HOW WILL YOU EXPLAIN GDP TO A LAYMAN?

“India is the fastest growing economy in the world and it is unlikely to be challenged soon. India’s GDP growth will hover near 7.5% by 2020.” -Organization for Economic Corporation and Development

“With investment picking up and consumption remaining strong, India is expected to grow 7.3 percent in the fiscal year 2018-2019, and average 7.5 percent in 2019 and 2020.” -Global Economic Prospects report by World Bank

“Near-term macroeconomic outlook for India is ‘broadly favorable’. Growth is forecast to rise to 7.3 percent in fiscal year 2018/19 and 7.5 percent in 2019/20 on strengthening investment and robust private consumption.” -A latest report by International Monetary Fund

What is the relation between the growth of a Nation’s economy and GDP? Why is this figure so important to the Global Organisations that they publish reports on it? Moreover, how do we calculate the GDP of a nation and what does it have to do with our personal income? How does our personal income contribute to the nation’s GDP?

An unaware, but the curious mind will try to find the answers to these questions. In this article, we have tried our best to provide not all, but some of the answers by explaining the concept of the GDP in the easiest possible way.

GDP or Gross Domestic Product of an economy is the aggregate annual value of final goods and services produced in one financial year within the boundary of that economy. Here economy refers to the particular state or nation under consideration.

Let us suppose that in an economy, only biscuits are produced. In one year (say year 0), say 1000 kg of biscuits are produced. Then the GDP of the economy will be the value of the biscuits. Now, if one kg of biscuits costs Rs 50, then the GDP of the economy becomes Rs 50*1000= Rs 50000 in year 0.

Now, for the next year (say year 1), there may be a change in the volume of production, or the price of goods, or both. In that case, four scenarios are possible.

Scenario 1: Production volume changes but price remains same.

Let the production of biscuits increases by 100 kgs. In that case, GDP will increase by the value of an extra 100 kg biscuits. Now if the price remains constant in year 1, the GDP will increase by Rs 5000.

Scenario 2: Production volume remains same but price changes.

Let the price of the biscuits somehow increases by Rs 5 per kg. In that case also, the GDP in year 1 will increase by Rs 5000. But there is no increase in the volume of production, so no actual increase in GDP.

To measure the actual change in GDP, we calculate the values of the product on basic prices i.e. the prices defined in year 0. The year 0 is called the base year and the GDP calculated like this is called GDP at constant prices or real GDP. GDP calculated on the prices of year 1 is called GDP at current prices or nominal GDP. So, in scenario 1, real GDP and nominal GDP both remain the same as price does not change. In scenario 2, real GDP remains the same (as there is no increase in production volume) but the nominal GDP will increase.

Scenario 3: production volume and price both change. In that case, both values will change.

Scenario 4: production volume and price both remain the same. In that case, both values will remain the same. The increase in GDP shall be 0%. This case has never occurred yet.

Now, look at the definition again. The word ‘final goods’ is mentioned there. The calculation for GDP is a bit more complicated. It is not just the added sum of production of all the industries in a given financial year. Suppose a farmer produces wheat worth Rs 1,00,000 in a particular year. A bread maker buys wheat worth Rs 50,000 and produces bread worth Rs 2,00,000 using that wheat. What is the output of an economy consisting of only these two producers? It won’t be Rs 3,00,000; in fact, it will be Rs 2,50,000; as wheat worth Rs 50,000 is used to produce bread which is the final product. By adding this price we shall commit the error of double counting. Hence, the goods consumed during the production process are not counted in GDP calculation and only the final products (and services) are taken into account.

The method described above to calculate the GDP is called ‘product method’. We can also calculate the GDP by adding the income of all the individuals and firms (income method) or by adding the expenditure incurred by the individuals and firms (expenditure method).

By adding the production of all the industries within a given boundary, we calculate GVA (Gross Value Added) or ‘GDP at factor cost’. As the government earns by levying taxes and loses money by giving subsidies, hence these two factors should be included while calculating GDP of a country. This is defined as ‘GDP at market prices’ and calculated by the following formula:

GDP at market Price = GDP at factor cost + Taxes – Subsidies.

In India, the Ministry of Statistics and Programme Implementation (MoSPI) has the responsibility to monitor and publish the GDP data. India usually revises the GDP base year in every 5 years to accommodate the change in product basket (by removing outdated products and including fresh products). A product basket has to be defined to calculate the GDP which includes the representative products of each type. Of course, we cannot take the value of each and every product available in the market and measure their change in price, as it is a very cumbersome process and practically impossible.

By last fiscal, the base year was 2011-12 which has been changed to 2017-18 from this financial year. Usually, nominal GDP is always higher than real GDP due to the increasing trend of inflation. However, it is real GDP which becomes the headline.

GDP is the measure of the richness of the people in an economy. The more we earn, the more we purchase, the more becomes the demand and so the production. GDP is the measure of monetary strength of a country on an international platform. That is why this figure has this much importance.

Now, as we mentioned inflation, so the questions definitely come to one’s mind, “How do we measure inflation? What are the factors deciding inflation? How and why it affects our economy?” Well, let this be the subject of our next article.