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Saturday, June 4, 2011

Everything that you should know about GDP

Every investor is bullish on two Asian countries China and India and the reason which  they cite is the GDP growth rate.
Let us know what GDP is and why GDP growth rate is so important.
GDP stands for Gross Domestic Product and is used as the macroeconomic indicator of country’s produced goods and services.
In simple words, GDP is the total value of all goods and services produced domestically in a country.
Formula for GDP is -
GDP= C+ I+ G+ Export-Import
Where C is Non-Government Consumption i.e. spending by consumers on goods and services also referred as Private Consumption or Private Expenditure.
‘I’ is the investment done by the industry which is generally capital expenditure like plants and machinery etc.
G stands for Government Spending or Public Sector Spending.
How GDP is measured?
(1)GDP considers Total Market Value- GDP adds up the dollar value (or local currency of a nation) of all goods and services produced in USA (or other concerned country), which gives the total market value of all the goods and services produced in terms of dollar.
(2) GDP considers only Final Goods and Services- In case of manufactured goods market value of final product is considered only and not of intermediary products used. So aluminium, rubber, plastic etc used in making a jet shall not be counted in GDP  as final price of the jet is inclusive of all these stuffs.
(3)GDP considers National Geographical Border-whether a medical check-up fee or final cost of a jet produced; everything is counted provided it takes place in the geographical boundaries of USA. Revenue earned by US subsidiary of an Indian IT company is also counted as it falls in USA territory despite parent company being Indian, but revenue earned by Microsoft in Germany shall not be counted.
Nominal GDP vs. Real GDP
Nominal GDP being Unadjusted for Inflation is also referred as Unadjusted GDP. In USA, it is also called Current Dollar GDP as it is calculated on current value of the dollar.
In simple word Nominal GDP uses current prices to value current production.
Change in nominal GDP can be due to either change in production of goods and services or change in the prices of those goods and services.
So nominal GDP shall increase even if there is no rise in the production of 'goods and services', but due to increased price of those ‘goods and services’.
And this is the biggest drawback of the nominal GDP, it often misleads.
To tackle this shortcoming of nominal GDP, Real GDP is used.
Real GDP (adjusted for inflation) takes the valuation of goods and services of some base year and thus keeping same price, real GDP shows how production of goods and services has changed over years.
Health of the economy is measured by the growth of real GDP.

Let us understand all these arcane stuff with the help of a lucid illustration-
If in the year 2010, a country produces goods and services worth $ 1000 billion domestically then on the basis of prices of year 2010, both Nominal GDP and Real GDP shall be $ 1000 billion.
In the year 2011, that country produces goods and services worth $ 1200 billion on the basis of 2011 prices; this means Nominal GDP shall be $ 1200 billion.
If this GDP is calculated on the basis of prices of 2010 and if it comes out to be $ 1000 billion, this is nothing but real GDP as it is inflation adjusted figure (as change in price is not considered).
And thus real GDP figure tells us the reality that there is no increase in the production of goods and services and increment in Nominal GDP is due to inflation only.

Limitations of GDP
(1)   GDP growth does not ensure well being of common man. Because of few very rich people a nation can have higher per capita GDP, but that’s not the real picture.
(2)   GDP does not consider the parallel economy (wealth accumulated but not reported to the government).In a country like India, it is said that illicit money deposited by unscrupulous citizens  in foreign banks is as high as the Indian GDP, which is around $1.38 trillion.
(3)   GDP considers only that income which is reported to the government and in countries like India lot of big transaction settled in cash, never gets reported.


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