Question

A. Separately define each component of Gross Domestic Product.

B. What are two separate purposes of measuring the GDP for each country?

C. Benjamin Franklin once said, “As far as I know, no country ever has been ruined by trade.” Explain why more international trade always increases the GDP.

Answer 1

A. Gross Domestic Product (GDP)

Gross Domestic Product (GDP) is the money value of all final goods and services produced within the domestic territory of a nation. It represents total income attributable to factor services rendered to resident producers of the country irrespective of whether they are supplied by normal residents of the country or others.

Domestic territory of a country consists of the territory lying within the political frontiers including territorial waters of a country and the following.

1. Ships and aircrafts owned and operated by the residents of the country between two or more countries.

2. Fishing vessels, oil and natural gas rigs and floating platform owned and operated by residents of the country in international waters or engaged in extraction in areas in which the country has the exclusive rights of exploitation.

3. The embassies, consulates and military establishments of the country located abroad. Thus it is clear that the domestic territory of a nation is wider than its political frontiers.

Thus, GDP is the monetary value of all final goods and services produced by the all the people within a domestic territory during an accounting year. It does not include the output of its underground economy (shadow economy or black economy). If GDP increases year by year, an economy is understood to be performing well. Income of foreign nationals living in domestic nation is counted in domestic nation’s GDP, but income of nationals of domestic nation outside the country is not counted in GDP.

The four components of gross domestic product are personal consumption expenditure, investment expenditure, government spending, and net exports. This tells you what a country is good at producing. It can be written as,

GDP = C+ I + G + (X - M)

Where,

C = Consumption expenditure

I = Investment expenditure

G = Government expenditure

X = Exports

M = Imports

X-M = Net export

The components can be explained as follows.

1. Personal Consumption Expenditures

Personal consumption expenditures include:

A. Goods

Goods are tangible objects. They are further sub-divided into two even smaller components.

1. The first is durable goods. These are items that have a useful life of three years or more. Eg, automobiles, furniture, books, home appliances, consumer electronics, tools sports equipment, jewellery, medical equipment etc.

2. The second is non-durable goods or soft goods. Eg, fast-moving consumer goods such as cosmetics and cleaning products, food, fuel, medication, paper, textiles, clothing, and footwear etc. The retailing industry is a critical component of the economy since it delivers all these goods to the consumer.

B. Services

Services are paid aid, help, or information. Most are non-tangible. Eg, banking, health care, education..

2. Investment expenditure

Investment means additions to the physical stock of capital during a period of time. Investment, also referred to as fixed investment is the amount of capital goods added by a country in a given year. It is very important to segregate the goods produced for present consumption versus the goods that will help in maximizing production in the future. Investment is a very essential component of GDP which gives a good idea about what the GDP of an economy in the future years will be. A higher investment in capital goods by the economy is a good sign indicating that production is expected to take off in the forthcoming years. The investment component is further divided into residential and non-residential investments. Most of fixed investment is non-residential investment and it is a good leading economic indicator.

Investment can be further classified into following four categories:

a. Business Fixed Investment: It is the investment amount that business units spend on purchase of newly produced capital goods like plant and equipment.

b. Inventory Investment (or change in stock): It is the net change in inventories (stock) of final goods awaiting sale of finished goods, semi-finished goods and raw material.

c. Residential Construction Investment: This is the investment amount spent on construction residential houses or flats.

d. Public Investment: This includes capital formation by government in the form of building of roads, bridges, canals, schools, hospitals, etc. for the public welfare.

3. Government Expenditure

Government expenditure includes all government consumption, investment, and transfer payments. This component summarises government spending on goods and services. It includes

a. Purchase of intermediate goods and

b. Wages and salaries paid by the government.

4. Net Exports of Goods and Services

Net exports is also known as balance of trade or commercial balance. It shows the difference between domestic spending on foreign goods (i.e., imports) and foreign spending on domestic goods (i.e., exports). Thus, the difference between Exports (X) and Imports (M) of a country is called Net Exports (X- M).

B. GDP can be expressed in two different ways—nominal GDP and real GDP.

Nominal GDP takes current market prices into account without considering inflation or deflation. Nominal GDP looks at the natural movement of prices and tracks the gradual increase of an economy's value over time.

On the contrary, real GDP factors in inflation. That is, it accounts for the overall rise in price levels. Economists generally prefer using real GDP as a way to compare a country's economic growth rate. It is calculated using a price deflator—the difference in prices between the current and base year, which is the reference year. Real GDP is how economists can tell whether there is any real growth between one year and the next.

C. Gross Domestic Product (GDP) is the money value of all final goods and services produced within the domestic territory of a nation. Suppose, the economy has no trade with other nations or it is an autarky. Then the output produced will be only for the domestic consumption. Whatever is produced are used only within the country. In this situation the scope of production is limited within the country. But when there is an international trade, the resources of the economy are used utilised efficiently to produce the commodities in which it has comparative advantage and the higher production or output with an expanded market internationally leads to an increase in the GDP. Now the goods and services produced domestically are marketed not only internally but internationally. Thus international trade is important because the scope for specialization increases if countries are expecting a wider market for their outputs. If the nation gains from trade, its income increases which leads to an increased private consumption expenditure and the increased investment expenditure in the production, trade and commerce. Thus international trade will fetch its good outcomes if the nation gains from its traded goods and services. The effects of globalization has this positive externality in most of the nations engage in international trade. In this view the words of Benjamin Franklin, “As far as I know, no country ever has been ruined by trade” is much worth.