a.  Gross domestic product (GDP) is the market value of all final goods and services produced within the economy in a period of time.

b.   The GDP can be calculated using one of the two approaches, i.e. income approach or output approach.

c.  Using the output approach, the GDP can be calculated by summing up the amount spent on all goods and services or the amount of all final goods and services produced or the value-added.
Thus the GDP calculated using this approach should:

     i.  Represents all goods and services produced during the period

    ii.  Excludes transfer payments from the government (e.g., welfare)

   iii.  Excludes capital gains

   iv.  Determined by being sold in a market

     v.  Includes only final goods, not intermediate (i.e., items to be resold)

d.  Using the income approach, the GDP can be calculated by aggregating income earned by all households, companies, and the government within the economy.
While calculating the GDP using this approach, the following should be excluded:

     i.  The transfer payments from the government to consumer, and

    ii.  Capital gains

e.  The value of receipts from the sale of all the final goods and services is equal to the sum of value added at all levels of production. This can be explained with the help of the following example:
Suppose the final product in a one-product economy is bread. To produce the same the farmer sells the wheat to the flour factory, the factory sells the flour to the bakery and the bakery sells the bread to the retailer, from whom finally the consumer purchases the bread. The transfer of cash, i.e. the sale receipt at each stage and the value-added would be as follows:

We can see from the above table that the value of goods consumed by the end consumer is equal to the total value-added, both being $ 200. Thus the GDP here is $ 200.

Another thing that needs to be noted here is that, if the bakery had sold the bread directly to the consumer, the GDP of the economy would have been $ 150. However, the consumer could have invested the $ 50 saved on bread for purchasing other goods.

1.1.         Inclusion in and Exclusion from the GDP

a.  The GDP should include the imputed value of those goods or services that are produced during the period but are either not traded or are not traded at the real market prices.
For example, the GDP should include the imputed value of services such as rent payable on the owner-occupied housing, the services provided by the police, public health-care departments of the governments, etc.

b.  The income from the following should be excluded from the calculation of GDP:

     i.  Non-market activity

    ii.  Underground economy

   iii.  Illegal activities

   iv.  Barter

1.2.         Real and Nominal GDP

a.  The GDP could be classified as real or nominal, depending upon whether it is adjusted for the effect of inflation or not.

b.  Real GDP is GDP calculated as if the price level did not change. Real GDP per capita is often used as a measure of the standard of living.

c.  Nominal GDP is GDP unadjusted for any price-level change.

d.  The relationship between the real GDP and the nominal one can be written as follows:

e.  Thus the difference between the nominal and the real GDP is the inflation rate.

f.  Since inflation reduces the real value of the GDP, it is considered a GDP deflator. The GDP deflator or the implicit price deflator reflects the amount of the GDP that is associated with the change in the price level.

g.  The measure of GDP deflator can be calculated using the following equation:

1.3.         Components of GDP

a.  A simplified equation for the calculation of GDP is:

b.  Consumer spending mainly comes from the household sector; the private domestic investment is from the business sector, government spending comes from the government sector, and net exports (i.e. exports minus the imports) are from the external or foreign sector.

c.  The factor market consists of land, labor, and capital; which is provided by the households to the firms. In return, the households receive income in the form of rent, wages, and interest, etc.

d.  The financial markets provide the funds in form of debt and equity, which come in the form of savings from the households.

e.  Thus we have the different sectors in an economy providing different inputs, such as:

     i.  Household Sector: It constitutes the consumption and the savings in an economy.

    ii.  Firms: They provide the economy private domestic investment, which is the most volatile component of the GDP, as it is discretionary. On average, investments constitute approximately 20% of the GDP.

   iii.  Government: The government component of GDP includes the net taxes, i.e. the gross taxes minus the transfer payments. These are approximately 30% of the GDP.

   iv.  External Sector: The external sector constitutes exports and imports. If the exports are more than the imports, there is a net trade surplus; and if the imports are greater than the exports there is a trade deficit.

