Decisions about allocation of a society’s resources require some understanding of how these decisions will affect the welfare of the citizens. The most convenient measure for the welfare of citizens has been found to be the volume of goods and services available in the society. Ideally we would like to assess how the availability of each type of good or service that people enjoy is changing. This, however, makes an overall assessment difficult when the availability of these goods changes by unequal amounts. Are we better off today because we have more of some of these products but less of some others? The concepts of gross national product (GNP) and its very close, and more popular, cousin gross domestic product (GDP) were developed to aggregate and measure the welfare effects of changing supplies of millions of goods and services in a modern economy.
To understand GNP, we start with the concept of GDP, which is the sum of the values of each and every good or service produced within the territory of a society during an accounting period. Every person who works for monetary wages is deemed to produce a good or a service equal to the wages paid to the individual. Every businessperson who coordinates a business activity is deemed to have produced goods or services equal to the value added to the goods and the profits of the business. Aggregate of these wages and profits is the GDP of the society. Divided by the population of the society (measured in the middle of the accounting period), GDP per capita provides an important measure of the average living standard of a country and is a useful measure for comparison of economic performance of different countries. GNP is the aggregate of all goods and services produced by citizens of a society anywhere in the world during an accounting period.
Gross Domestic Product And Gross National Product
GDP includes output of all residents of a country regardless of whether the resident is a citizen of the country or not. Thus the income earned by an American technician who accepts a job with a Japanese firm in Tokyo is counted as part of the Japanese GDP. A Finnish firm that establishes a subsidiary in the United States to manufacture cellular phones is contributing to the U.S. GDP whether it employs U.S. or Finnish workers or managers in its subsidiary. Profits earned by this subsidiary, however, will become part of Finland’s GNP even though the value added by this subsidiary will not be part of Finland’s GDP. For the measurement of GDP, it does not matter who the producer is—a citizen or a foreigner—as long as the work is done within the economy. U.S. GDP is the value of all goods and services produced within the 50 states and the territories of the United States—regardless who produces it. GNP, on the other hand, measures the output (or income) of all citizens, wherever they may have earned the income.
For most countries, there is only a small difference between GDP and GNP. In the first quarter of 2008, U.S. GDP was $14.1956 trillion, whereas the GNP was $14.3508 trillion, a difference of merely about 1.1 percent. This difference reflects receipts of $796.8 billion as income from abroad by U.S. residents and a payment of $641.6 billion to the rest of the world for income foreigners earned in the United States. For some countries such as Singapore there can be a large difference between GDP and GNP. Singapore’s economy depends heavily on foreign workers and Singapore’s citizens and firms invest a large part of their savings abroad. Two other countries for which the foreign sector creates a significant gap between GDP and GNP are Ireland and Switzerland.
Interpretation
There are a number of considerations to keep in mind when interpreting concepts such as GDP (or GNP). GDP is a measure of production of goods and services for “final” consumption. Two main categories of final consumption are goods and services used for consumption by the citizens (as well as the government) and goods and services used by business firms to make investments to build the future productive capacity of the society. Two other categories that are included in GDP are sales to foreigners (regardless of the use) and changes in inventories. By definition, therefore, intermediate goods—goods and services that are used as inputs for the production process—are excluded from calculations of GDP. It is sometimes difficult to define whether a product is destined for final consumption or as an input for production of other goods or services. A computer used by an individual for playing games is a final product, one used by a business in an intermediate product.
Treatment of some goods and services deserves special mention. Research and development expenditures are treated as intermediate products and not counted as part of business investments. Purchase of a house by a private citizen is treated as investment whereas purchases of all consumer durable items, including cars, are treated as consumption expenditure.
GDP includes goods and services produced for exchange in a market setup and are aggregated at the price at which the exchange takes place. GDP also includes some goods and services which are produced by governments or nonprofit organizations for citizens and provided to the citizens outside the market framework. These include defense services, educational services, law and order services, and emergency medical services. GDP figures, however, do not include values of care given by family members (looking after our children) or housework (a doctor marrying her cook would lower the country’s GDP), voluntary services, black market (unrecorded services paid for in cash), or illegal (street corner drug lord’s contributions to fighting emotional slumps), and barter activities (a plumber and a dentist helping each other out) since these activities are difficult to measure accurately. Some countries, however, may accept that such activities are part of the economic life and may adjust their GDP figures by a certain percentage to account for the impact of such activities.
