Measuring the Economy 1

Gross Domestic Product (GDP)

Summary Gross Domestic Product (GDP)

The distinction between GDP and GNP is theoretically important, but not often practically consequential. Since the majority of production within a country is by nationals within that country, GDP and GNP are usually very close together. In general, macroeconomists rely on GDP as the measure of a country's total output.

GDP is an excellent index with which to compare the economy at two points in time. That comparison can then be used formulate the growth rate of total output within a nation.

In order to calculate the GDP growth rate, subtract 1 from the value received by dividing the GDP for the first year by the GDP for the second year.

GDP growth rate = [(GDP1)/(GDP2] - 1
For example, using , in year 1 Country B produced 5 bananas worth $1 each and 5 backrubs worth $6 each. In year 2 Country B produced 10 bananas worth $1 each and 7 backrubs worth $6 each. In this case the GDP growth rate from year 1 to year 2 would be:
[(10 X $1) + (7 X $6)] / [(5 X $1) + (5 X $6)] - 1 = 49%

There is an obvious problem with this method of computing growth in total output: both increases in the price of goods produced and increases in the quantity of goods produced lead to increases in GDP. From the GDP growth rate it is therefore difficult to determine if it is the amount of output that is changing or if it is the price of output undergoing change.

This limitation means that an increase in GDP does not necessarily imply that an economy is growing. If, for example, Country B produced in one year 5 bananas each worth $1 and 5 backrubs each worth $6, then the GDP would be $35. If in the next year the price of bananas jumps to $2 and the quantities produced remain the same, then the GDP of Country B would be $40. While the market value of the goods and services produced by Country B increased, the amount of goods and services produced did not. This problem can make comparison of GDP from one year to the next difficult as changes in GDP are not necessarily due to economic growth.

In order to deal with the ambiguity inherent in the growth rate of GDP, macroeconomists have created two different types of GDP, nominal GDP and real GDP.

  • Nominal GDP is the sum value of all produced goods and services at current prices. This is the GDP that is explained in the sections above. Nominal GDP is more useful than real GDP when comparing sheer output, rather than the value of output, over time.
  • Real GDP is the sum value of all produced goods and services at constant prices. The prices used in the computation of real GDP are gleaned from a specified base year. By keeping the prices constant in the computation of real GDP, it is possible to compare the economic growth from one year to the next in terms of production of goods and services rather than the market value of these goods and services. In this way, real GDP frees year-to-year comparisons of output from the effects of changes in the price level.