Gross Domestic Product (GDP): Three Approaches, Importance, How to Calculate

Gross Domestic Product (GDP) is the total market value of all final goods and services produced in the domestic economy during a certain period. Alternatively, we can also define GDP as the total expenditure or total income in the economy. 

Central Bureau of Statistics measures GDP at constant prices (real GDP) and current prices (nominal GDP); releases it quarterly or annually. Percentage year to year change of real GDP reflects economic growth, while the value of nominal GDP reflects the economic sizes of the country.

Three approaches in Gross Domestic Product calculation

Three approaches are to calculate GDP, namely the income approach, expenditure approach, and the output approach. The result from the three approaches should be equal. Although, in practice, it is not because of statistical discrepancies, an error dues to the difference in calculating methods and incomplete data sources.

Output approach

Under this approach, GDP is the sum of the market value of final goods and services. Alternatively, the Statistics Bureau calculates it by summing value added to the products and services at each stage of the production chain. 

Please note, when using the market value of the final product, the Bureau excludes semi-finished goods in the calculation because the value-added of these items is reflected in the selling price of the final goods produced.

For example, assume that the goods in the economy are only bread and one producer. The producer produces ten units of bread for IDR100.

Say, to produce all bread; the bread producer buys IDR500 worth of flour. And, to produce fluor, flour producers bought wheat from farmers for IDR200.

Using the value of the final good, GDP is equal to IDR1,000 (IDR100 x 10). That value will be the same as the added value of the supply chain, which is IDR500 + IDR300 + IDR200.

• The value-added of bread is IDR 500 = IDR1,000 – IDR500
• The value-added of flour is IDR300 = IDR500 – IDR200.
• The value-added of wheat is IDR200.

Expenditure approach

The expenditure approach sums total expenditure for goods and services produced in the domestic economy over a specified period. The spending comes from four macroeconomic sectors: household, business, government, and external.

Mathematically, we formulate this approach as:

GDP = C + I + G + (X – M)

Where

• C = Household spending 
• I = Business investment
• G = Government expenditure
• X = Export
• M = Import

Imports are negative because, by definition, GDP only counts goods and services produced domestically. Meanwhile, imports represent foreign production purchased by domestic consumers. Conversely, exports are positive because they represent domestic goods that foreign consumers buy. 

Income approach 

Under this approach, GDP is the sum of the money received by owners of factors of production in the economy. Types of owner income include rent, profits, employee compensation (such as wages), and interest.

Under the income approach, GDP at market prices can be calculated as follows:

GDP = NI + CA + SD

Where

• NI: National income
• CA: Capital consumption allowance
• SD: Statistical discrepancy

Meanwhile, national income equals to Employee compensation + Pretax income of company + Interest income + Owner income + Rent + Indirect business tax less subsidies.

Owner income refers to income received by non-legal owners and unincorporated businesses (small business).

Why is Gross Domestic Product important?

We use GDP as a country’s economic health indicator. Positive growth in real GDP shows expansion, while negative growth shows contraction. Further, negative real GDP growth for two consecutive quarters indicates a recession.

GDP also serves as an essential input for economic policies. When contraction occurs, governments will adopt an expansionary policy to stimulate economic activity, either by increasing its spending, lowering tax, lowering policy rates, or other policy instruments. 

GDP is also crucial for businesses in preparing their strategy. They are confident when real GDP is growing. They are likely to hire new employees, open new factories, and launch more products. In contrast, when real GDP growth falls, they are reluctant to invest in capital goods and take cost-cutting measures such as through layoffs.

In the capital market, GDP considerably affects the stock market. Stock prices weaken when GDP falls as more businesses make less money. And, during this period, investors tend to reallocate their portfolios more into defective stocks. Contrarily, in the bond market, investors expect bond prices to increase as slower real GDP growth urges the central bank to lower interest rates. 

When real GDP grows stronger, households are more confident about their income and employment as businesses employ more workers and are likely to offer a high salary. However, if the increase followed by a high inflation – boom period -, such confident might vaporizes because high inflation reduces their purchasing power.

Nominal GDP or real GDP, which one should we use?

Real GDP reflects the monetary value of total output adjusted for price changes. It is measured using constant prices. Thus, it ignores the effects of inflation or deflation in the final value. Hence, its change over time reflects the change in the quantity of output. For this reason, the percentage change in the real GDP, by definition, measures economic growth.

Conversely, nominal GDP is not adjusted for price changes because of using current prices in its calculation, which increases during inflation and decreases during deflation. Therefore, its value will change due to changes in price, quantity, or the combination of both. For this reason, the Bureau does not use it as an economic growth measure.

Then, when do we use nominal GDP?

Nominal GDP reflects the current economic size. We can use it to compare it between countries. Also, we can use it to calculate the current contribution of output from the GDP-forming sectors, for instance, comparing the mining sector and the manufacturing sector.

Please note, for international comparisons of economic size between countries, differences in the purchasing power of currencies make the comparison unreasonable. For this reason, we should use nominal GDP values after adjusted by purchasing power parity (PPP).

Gross Domestic Product per capita

While GDP shows the aggregate statistics, GDP per capita measures output per person. To get the number, we divide GDP by the total population. 

Economists usually focus on annual changes in real GDP per capita in analyzing the trend of the country’s living standard. Positive moderate growth in real GDP per capita is preferable and should have a significant impact on improving living standards in the long run. 

In contrast, high growth in real GDP per capita usually becomes a warning sign. It is not always good because high growth traditionally followed by high inflation, which harms people’s purchasing power. 

What to read next

• What is economic activity?
• How Do Economists Measure Economic Activity?
• Circular Flow of Income: Types and Descriptions
• Gross Domestic Product: Three Approaches, Importance, How to Calculate
• Gross National Product: Meaning, Importance, How to Measure
• Injections and Leakages in the Circular Flow of Income: Examples and Impacts