GDP calculations do not make a value judgment as to the usefulness of the products or the services offered for sale in the economy. The assumption is that people have complete freedom of choice and purchase goods and services only when they see a gain from the transaction. All transactions that lead to higher GDP, however, may not be welfare enhancing. Increased level of road accidents will create demand for medical and repair services, giving rise to higher GDP, although a higher GDP in this case does not reflect an increase in society’s welfare.
GDP is aggregated by valuing every good or service at the market price—the price at which the exchange may have taken place. This could create anomalies and errors in GDP figures if a citizen or a firm carries out an activity itself replacing what was previously a market transaction. Consider an important “final” consumption product—housing for individuals. If a citizen rents the house, it is clearly a market activity because rent is paid. Should it cease to be included in the GDP if the renter buys the house? The house owner does not pay “rent” anymore, yet the consumption of final products has not decreased. To prevent a possible anomaly arising from situations like this, certain activities like house ownership are “imputed” a value equal to the value of a comparable market transaction (rental of an equivalent house). When comparable market transactions are not available, imputation can be made on the basis of costs of inputs. This type of imputation will be applied, for example, to on-the-job meals provided to employees.
GDP measures values of goods and services when they are produced, not when they are sold. The market transaction is deemed to have taken place at the price at which the goods were produced. Unsold goods at the end of an accounting period are included in the GDP as changes in inventories. Also, when the value of capital equipment that is wearing out or is damaged due to accidents is excluded from the GDP, we obtain the net domestic product.
GDP figures are estimates and not as accurate as, for example, company accounting statements. It is common for GDP figures to be revised by 1–3 percent. On occasions, some countries may revise their GDP figures by more than 15 percent (Italy in 1987, China in 2005).
Measurement of GDP
The national income accounting system divides an economy into four sectors:
- Households. This sector consists of private households, owner-occupants, and nonprofit institutions serving households. Income of this sector arises from wages and returns on investments. In the industrialized countries, household consumption may account for between 60 and 70 percent of the GDP.
- Businesses. This sector produces goods and services and includes private enterprises and government enterprises that engage in providing goods or services to other sectors at close to their cost of operations.
- Government. General government sector provides public goods and services including defense, law and order, infrastructure of the economy, education, etc., and earns revenues through taxes.
- External sector. Rest-of-the-world engages with an economy through trade and capital flows.
While each country has a different approach, there are two important sources of information that form the basis for the assimilation of national accounts.
Every country requires that business firms submit detailed information on their activities. This information provides the basis for estimation of flow of goods and services as well as payments made to individuals by the private sector in the economy. Government entities also submit detailed accounts of their activities. This provides the basis for the estimation of the contribution of government to the economy. Data on individual income and expenditures is deduced from data provided by the other two sectors.
GDP is measured in three different ways allowing for more accurate assessment of the level of economic activities in the society. In the expenditure approach, total expenditures made by consumers and public authorities, investment expenditures made by business firms and any increases in inventories are first added and then net imports (imports less exports) and taxes paid to government are subtracted to obtain the value of the GDP.
The income approach adds up the incomes earned by different factors of production. Labor’s income is measured as wages, entrepreneurs’ income is measured as income from self-employment, and capital’s income is measured as profit earned by firms. Values calculated by the income approach are often called gross domestic income. NDI is obtained after depreciation of capital stock of the economy is deducted from the sum of incomes of these factors of production. When income earned by society’s factors of production employed outside the country is added, we obtain GNI.
The same result should be obtained by following the output approach, in which value added at each stage of production in basic industries (agriculture or mining), manufacturing, and services and construction are added up. Total value added within the society should add up to the total income of all factors of production as well as to the total expenditures of the society.
GDP Comparisons
We are interested in two types of comparisons of GDP data. First, we would like to compare changes in the GDP of an economy over time. Second, we would like to compare different countries on the basis of their GDPs. For comparison within the same country, we need to differentiate between real GDP and nominal GDP and understand the importance of different ways of aggregating data. For international comparisons, we need to determine an exchange rate at which numbers of one country can be compared to others.
Nominal versus Real GDP: GDP and GNP figures are always collected in terms of current prices. These numbers provide the nominal value of the GDP. For comparisons over time, we would like to know how much of the change in the nominal GDP is due to increased volume of goods and services and how much is due to increase in prices. “Real GDP” figures measure the changes in the volume of production. Along with the value of the real GDP, a “GDP deflator” is calculated that indicates the inflationary component in the rise of the nominal GDP. The U.S. GDP almost doubled between 1990 and 2007, but grew only by about 35 percent in real terms over the same period.
