What is the Gross Domestic Product and Why is it Important?

In other postings, we have looked at 2 important economic indicators: the Consumer Price Index (CPI) and the Unemployment Rate. In this posting we will examine the Gross Domestic Product (GDP) and how it relates to the Real Gross Domestic Product.

The GDP is the sum of domestic consumption; new capital investments; government spending, and the difference between the value of goods imported into the United States and the value of exports to other countries. In mathematical form:

GDP = consumption + capital investment + government spending + (exports − imports),

Or

GDP = C + I + G + X_N; where

C = Consumption, I = Investment, G = Government Spending (federal, state, county, and local), and X_N is the "Net Export," the difference between the value of goods imported into the United Sates and the value of goods exported from the United States. Since X_N is the total value of imports minus exports X_N can be, and usually is, a negative number.

Historically, the GDP has increased each year. The problem facing economists is how to account for changes in the price, either upward or downward, caused by inflation or deflation on the goods and services that make up the GDP. This is done by the use of the GDP Deflator which, in turn, will be used to determine the real GDP (RGDP). To understand the RGDP and the GDP Deflator, we can use a brief example.

(Note: For those with a strong aversion to math, just take my word for it when I say that inflation affects the computation of the RGDP. You can skip the next few paragraphs and start reading again when you see the next note).

The GDP is calculated by multiplying the number of individual units of goods and services by their unit cost, with the GDP being the sum of the costs of all the individual units. Now we want to know how price changes have affected the monetary value of this year's GDP. We first take this year's GDP and rename it the nominal (not adjusted for inflation) GDP. The next step is to compute the GDP by multiplying the individual units in this year's GDP by their

cost in a different year. Usually, the previous year's unit costs are used in place of the current unit costs and the sum of these are added together to create what we can call the index, or base, year GDP. This can be stated as:

GNP Deflator = nominal GDP ÷ base year GDP × 100

Let's say that we have 5 items of domestic production in the current year, with their price per unit:

Item A = 10 units × $1.50 per unit/item = $15

Item B = 7 units × $7.00 per unit item = $49

Item C = 20 units × $1.00 per unit item = $20

Item D = 10 units × $5.00 per unit item = $50

Item E = 15 units × $2.00 per unit item = $30

From the above, we get a dollar value of $164. This is our nominal GDP. Since the nominal price per unit has changed over time, we will substitute the unit prices from a previous year for the current unit prices:

Item A = 10 units × $1.00 per unit/item = $10

Item B = 7 units × $7.00 per unit item = $49

Item C = 20 units × $0.75 per unit item = $25

Item D = 10 units × $4.00 per unit item = $40

Item E = 15 units × $1.00 per unit item = $15

We call this total ($139) the base year GDP. By substituting our numbers into the above equation, we gets:

GDP Deflator = $164 ÷ $139 = ~1.18 × 100 = 118

In plain English, this means our nominal GDP has been inflated by about 18% (118-100) from the base year. Therefore, the real GDP is actually $139 ($164 × [100% - 18%]). After allowing for inflation, the real GDP is actually $35 less than the nominal GDP.

(Note: Math haters, resume reading here)

There is one more important concept related to the GNP that must be mentioned: the natural real GDP.

When I talked about the unemployment rate in the last posting, I mentioned that the natural unemployment rate (which is usually taken to be ~5%) is considered to be the same as full employment. The natural real Gross Domestic Product is the theoretical real GDP when the labor force is at full employment (i.e. when 95% of all available workers are employed).

The natural real GDP and the natural unemployment rate are important to economists because these are the points that define whether the economy is stable, inflationary, or deflationary.

Inflation and deflation, their potential causes, and their effects on the GDP, will be discussed in more detail in an upcoming post.