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Gross Domestic Product

Gross Domestic Product, or GDP for short, measures the value of a nation's output of goods and services for some period of time, usually a year. It is not the only measure of output—the Federal Reserve, for example, publishes an index of industrial production—but the GDP has become a favorite among economists because it is the most comprehensive of output measures.1

In arriving at GDP, the Commerce Department is careful not to double count transactions. If it counted the sale of steel to General Motors from U.S. Steel and also the value of the cars that GM produced, it would count the steel twice, once in an unfinished form, and once in a finished form. In practice it avoids double counting by only including the value added at each stage of production. Value added is sales minus the cost of raw materials and unfinished goods.

Neither does the Commerce Department count the sale of second-hand items. These were counted when they were originally purchased, and to count them again would involve double counting. Finally, it does not count financial transactions, such as the sales of stocks and bonds. These transactions involve sales of ownership or debt and do not spring directly from the production of final output. The total of all transactions not counted is much larger than the size of GDP; the transactions of GDP are only a tiny fraction of total transactions of the economy.

Because GDP measures the value of output, it can increase for two distinct reasons. It can increase because more goods and services are being produced, or it can increase because prices of goods and services have risen. To eliminate the effects of changing prices, one must compute real or constant-dollar GDP which values the output of various time periods with a set of fixed prices.

The table below contains output and price statistics for a simple economy that produces only three goods. In the first year the value of output or GDP is $1000, and in the second year GDP is $1120. These numbers are obtained by multiplying quantities by prices, and then summing the resulting values. They give us current-dollar or nominal GDP, that is, the value of output measured in prices that existed when the output was produced.











GDP has risen by 12% from the first year to the second, but this increase is only partially due to additional output. Part of the increase is due to changed prices. To get a measure that contains only the increase in output, we can multiply the outputs of the second year by the prices of the first year. When we add up these values, they total $1025. This number implies that if only the quantities of output had changed and not the prices, GDP would have only increased from $1000 to $1025, a rise of 2.5%. Before the mid-1990s, this is the way in which the Commerce Department computed real GDP. The procedure has gotten much more complex since then, and if you want the details, click the "Explore" button at the bottom of the page.

The two values of GDP for the second year allow us to obtain a measure of inflation called the implicit price deflator or the GDP deflator. The formula for this index is:

Price Index = 100 x (Nominal GDP/Real GDP)

For the example in the table above, the price index will be 100x(1120/1025) = 109.27. This index says that the price level rose a bit more than 9% from the first year to the second.

Why does dividing current-dollar GDP by real GDP yield a price index? Since the same amount of production is in both current and real GDPs, and the only difference between them is in prices. The ratio of them tells how important those price changes are. 2

Notice that if any two of the variables in the above equation are known, one can solve for the third using simple algebra. Also, notice that the GDP deflator is not identical with the CPI but provides an alternative to the CPI as a measure of inflation. Over long periods of time, both provide similar numbers, but they can diverge in shorter periods. For example, from 1974 to 1975 the deflator showed inflation increasing from a 5.9% rate to a 9.3% rate, while the CPI showed it decreasing from an 11% rate to a 9.1% rate.

Like other economic statistics, we must be aware of the limitations of the GDP statistics if we want to use them wisely.

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1 Until the 1990s the Commerce Department computed Gross National Product (GNP) instead of Gross Domestic Product. The differences between the two are slight and involve how to count earnings of assets owned by foreigners. Gross National Product counts the earnings in the homeland of the owner of the asset while Gross Domestic Product counts them in country in which the assets are located. For the United States there is virtually no difference between the two measures.

2 More technically, current-dollar GDP can be thought of as a price level multiplied by an output level, or PtQt, where the subscript t indicates the time period. Real GDP is the price level of the base year multiplied by the output level of time t, or PbQt. Dividing the first by the second, the Qt terms cancel out and we are left with Pt/Pb, or the price level of time t divided by the price level of the base year. Multiplying by 100 puts this into percentage terms, and thereby converts it to the form in which price indices are normally reported.

In the late 1990s the Commerce Department introduced more complicated ways to compute real GDP. They now use chain-linked indexes. The details of this measure go beyond where an introductory course needs to go.

Copyright Robert Schenk