Macroeconomic Measurement: GDP and its Limitations

Macroeconomic Measurement: GDP

Why Measure a Country’s Income?

  • To measure absolute and relative progress, allowing for comparisons over time and against other nations.

  • To analyze economic effects of government policies, providing insights into how policies impact economic performance.

  • To compare with other countries, facilitating international benchmarking and understanding of economic standings.

System of National Accounting (SNA)

  • Adopted by the US government during the Great Depression of 1930s to better understand and manage the economic crisis.

  • National Accounting: keeping an account of all economic activities of a country, offering a comprehensive view of economic transactions.

  • First set of accounts developed by Simon Kuznets in 1937 for the US govt, laying the groundwork for modern national accounting practices.

  • First estimates of GNP were presented to the govt in 1942, providing crucial data for wartime economic planning.

  • Sir Richard Stone won the Nobel Prize for developing systems of national accounts, recognizing his significant contributions to standardizing economic measurement practices.

Current SNA Practices

  • In the US: Bureau of Economic Analysis (BEA) maintains its National Income and Product Accounts (NIPA), ensuring consistent and reliable economic data.

  • In India: Central Statistical Organisation, Ministry of Statistics and Programme Implementation (MOSPI), responsible for collecting and disseminating national statistics.

  • India depends primarily on Net Value Added (NVA) and Expenditure Methods to calculate its GDP, reflecting its statistical priorities and data availability.

Conventions of SNA
Division of Economy into Four Sectors:

  1. Household and Institutions: Includes households as well as the Non-Profit institutions that serve households such as schools, universities, hospitals, trade unions etc.

  2. Business (Firms): private firms (industries, factories, service providers, wholesale or retail sellers), NPOs serving businesses such as trade associations and chambers of commerce, and government agencies engaged in ‘selling’ goods and services, such as postal services, railways.

  3. Government: All government entities till the lowest level (such as panchayat). Excludes business-like govt. enterprises (which are engaged in selling goods and services.)

  4. Foreign (Rest of the world): Any of the above three sectors which are located outside the geographic boundaries of the country.

Capital Stock

  • In economics, capital always means ‘manufactured capital’, measured at a point of time. It does not include financial assets (such as holding of bonds or shares of any company).

  • Includes:

    • current manufactured capital

      • Fixed assets: machinery, factory buildings, equipment etc.; residential buildings

      • Inventories: stock of raw materials, unsold finished goods maintained by firms.

      • Consumer durables: those goods which are expected to last more than 3 years, such as cars, appliances, etc.

Investment

  • Any change or addition to the capital stock over a period of time.

  • NEW machinery purchased, buildings constructed, or additions to the stock of raw materials.

    • Gross Investment: all changes/additions to the stock of capital goods

    • Depreciation: Wear and tear of the existing stock of capital/ consumption of fixed capital/ decrease in the quantity or quality of fixed capital. breakdown of machinery, equipment becoming obsolete, cars requiring higher maintenance, etc.

  • Net Investment = Gross Investment – Depreciation

Gross Domestic Product (GDP): Its meaning

  • GDP is the market value of all the final goods and services produced within a country, in a given period of time.

Market Value

  • Value of output measured at market prices.

  • A uniform unit - prices measured in currency - is used to measure the value of variety of goods and services.

Final

  • Records the value of only final goods and services and not intermediate goods, as it may lead to double counting.

    • Final goods: which are meant for final consumption.

    • Intermediate goods: which need further processing to turn into a final good.

Goods and Services

  • Includes tangible goods (which can be seen) such as food, clothing, cars, etc.

  • Includes intangible services (which cannot be seen, only felt or experienced) such as services of a doctor, teacher, telecommunication, entertainment, transport etc.

Produced

  • Includes items produced currently and not in the past.

  • Resales of already produced goods are not included.

  • Transactions involving sale and purchase of stocks and bonds do not involve ‘real production’ of any good or service.

Within a Country

  • Includes only those goods and services which are produced within the physical/geographical boundaries of the country – domestically produced.

  • For calculating India’s GDP, output generated by ‘citizens of other countries working in India’ should be included.

In a Given Period of Time

  • GDP includes the value of goods and services produced within a specific period of time (year, six months or a quarter).

Circular Flow of Income: Two Sector Economy

  • Captures flow of the factors of production and factor payments made to the factors of production.

  • Does not capture ‘Government’ sector, responsible for collection of taxes and transfer payments.

  • Does not capture ‘Financial Markets’, responsible for routing savings of the households via the market for loanable funds.

  • Does not have a ‘Foreign sector’ - no exports and imports in this economy.

  • Expenditure of the buyer becomes the income of the seller.

How to Measure/Calculate GDP?

Value of output = Value of expenditure/spending = Value of Income

Therefore, there are three methods to calculate GDP:

  1. Production/Value-Added Method

  2. Expenditure/Spending Method

  3. Income Method

Production (Value Added) Method

  • GDP is calculated as the total of the value of all ‘final goods’ (and not intermediate goods) produced by different sectors of the economy.

  • Net value added = Gross value of output - Value of intermediate consumption

  • GDP is the sum of net value added (NVA) in various economic activities across all sectors.

Advantages of this method:

  1. Easy to avoid the problem of double counting.

  2. It reveals the relative importance of each sector in the economy, in terms of their respective contributions to GDP.

Value added by all four sectors in the economy:

  1. Firms sector: value added = value of output - value of inputs

  2. Foreign sector: Includes transactions of exports by domestic firms and imports by foreign firms. Therefore, use the same methodology as that for private/domestic firms explained until now.

