The gross domestic product is a measure of the total economic performance of an economy within a certain period of time. It serves as an important indicator for the performance of an economy, as it provides information about value added, i.e. the production of goods and services minus intermediate consumption and domestic imports.
In this lesson we explain the meaning of the gross domestic product and introduce you to the three common calculation methods. You will then have the opportunity to check your newly acquired knowledge with a few practice questions.
Why is the gross domestic product important?
According to acronymmonster, GDP is a reliable indicator of the total production of goods and services within a country. This makes the gross domestic product the most important variable within the national accounts. GDP is calculated for both years and quarters. The annual results are usually published in January of the following year or 45 days after the end of the quarter.
Features of the gross domestic product
In the following we explain two of the essential characteristics of the gross domestic product to you. We start with the distinction between nominal and real GDP. The domestic principle is then explained. This is one of the main distinguishing features of gross national income.
Gross domestic product: nominal and real GDP
Nominal and real gross domestic product
The gross domestic product can be calculated both at current prices and after adjustment for prices. With nominal GDP, the value of the end products produced is based on the prices that are achieved for them on the market.
Two factors are therefore decisive for the level of GDP: The amount of goods produced and their prices, as these increase the value of the end products.
The real gross domestic product makes the GDPs from two periods comparable, since the price is no longer a value-determining factor here. A base year is selected for this, the price level of which then serves as a reference.
Domestic principle
In contrast to the gross national income, the domestic principle applies to the gross national product. There are thus covers all consumer and capital goods and services produced within a country. The gross national income includes all goods and services that were created by residents, regardless of whether this was done domestically or abroad.
Calculation of the gross domestic product
There are three methods available for calculating the gross domestic product.
These differ mainly in that they start at different points in the economic cycle:
- Production calculation
- Usage calculation
- Distribution calculation
While the production calculation starts directly with production, the use calculation is based on demand and the distribution calculation is based on national income. To calculate the GDP using the production calculation, the gross value added of the country must first be determined, which we have put in front of it in the following.
Determination of gross value added
The production calculation considers the gross domestic product from the production side. However, in order to be able to map the entire economic production result, a correct calculation of the gross value added, and thus the generation calculation of the individual economic sectors, is necessary.
The production value of a company corresponds to the totality of all sales and services valued at market prices plus the commodities to other economic entities without taking value-added tax into account. The output value is then determined using the production costs for each individual economic sector.
A distinction is made between the following economic sectors:
- Agriculture, forestry and fishing
- construction industry
- Manufacturing
- Commerce, hospitality and transport
- Financing, rental and business services
- Public and private service providers
In order to obtain the macroeconomic output value as the result, the output values of the sectors listed here are summed up. However, all intermediate consumption (all goods and services that one economic entity has received from another in order to then use it for its own production) must be deducted from this. If this step were omitted, individual products would be counted twice.
Example for determining gross value added
A hard drive manufacturer buys raw materials worth € 25 from its supplier at the beginning of its production. He then uses the supplied parts to make a hard drive that is sold to a wholesaler for € 50. This in turn supplies a specialist dealer at a price of € 75 per hard drive. The specialist retailer last sold the device to his customers for € 100.
If one were now simply the proceeds of the participating companies add, the bill would look like this:
25 € + 50 € + 75 € + 100 € = 200 €
The value of the raw materials from which the hard drive was originally assembled would be included eight times in this total, since the invoice includes the price of the manufacturer as well as that of the wholesaler and retailer. Such a calculation would therefore result in too high gross value added and consequently also too high gross domestic product.
Therefore, all advance payments must be subtracted in the course of the calculation:
25 € + (50 € – 25 €) + (75 € – 25 € – 25 €) + (100 € – 25 € – 25 € – 25 €) = 100 €
The gross value added is now equal to the retailer’s selling price and the gross value added is correct.
Production calculation
The following method can be used to calculate gross domestic product based on production. Following the procedure described above, we now have the unadjusted gross value added, from which the imputed bank charges must be deducted in order to arrive at the adjusted gross value added and thus the GDP. The imputed bank fees are banking services for which no fees are charged.
| Production values of all economic sectors at market prices | |
| – | Advance payments |
| = | Value creation of the economic sectors |
| = | unadjusted gross value added |
| – | imputed bank charges |
| = | adjusted gross value added |
| = | gross domestic product |
Usage calculation
GDP can also be calculated based on demand within an economy. This procedure is based on the idea that the demand of an economy must also correspond to its production. To determine the demand, it is broken down into its individual components and the gross domestic product is then calculated by adding the corresponding partial values.
In the first step, all expenditures for the purchase of goods or services by consumers are determined. However, this only includes those end products that are not included in a further production process. In the second step, all consumer services provided by the state are added; in the third step, the gross investments are added.
A gross investment is a good that can be provided by both the state and the company and is productive in the broadest sense. This can be, for example, a state university or a section of the motorway. The defining characteristic of such goods is that they help to increase future consumption.
Gross investments can be roughly divided into:
- Equipment investment
- Construction investment
- Other plants
In the last step, the external contribution is added. This is the balance of imports and exports.
| Private consumer spending | |
| + | State consumer spending |
| + | Gross investment |
| + | Exports of goods and services |
| – | Imports of goods and services |
| = | gross domestic product |
Distribution calculation
The distribution calculation is based on the distribution of national income, i.e. on the distribution of the sum of those factor incomes that are received by residents. A distinction is made between income from employment (employee wages) and income from entrepreneurial activity. The national income is calculated by adding these components.
| Compensation of employees | |
| + | Entrepreneurship income and wealth |
| = | National income |
National income is also known as the net national product. It is noticeable here that the gross domestic product is not calculated using the distribution calculation. However, this could be derived from the net national product:
| Net national product | |
| – | Subsidies |
| + | Indirect taxes |
| = | Net national income |
| + | Depreciation |
| = | Gross national income |
| + | Income of foreigners from the domestic product |
| – | Income of residents from abroad |
| = | gross domestic product |