Income is one of the most significant factors in measuring economic performance, and gross domestic product (GDP) is the most commonly used measure of a country's economic activity. In short, GDP reflects the value of all final goods and services legally produced in an economy in a given time period.
The distinction between final goods and intermediate goods is an important one. A tomato sold to a ketchup manufacturer would NOT be included in the GDP number, while a tomato sold in a store as produce would be included, as it represents the final use of that good. It is also worth noting that trade in illegal goods and services are also excluded from GDP figures.
There are two ways of approaching GDP – the expenditure approach and the resource cost-income approach. The expenditure approach totals the amount spent on goods and services during a year, while the resource cost-income approach adds up the payments made to suppliers of resources and other inputs that go into goods and services.
The expenditure approach is arguably more common, and it breaks GDP into four commonly watched components – personal consumption, gross profit domestic investment, government spending, and net exports to foreigners. Personal consumption has long been the largest component of GDP in the United States and is made of household spending on goods and services. Domestic investment refers to spending on fixed assets (capital expenditures) and additions made to inventories during the year.
By comparison, under the resource cost-income approach, compensation paid to employees is the largest component of GDP, with depreciation, indirect taxes, interest, corporate profits, and the income of the self-employed following. (To learn from the past, check out A Review Of Past Recessions.)
Going a step further, there are other types of analysis that can be applied to GDP. Real GDP is the broadest view of an economy's output, and the one most widely used by economists. Real GDP differs from nominal GDP in that it attempts to adjust for rising price levels to determine what amounts to changes in the volume of activity in an economy.
Economists observe not only the absolute level of GDP, but its growth over time. In fact, most discussions of GDP are undertaken in terms of growth. Going another step further, it is often useful to examine GDP in the context of its relationship to the number of participants in an economy.
GDP per capita often correlates to the standard of living and the extent of economic development in a country. The U.S. and China, for instance, have similar GDPs in absolute terms, but the per capita GDP in each country is much different and reflects the much higher standard of living in the United States.
There are some drawbacks and limitations to the use of GDP. GDP excludes any unpaid activity as well as illegal activity, so it cannot account for the value of all economic activity in a nation. GDP also fails to account for reductions in quality of life and losses to natural disasters or crime. The destruction wrought by an earthquake, for instance, would not be accounted for in GDP accounting, but the rebuilding efforts would be counted. Likewise, even per-capita GDP does not necessarily reflect the wealth of the typical citizen, as a majority of low-earning citizens could be offset by a small group of very high earners. (For more on GDP, read High GDP Means Economic Prosperity, Or Does It?)
There are other significant measures of income to consider. National income refers to the total income paid to owners of human capital (wages for labor) and physical capital, and includes both domestic and foreign income. National income can also be calculated as the sum of wages, interest, self-employment income, rent and business profits.
Personal income, in contrast, is the income received by individuals; it excludes corporate profits and social security taxes, but adds back transfer payments (like Social Security), interest and dividend. Disposable income is personal income that is actually available for spending or saving; it is personal income net of personal income taxes.
Models of Growth
While the large majority of economists basically agree with the use of metrics like GDP and GDP per capita as measures of growth, there is considerably less agreement in how to explain how economies grow over time.
Some models hold that growth is exogenous – long-term growth is determined by factors external to the economy. Other models post that growth is endogenous – long-term growth is determined by factors within the system. More specifically, there are models like the Harrod-Domar model that examine the consequences of fixed capital and labor ratios and the propensities to save. This model highlights the problems of rigidities in the capital/labor ratio and savings rate. By comparison, the Solow model holds that growth in GDP is explained by population increases, technical progress and increased investment. As with many economic models, these are not so much predictive as explanatory; seeking to identify the impact of certain variables and conditions.
While economic growth is clearly an important objective for most governments, most economies do not operate at their full potential. Often there is a gap between the amount of GDP actually produced and the potential GDP that the economy could produce with full employment and full resource utilization – this gap is called the output gap (or the GDP gap). (For examples of some fast growing economies, see The 6 Fastest-Growing Economies.)
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