Understanding GDP

GDP at PPP best indicator

What is GDP? The gross domestic product (GDP) is perhaps the most talked about economic indicator. In simple terms, the GDP is the combined market value of all goods and services produced within an economy in a year.

In order to avoid the same things getting counted repeatedly for instance, the tyres on your car getting counted when they are produced as tyres and then again as part of the value of the car, what is actually added up is the value added at each stage, that is the value of the output minus the value of the inputs. In a typical economy, the vast majority of the goods and services are created for consumption domestically while a much lesser quantity is exported to other countries.

Hence, GDP gives a rough idea about the general standard of living in the economy. Thanks to globalisation, income is not confined within the borders of a country because many persons and companies generate income from work or investments abroad. Most of the governments also calculate the gross national product (GNP), which estimates the value of goods and services produced by all nationals of a country, within or outside the country.

If all these calculations are on market value, wouldn't inflation distort the picture?

Undoubtedly, inflation would give a distorted figure of the GDP, if we didn't adjust for it. Most governments have devised various indices to measure the movement of prices. To offset the effect of all forms of inflation in the economy, a GDP deflator is calculated, which is then used to calculate the real increase in GDP over a particular base period. The base period is the year whose prices are used to find the adjusted value of goods at some other period of reference. The GDP so calculated is called GDP at constant prices. The real per capita income, which is one of the best methods of measuring the economic standard of a country, is calculated by dividing real GDP by the countrys population.

Why do governments keep changing the base year?

Considering the ever changing economic scenario across the world the base year needs constant revision so that all kinds of economic activities get included in the GDP calculation. For instance, having a base period from the early 90s would underplay incomes from IT and other fast emerging services sectors. After all, gathering all the information about economic output within the economy is a fairly complex task, which involves economists and statisticians analysing various data from tax collections to industry reports and so on. Even after doing all this, GDP remains an estimate.

If it's just an estimate can't it be fudged?

To have internationally comparable figures of GDP, its mandatory for all governments to follow the system of National Accounts 1993 (1993 SNA), which is a conceptual framework that sets the international statistical standard for the measurement of market economy.

It is jointly published by the UN, the Commission of the European Communities, IMF , the Organisation for Economic Co-operation and Development, and the World Bank. It is a general convention to convert the GDP so calculated in the national currency into American dollars at the market exchange rates and hence an internationally comparable GDP figure is obtained which uses a similar methodology and is also expressed in the same currency.

Why do some people consider GDP expressed in purchasing power parity (PPP) rates a better indicator?

Market exchange rates are determined by the daily demand and supply of currencies in the international market, in turn determined mainly by things that are globally tradable, while many goods and services are never traded internationally.

Also, developing countries have relatively lower prices of these non-tradable goods and services. Hence, conversion of GDP into dollars at the market exchange price would give a lower value to the GDP of a developing country like India than is warranted. Hence, to make an apples to apples comparison, PPP exchange rates are calculated by comparing the prices of a similar basket of goods and services in different countries.

These rates are then used to determine the GDPs of different countries in PPP dollars. To see how much of a difference using PPP rates can make, consider this: In nominal dollars, Chinahas only just overtaken Japan as the second largest economy in the world and is only a little more than one-third the size of US economy. India is ranked 12th and is just 10% of the US economy.

In PPP terms, China is more than double the size of Japan and about two-thirds the size of the US. India is ranked fourth just a little behind Japan and about one-fourth as big as the US economy.

Source: timesoindia