1.3.1.     GDP as per the Expenditure Approach

As per the expenditure approach, the GDP consists of the following:

a.  Consumption: Consumption includes all the consumption by the households (denoted by C).

b.  Investment: Investment includes the investment in two components:

     i.  Fixed investments (denoted by I), and

    ii.  Investment in Inventories (denoted by Δi)

c.  Government Expenditure: This consist of two components:

     i.  Government Regular Expenditure (denoted by G), and

    ii.  Government’s Fixed Investment (denoted by G_F).

d.  Net Exports: This consists of two things exports minus imports.

e.  Statistical Discrepancy: This accounts for the errors in totaling plus the seasonal errors.

1.3.2.     GDP as per the Income Approach

The GDP calculated as per the income approach consists of all the income earned by all the factors of production, i.e.:

a.  Wages: Wages include all the payroll expenses incurred on the human capital of the economy.

b.  Profits: It includes all the profits by both the corporations and government. It includes the earning before taxes (i.e. dividends, plus retained earnings, plus taxes).

c.  Interest: Interest income is all the income earned on the fixed investment.

d.  Private Profits: These include all the profits from the small businesses and the privately-held corporates.

e.  Rent: The expenditure on housing is not considered as consumption expenditure. Rather, it is considered a fixed investment. Thus, we calculate the imputed income from rent and include it in the national income of the economy.

f.  Net Taxes: It includes indirect business taxes less subsidies.

The GDP includes National Income (calculated as per the income approach), capital consumption allowance, and statistical discrepancy.

1.4.         Personal Income

a.  Personal income is a measure of total household earnings in an economy. It also defines the capability of households to make spending.

b.  It can be calculated using the following equation:

Personal Income = National Income – Indirect Business Tax – Corporate Taxes -Retained Earnings + Transfer Payments 

c.  To calculate the personal income we start with the national income and reduce from it all its components that do not accrue to the households.

     i.  The indirect business taxes and corporate taxes accrue to the government sector and not households.

    ii.  The retained earnings are retained by the corporates and are not available to the households for spending.

   iii.  The transfer payments, on the other hand, are added because it is available to the household sector for consumption and spending.

1.5.         Personal Disposable Income

a.  It is the final personal income after reducing the personal taxes on these incomes, which is finally available for disposal to the household sector.

b.  The equation for calculating the personal disposable income is:

Personal Disposable Income = Personal Income – Income Taxes

c.  Personal disposable income can be used either for consumption or savings.

Savings = Personal Disposable Income – Consumption – Paid Interest – Transfer Payments to Foreigners

d.  Savings consist of all the personal disposable income that is not consumed or paid in the form of interest or transferred to the foreigners. That is:

1.6.         Relationship Between Savings, Investment, Fiscal Balance & Trade Balance

We can depict the relationship between the savings, consumption, fiscal balance, and trade balance as follows:

a.  The simplified equation for the national income is:

Y = C + I + G + (X – M)

This equation signifies that the total output in an economy equals the consumption plus investment, plus government spending and net exports.

b.  If we subtract taxes (i.e. T) from both sides, we get:

Y – T = C + I + (G – T) + (X – M)

The right-hand side of the equation represents the disposable income (say Y_d). Thus, the national income minus the taxes equals the disposable income.

c.  Now, if we subtract C from both the sides, we get:

Y_d – C = I + (G – T) + (X – M)

The left side of the equation represents disposable income less consumption, which equals savings.

d.  Thus we can say that:

S = I + (G – T) + (X – M)

This represents the equation for the fundamental output in an equilibrium economy.

e.  We can interpret the above equation by saying that, saving can be used by:

     i.  Investment spending (I),

    ii.  Government’s deficit (G-T), and

   iii. Claims against foreigners (X-M).

e.  Thus, to understand the relationship between the different components of the above equation we can change the sides of its components, as follows:

     i.  If we reduce the government deficit from both sides we get:

S + (T – G) = I + (X – M)

That is, savings plus the government surplus (note that the terms on the left side are ‘T – G’ instead of ‘G – T’, hence it is surplus and not deficit) equals the investment plus trade surplus.

    ii.  If we reduce trade surplus from both sides, we get:

S + (M – X) = I + (G – T)

That is, savings plus the trade deficit equals investment plus the government deficit.
This is the worst situation as there is both a deficit at the trade end and the government’s spending.

   iii.  If we reduce both trade surplus and government deficit from both sides, we get:

S + (M – X) + (T-G) = I

That is savings plus the trade deficit and the government’s surplus equals the investment.