The general definition of GDP is rather simple – however, economists seldom like simplicity, and therefore there are three different ways to calculate GDP.
1. Production Method
The production
approach to GDP is the market value of all final goods and services. Also
called the “net product” method, it includes three statistics:
Ø
Gross Value
Added: Estimation of the gross value of
various domestic economic activities.
Ø
Intermediate
Consumption: Determination
of the cost of materials, supplies, and labor used to create goods and
services.
Ø
Value of
Output: Deduction of
the intermediate consumption from the gross value, which gives you the GDP.
This is how you determine GDP via the production method.
Weakness of the Production Method
The
major problem with the production method of measuring GDP is that there is no
100% accurate way to determine what is true production. Services like babysitting
have no way of being measured, and therefore are not included – though it can
be argued that a babysitter allows parents to go out and spend money on a
service, like dinner at a restaurant, and therefore has a positive effect on
the economy. Also, if you make baked goods or have a small garden, you are
producing, but your output is likely not included in the GDP, especially if you
do not sell your goods.
If
you do sell your baked goods, that could be considered part of the underground
economy. For example, if you pay a person cash under the table to fix your car,
it does not count toward GDP, although a service has been rendered.
2. Income Approach
Many
economists dislike the production method as a means to measure GDP as it does
not include income. Rather, they believe that the money each family brings home
is a better way to evaluate the economic strength of the country. Therefore,
the income approach measures the annual incomes of all individuals in a
country.
Incomes are culled from five different
areas:
ü Wages, salaries, and supplementary labor income
ü Corporate profits
ü Interest and miscellaneous investment income
ü Farmers’ income
ü Income from non-farm unincorporated businesses
Once
these numbers are added, two further adjustments must be made to arrive at the
GDP via this method. Indirect taxes, such as sales taxes at a convenience
store, minus tax subsidies (tax breaks or credits) are added to arrive at
market prices. Then, depreciation on various hard assets (buildings, equipment,
etc.) is added to that to arrive at the GDP number. The idea behind the income
method is to try to get a better handle on real economic activity.
Weakness of the Income Approach
A
quick review of the items utilized in the income approach makes its weakness
obvious: Production is not included, nor is saving or investment. When you sit
with an investment advisor and invest money in a mutual fund,
you are releasing money from your hands to get more back. That is economic
activity, but it is not counted in the income approach. Similarly, increased
production at factories can occur without higher wages, and because there is a
delay from the time the increased production of goods hits the marketplace and
sales are recorded, the increased income may not show up in the corporate
profits until later.
3. Expenditure
Approach
There are, in
fact, other economic theorists who believe that neither the income approach nor
the production method is sufficient. In theory, income is not generated to be
hoarded. People might save and invest, but they will definitely purchase
needed and desired goods. From this basic viewpoint, the expenditure approach
was developed. This approach measures all expenditures by individuals within
one year.
The components of this method are:
Consumption as defined by purchases
of durable goods, non-durable goods, and services. Examples include food, rent,
gas, clothes, dental expenses, and hairstyling. The purchase of a new house,
however, is not included as consumption. Consumption is the largest component
of this method of determining GDP.
Investment means capital
investments, such as equipment, machinery, software, or digging a new coal
mine. It does not mean investments in financial products, like stocks and mutual funds.
Government
Spending is the total of government expenditures on goods and
services, including all costs of government employee salaries, weapons
purchased by the military, and infrastructure costs. For example, the money
spent on the war in Iraq is included, as is the money spent in the stimulus
bill in 2008. Social Security and unemployment benefits, however, are not
included.
Net
Exports are calculated by subtracting the value of imports
from the value of exports. Exports are goods that are created in this country
for other nations to consume, while imports are created in other nations and
consumed domestically.
Weakness of the Expenditure Method
The weakness of
this method is similar in nature to the weakness of the income approach. First,
savings are not included in the equation – so savings accounts and stock
investments are not accounted for. Also, deeply discounted and even free
services from government, business, and nonprofit organizations are
included. This presents a problem because the actual value of these services –
not what is charged for them – is estimated. For this reason, the final GDP
number is likely to be inaccurate.
Lastly, some
services are counted based on their costs, but that value can be substantially
higher than is estimated or reported. For example, when a major infrastructure
collapse happens, such as the result of 9/11 or the tornadoes in Alabama,
medical and building costs go up. This creates a temporary increase in
infrastructure costs, which increases the final GDP number. This skews the
numbers by representing a spike – but not a growth curve that is sustainable.
Consider this: When you buy a new house, you may spend a lot of money on new
furniture – but you do not buy new furniture every month.