Imagine you live on a small island, and are in charge of its economy. Periodically, it would be very beneficial to know what the state of economic activity on your island is, especially if you're considering implementing taxes.
To do this, you would want to know everything that was being produced on the island and how much of it was produced. Then, you'd compare those metrics to last year to assess the growth / decline of your island's economy!
This embodies GDP, which is a metric used to measure economic activity!
What is GDP?
GDP, or Gross Domestic Product, is the total value of all final goods and services within the borders of a given country.
GDP is calculated every three months (quarterly). There are two methods for calculating it: the Expenditure Approach and the Income Approach.
Expenditure Approach
The conceptual way to understand GDP through the Expenditure approach is…
GDP = All purchases ± ΔInventories
The formula we will actually utilize for calculations is…
GDP = Consumption + Gross Investment + Government Purchases + Net Exports
...which can be abbreviated as:
GDP = C + I + G + Nx
Let’s try an example using the Expenditure approach!
Using the data below, calculate the GDP of your small island…
| Consumption = 800 | Gross Domestic Investment = 200 |
| Government Purchases = 300 | Government Transfer Payments = 100 |
| Indirect Business Taxes = 200 | Depreciation = 100 |
| Imports = 250 | Exports = 100 |
First thing I want to make clear is...
Don't get tricked by thinking you need to utilize all the values given to you! There may be some extras.
Utilizing the formula…
GDP = Consumption + Gross Investment + Government Purchases + Net Exports
We can see Consumption is 800...
| Consumption = 800 | Gross Domestic Investment = 200 |
| Government Purchases = 300 | Government Transfer Payments = 100 |
| Indirect Business Taxes = 200 | Depreciation = 100 |
| Imports = 250 | Exports = 100 |
GDP = 800 + Gross Investment + Government Purchases + Net Exports
...Gross Investment is 200...
| Consumption = 800 | Gross Domestic Investment = 200 |
| Government Purchases = 300 | Government Transfer Payments = 100 |
| Indirect Business Taxes = 200 | Depreciation = 100 |
| Imports = 250 | Exports = 100 |
GDP = 800 + 200 + Government Purchases + Net Exports
...Government Purchases are 300.
| Consumption = 800 | Gross Domestic Investment = 200 |
| Government Purchases = 300 | Government Transfer Payments = 100 |
| Indirect Business Taxes = 200 | Depreciation = 100 |
| Imports = 250 | Exports = 100 |
GDP = 800 + 200 + 300 + Net Exports
Now, for Net Exports, we've gotta find the difference between Exports and Imports...
Net Exports = Exports - Imports
...which, based on the table...
| Consumption = 800 | Gross Domestic Investment = 200 |
| Government Purchases = 300 | Government Transfer Payments = 100 |
| Indirect Business Taxes = 200 | Depreciation = 100 |
| Imports = 250 | Exports = 100 |
...we can see equal -150.
Net Exports = 100 - 250 = -150
Therefore, we can plug it into our GDP equation like so:
GDP = 800 + 200 + 300 + (-150)
When we solve this out...
GDP = 800 + 200 + 300 + (-150)
GDP = 1150
...we get a GDP for your island of 1150!
Income Approach
The conceptual way to understand GDP through the Income approach is…
GDP = All income earned producing GDP ± 2 adjustments
These 2 adjustments are for (1) depreciation and (2) indirect business taxes (usually sales tax), which are in GDP but not included in anyone’s income.
GDP = All income earned producing GDP + [Depreciation + Indirect Business Tax]
All income earned producing GDP can be represented as Net Income at Factor Cost (NIFC)...
GDP = [Net Income at Factor Cost (NIFC)] + [Depreciation + Indirect Business Tax]
...which can be broken down into Labor Income (Wages / Salaries) and Income of K.
GDP = [Labor Income (Wages / Salaries) + Income of K] + [Depreciation + Indirect Business Tax]
Let’s try an example using the Income Approach! Using the data below, calculate GDP…
| Wages & Salaries = 900 | Rental Income = 100 |
| Net Interest = 200 | Profits = 300 |
| Depreciation = 400 | Indirect Business Tax = 200 |
Utilizing the formula…
GDP = [Labor Income (Wages / Salaries) + Income of K] + [Depreciation + Indirect Business Tax]
...we can plug in 900 for Labor Income (Wages / Salaries).
| Wages & Salaries = 900 | Rental Income = 100 |
| Net Interest = 200 | Profits = 300 |
| Depreciation = 400 | Indirect Business Tax = 200 |
GDP = [900 + Income of K] + [Depreciation + Indirect Business Tax]
For Income of K (the K representing capital), we can add together these 3 elements of the table.
