wear down with use—is also added to the national income. All of this together constitutes a nation’s income.

The production approach is essentially the reverse of the expenditure approach. Instead of measuring the input costs that contribute to economic activity, the production approach estimates the total value of economic output and deducts the cost of intermediate goods that are consumed in the process (like those of materials and services). Whereas the expenditure approach projects forward from costs, the production approach looks backward from the vantage point of a state of completed economic activity.

GDP can be determined via three primary methods. All three methods should yield the same figure when correctly calculated. These three approaches are often termed the expenditure approach, the output (or production) approach, and the income approach.

The Expenditure Approach

The expenditure approach, also known as the spending approach, calculates spending by the different groups that participate in the economy. The U.S. GDP is primarily measured based on the expenditure approach. This approach can be calculated using the following formula:

GDP = C + G + I + NX

where

C=consumption;

G=government spending;

I=investment; and

NX=net exports

All of these activities contribute to the GDP of a country. Consumption refers to private consumption expenditures or consumer spending. Consumers spend money to acquire goods and services, such as groceries and haircuts. Consumer spending is the biggest component of GDP, accounting for more than two-thirds of the U.S. GDP.3

Consumer confidence, therefore, has a very significant bearing on economic growth. A high confidence level indicates that consumers are willing to spend, while a low confidence level reflects uncertainty about the future and an unwillingness to spend.

Government spending represents government consumption expenditure and gross investment. Governments spend money on equipment, infrastructure, and payroll. Government spending may become more important relative to other components of a country’s GDP when consumer spending and business investment both decline sharply. (This may occur in the wake of a recession, for example.)

Investment refers to private domestic investment or capital expenditures. Businesses spend money to invest in their business activities. For example, a business may buy machinery. Business investment is a critical component of GDP since it increases the productive capacity of an economy and boosts employment levels.

The net exports formula subtracts total exports from total imports (NX = Exports − Imports). The goods and services that an economy makes that are exported to other countries, less the imports that are purchased by domestic consumers, represent a country’s net exports. All expenditures by companies located in a given country, even if they are foreign companies, are included in this calculation.

• Nominal GDP. It includes the value of all final goods and services of the region or state in question, expressed in current market prices.
• Real GDP. It takes into account the extent to which GDP growth is determined not by price increases, but by real production growth.
• Actual GDP. This is GDP taking into account part-time employment. Shows realized opportunities of the economy.
• Potential GDP. This is GDP at full employment. Shows the potential of the economy.
• Gross national product (GNP). Unlike GDP, which takes into account the value of all goods and services created in a particular country. GNP takes into account only the value of goods and services created only by its residents, and not by foreign representatives
• Net national product. This is the GNP from which the cost of depreciation is subtracted.
• GDP per capita. It is calculated by dividing the GDP by the population of the country. Reflects the welfare of the country as a whole.

Many economists point out that the use of GDP as an indicator for determining the welfare of countries is an erroneous practice and leads to great misconceptions. An example here is India, which ranks third in the world in terms of GDP, but at the same time is one of the poorest countries in the world.

Also, when calculating GDP, the shadow economy is not taken into account, which can significantly distort economic growth indicators.

GDP takes into account only those goods and services that are intended directly for consumption or use in all sectors of the economy in the territory of a particular state. GDP excludes financial transactions, including government transfer payments (social benefits), private transfer payments (gifts from relatives, one-time financial assistance), securities transactions, and the sale of second-hand goods.