  3. Household sector: Goods and services produced within the household do not necessarily have a market price, such as food produced for self-consumption, shelter services of owned houses, child-care and elderly care services, other household chores etc.

  4. Government sector: Likewise, the govt. provides goods and services either at zero market price or at very low/subsidised market prices, such as education, health, etc.

Imputation Method

  • Market price of similar outputs available in the market; or addition of value of inputs used to produce that output (in case no similar marketed product exists).

  • For household sector, imputed values of only ‘self-consumption’ and ‘rent’ are included.

  • For govt. sector, imputed values of their services such as education, are based on addition of value of inputs such as salaries to teachers etc.

Expenditure (Spending) Method

  • Economy is divided into four sectors

  • GDP = C + I + G + (X − M)

    • Consumption (C): Consumption expenditure of the private (household) sector. Includes expenditure on purchase of all goods and services by the household sector meant for end-consumption.

    • Investment (I): Investment expenditure by the private (firms) sector. The spending on purchase of capital goods (fixed assets)

    • Government purchases/spending (G): Consumption and investment expenditures by the government sector. The spending on goods and services by local, state, and central governments.

    • Net Exports (X-M): Exports minus imports.

Relationship between Savings and Investment; based on Expenditure Method

GDP - Private Consumption - Government Consumption = Private Investment + Government Investment + Net Exports

Savings = Investment + Net Exports

Savings = Investment

Income Method

  • As per this method, GDP calculations are based on adding up all the production related incomes, that is, incomes received by all the factors of production.

  • Total income = wages + rent + interest + profits

  • National Income = GDP

  • GDP = National Income + Income generated from domestic production owned by a foreign entity - Income generated from foreign production owned by a domestic entity + Depreciation

GDP Growth Rate

Percentage growth rate of GDP between time period t and t−1=GDP<em>t−GDP</em>t−1GDPt−1∗100Percentage\ growth\ rate\ of\ GDP\ between\ time\ period\ t\ and\ t − 1 = \frac{GDP<em>t − GDP</em>{t-1}}{GDP_{t-1}} * 100

For example, for an economy, its GDP growth rate between years 2011 and 2012 will be given by:

GDP growth rate=GDP<em>2012−GDP</em>2011GDP2011∗100GDP\ growth\ rate = \frac{GDP<em>{2012} − GDP</em>{2011}}{GDP_{2011}} * 100

Real GDP versus Nominal GDP

  • Nominal GDP: value of goods and services produced in an economy, arrived at based on a measure of prevailing prices, or ‘current prices’.

  • Real GDP: value of goods and services in an economy arrived at, based on some ‘base prices’ or ‘constant prices’.

GDP Deflator and Inflation

GDP Deflator=100∗NominalGDPRealGDPGDP\ Deflator = 100 * \frac{Nominal GDP}{Real GDP}

Inflation=GDP deflator<em>t−GDP deflator</em>t−1GDP deflatort−1∗100Inflation = \frac{GDP\ deflator<em>t − GDP\ deflator</em>{t-1}}{GDP\ deflator_{t-1}} * 100

GDP as a Measure of Well-Being

  • Per capita GDP is a related concept that measures average income levels in the economy.

  • It is a measure of average living standard of the population or their average spending capacity.

  • Higher GDP per capita implies higher living standard/ spending capacity.

  • GDP does not measure the level of happiness, quality of life, or well-being in general.

Critiques of GDP as a Measure of Well-Being

  • GDP is an inadequate measure as it ignores various aspects of the well-being of individuals as well as that of the economy as a whole.

    • Household production of goods and services – such as those provided by women.

    • Leisure - even when it contributes to positive utility and hence, health of an individual.

    • Human and social capital formation – such as skills of labourers.

    • Interaction of economy and environment – climatic impact of production activities

    • Financial Debt and GDP - GDP alone does not indicate the financial debt behind the production of those goods and services.

    • Inequality and GDP - a higher GDP does not necessarily mean it is equally distributed. Rich may be becoming richer and poor becoming poorer.

Measurement Issues with GDP

  • Various critiques of GDP as a measure of well-being are basically centered around the measurement issues with it:

    • Under-reporting of income - income generated for self consumption is high in developing countries, undocumented household work.

    • Prices of many goods are not adequately reflected in exchange rates, pertinent for goods and services that are not internationally traded, resulting in underestimation of real incomes of developing countries.

    • Reliance on the use of market prices to convert highly ‘disparate’ goods into a common currency.

    • Prices may reflect the nature of market to be monopoly or oligopoly, instead of actual preferences.

    • Reflects only private costs and ignores social costs like those arising out of externalities.

    • States only the ‘level’ of income and not its ‘distribution’ . Thus, rising GDP may be accompanied by rising inequalities.

Why do we care about GDP?

  • There are evidences that suggest that higher GDP is related to better quality of life.

  • Many of the indicators of quality if life, like level of literacy, life expectancy etc. have been found to positively related to the GDP of the economy.

  • Countries with higher GDP have been found to be performing better than the economies that have lower levels of GDP.

  • Therefore, we can conclude that while GDP is an insufficient and possibly an incomplete measure of overall well-being (objective as well as subjective), it is nevertheless one of the most important macroeconomic variables to be looked at.

Alternatives or Complementary Indicators

  • GDP could be complemented with a host of other indicators to arrive at composite indices to reflect more accurate picture of development for any country.

    • Human Development Index

    • Physical Quality of Life Index

    • Satellite accounts

    • Green GDP

    • Gross National Happiness (GNH)