| Wages & Salaries = 900 | Rental Income = 100 |
| Net Interest = 200 | Profits = 300 |
| Depreciation = 400 | Indirect Business Tax = 200 |
GDP = [900 + (100 + 200 + 300)] + [Depreciation + Indirect Business Tax]
Next, we can plug in Depreciation as 400 from the table...
| Wages & Salaries = 900 | Rental Income = 100 |
| Net Interest = 200 | Profits = 300 |
| Depreciation = 400 | Indirect Business Tax = 200 |
GDP = [900 + (100 + 200 + 300)] + [400 + Indirect Business Tax]
...and Indirect Business Tax as 200 from the table...
| Wages & Salaries = 900 | Rental Income = 100 |
| Net Interest = 200 | Profits = 300 |
| Depreciation = 400 | Indirect Business Tax = 200 |
GDP = [900 + (100 + 200 + 300)] + [400 + 200]
...resulting in a GDP of 2100!
GDP = [900 + (100 + 200 + 300)] + [400 + 200]
GDP = [1500] + [600]
GDP = 2100
What is GNP?
GNP, or Gross National Product, is the output of goods and services by the workers of a home country, wherever they may be located in the world.
For instance, when looking at the United States, GNP is comprised of US workers at home and US workers abroad.
GNP = Output of US workers and firms (in the USA and abroad)
This reflects the total income of American workers and American firms.
Relating GNP to GDP mathematically
In order to find the GNP from GDP, we must exclude foreign output in the home country and include the output of native workers abroad. Mathematically, this can be written as…
GNP = GDP — [Foreign output in home country] + [Native output abroad]
We may be asked to solve for any of these terms, but all that's required is a simple algebraic rewriting of the equation.
When relating this mathematically to the United States, it'd look like so:
US GNP = US GDP — [Foreign output in United States] + [US worker output abroad]
Let's try out an example!
If GDP is 2000, US output abroad is 100, and foreigner production in the US is 300, how much is US GNP?
Starting with our equation...
US GNP = US GDP — [Foreign output in United States] + [US worker output abroad]
...we can plug in the US GDP of 2,000...
If GDP is 2000, US output abroad is 100, and foreigner production in the US is 300, how much is US GNP?
US GNP = 2000 — [Foreign output in United States] + [US worker output abroad]
...and then the foreign production of 200...
If GDP is 2000, US output abroad is 100, and foreigner production in the US is 300, how much is US GNP?
US GNP = 2000 — 300 + [US worker output abroad]
...and then the output of US workers abroad as 100...
If GDP is 2000, US output abroad is 100, and foreigner production in the US is 300, how much is US GNP?
US GNP = 2000 — 300 + 100
...resulting in a GNP of 1800!
US GNP = 2000 — 300 + 100
US GNP = 1800
Solving for a different variable
With GNP, you may be required to solve for a variable other than GNP. For example...
Calculate GDP if GNP is 5,000, if US output abroad is 400, and foreign output in the US is 800.
In this case, we're given GNP in order to solve for GDP!
Let's start with our equation for GNP...
US GNP = US GDP — [Foreign output in United States] + [US worker output abroad]
...and plug in 5,000 for GNP...
Calculate GDP if GNP is 5,000, if US output abroad is 400, and foreign output in the US is 800.
5000 = US GDP — [Foreign output in United States] + [US worker output abroad]
...400 for US output abroad...
Calculate GDP if GNP is 5,000, if US output abroad is 400, and foreign output in the US is 800.
5000 = US GDP — [Foreign output in United States] + 400
...and 800 for foreign output in the US...
Calculate GDP if GNP is 5,000, if US output abroad is 400, and foreign output in the US is 800.
5000 = US GDP — 800 + 400
...resulting in a GDP of 5400!
5000 = US GDP — 800 + 400
5000 = US GDP — 400
5000 + 400 = US GDP — 400 + 400
5400 = US GDP
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 | Apply | PRACTICE PROBLEMS (PREVIEW ONLY) |
 | Concept | GDP vs. GNP |
| Concept | GDP Deflator |
| Concept | Stock vs. Flow |
| Concept | Real Interest Rates (PREVIEW ONLY) |
| Concept | Loanable Funds Theory of Interest (PREVIEW ONLY) |
| Concept | Calculating Money Supply (M0, M1, etc.) (PREVIEW ONLY) |
