By: Cynthia Kurtz
Posted: 5/21/2014
When someone says "GDP" we know the reference is to Gross Domestic Product. You hear the term being bantered about all the time as a way to compare a country's output, determine its economic health, and even judge its standard of living. How effective is the GDP at making these comparisons?
The answer is "it depends." There are different ways GDP can be calculated and different ways to use it as a comparison. Let's start at the beginning. There are two basic approaches to calculating GDP: Income or Expenditure.
The Income approach for GDP is the sum of everyone's earnings. The formula is W + R + i + PR = GDP. W is wages or labor income including salaries, benefits and unemployment insurance; R is rental income from properties and patents; i is interest income received by households and PR are profits made by companies after paying for the costs of doing business.
The more common Expenditure approach is a sum of everything we spend. In this case the formula is C + G + I + NX = GDP. C is consumer spending - the total sales of all products and services; G is government spending; I is industry investment - meaning how much businesses spent on capital; and NX is net exports - the total value of goods exported minus the total value of goods imported.
The numbers used in these formulas depend on a number of factors. The Official Exchange Rate (OER) compares a country's output using its own currency over a set period of time such as one year or one quarter. The OER method tells you the "size" of the economy but it can be manipulated. For example, China pegs the value of the Yuan so it is always lower than the dollar. That means the costs of goods are lower in China so the GDP will be lower.
Another arguably more useful method is Purchasing Power Parity (PPP) which takes into account exchange rates and inflation. The value of each of the numbers in the formula must be determined in like currencies. Keeping with our China example, the value of everything sold in China would be adjusted to what it would cost in the United States. In 2012 the China GDP using PPP was $4 trillion more than what was computed using the OER method.
Finally, there is the GDP per Capita. This is what economists use to compare standard of living. Here is where population comes into play. A country could have a high GDP but when divided by the number of residents, a very low average economic output per person indicating a low standard of living.
While the outcomes of using either the Income or Expenditure approach should be similar, the rankings of individual countries can change dramatically when changing the inputs using the ORE, PPP or GDP per Capita. According to the CIA World Fact Book, in 2013 the United States had the largest economic output using PPP data, but dropped to second behind the European Union using OER data and to fourteenth in GDP per Capita.
Bobby Kennedy is credited with saying "the GDP measures everything except that which makes life worthwhile." Income disparity, population health and quality of life can't be adequately measured by GDP.
GDP is a good way to get a read on emerging economies and watch how well public policies are working in countries which are attempting to build a stronger economic base. So I agree it isn't necessarily so very important to be at the top of each of the GDP rankings. Still there is something comforting about seeing our country consistently at or near the top.
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