Fixed-weight versus chain-weighted data: GDP figures are aggregated across millions of products and services by calculating their weights in a base year. Over time, however, there may be relative price changes in the economy, that is, prices of various goods and services may change by different amounts. In what is known as the fixed-weight method of aggregation, weight assigned in the base year continues to be used to aggregate GDP figures. This can introduce significant distortions if the relative price changes are large and do not reverse themselves in the future.
This distortion is best explained with the help of an example adapted from the work of Charles Jones. Suppose there are only two products in an economy— oranges and computers—and consumers spend half their income on each of these products in the base year. Further suppose that the number of oranges produced remains the same as in a base year but the number of computers grows by 10 percent a year. Since the real GDP measures the change in the volume of production, the growth of real GDP will appear to be close to 10 percent a year in a few years if we combine the output of the two products in terms of their weights in a base year. This is because the fixed-weight method of aggregation of data ignores the effects of price changes. In reality, as the volume of computers grows, their prices will fall. With a fall in the prices of computers, households will shift their expenditure patterns between computers and oranges. Chain weighted data attempts to correct for these price movements and shifts in expenditure patterns. This is achieved by assigning weights to different goods and services not according to a base period but by averaging the weights over shorter intervals. Thus, quarterly data may be used to calculate weights and then those weights averaged to yield annual chained-weighted data. All national income accounts data in the United States have been chain-weighted since 1997.
International comparisons: Since each country measures its nominal GDP in its national currency, an exchange rate has to be used to convert each country’s information into a common currency for international comparisons. Two exchange rates are used to make such comparisons—one actual and the other an artificial construct. We can use the actual exchange rate between the country’s currency and an international currency—usually the U.S. dollar—in which comparisons have to be made.
The actual or market exchange rates are heavily influenced by trade and capital flows of the economy and may distort the real value of goods and services available in that country. To overcome this problem, a concept of “purchasing power parity” exchange rate has been developed to compare national accounts across countries. The “purchasing power parity” exchange rate allows for the fact that due to differences in prices of many products, especially services, one can acquire a significantly different basket of goods in some countries than, say, in the United States for the same number of dollars. A purchasing power parity (PPP) exchange rate is defined as the rate that equalizes the cost of acquiring similar baskets of goods and services in two countries. PPP exchange rate provides a better comparison of the sizes of the economies.
According to the estimates of the World Bank, global GDP in 2006 amounted to US$48.245 trillion. With a world population in excess of 6.5 billion, this implies an average income of $7,439 per capita in the world. There is, however, a great disparity in the average incomes of countries around the world. There are many countries for which GDP calculations based on PPP exchange rates show dramatically different results than those based on actual exchange rates. For some countries, the GDP with PPP exchange rate shows much better results. For others, it shows better results with the actual exchange rate. The per capita income ranges from more than $80,000 (based on actual exchange rate) to only about $120.
Is GNP A Good Measure Of Welfare?
The concept of GNP was originally developed to measure the state of welfare of a society. The assumption behind this idea was that the living standard of citizens can be measured by the volume of goods and services available in the society. Has the concept lived up to its expectations? Are other measures of economic activities available that may provide a better indication of the state of a society’s welfare? Can this idea be modified to better reflect how well a society is meeting the needs of its citizens?
It is generally recognized that GNP measures only one aspect of human life—material well-being. GNP as a measure of welfare would still be acceptable if we could be sure that other aspects of our lives correlate strongly with the material well-being. Social scientists have always raised questions about this assumption, but the debate seems to have become more serious over the past decade. Some of the glaring omissions of GNP figures include consideration of distribution of income, environmental impact of economic development, and leisure time available to citizens. An OECD study has identified other measures that contribute to human welfare that correlate only poorly with GDP. These measures attempt to identify degrees of self-sufficiency, indicators of health including infant mortality rate and life expectancy, and extent of social cohesion.
The king of Bhutan introduced the concept of Gross Domestic Happiness in 1972 to measure spiritual as well as material development. The United Nations Development Programme has created a human development index that combines economic factors with health, social, and sustainability factors to provide a more balanced view of the state of welfare in countries. In early 2008 President Nicolas Sarkozy of France invited two economics Nobel laureates to develop a measure of economic activity that would take into account quality of life and environment. It is quite likely that the concept of GNP will be modified significantly in the near future.
Bibliography:
- Andrew B. Abel and Ben Bernanke, Macroeconomics, 5th ed. (Addison-Wesley,, 2005);
- Romina Boarini, Asa Johansson, and Marco Mira D’Ercole, “Alternative Measures of Well-Being,” OECD: Economics Department Working Paper no. 476 (2006);
- Bureau of Economic Analysis, U.S. Department of Commerce, “Measuring the Economy: A Primer on GDP and the National Income and Product Accounts, September 2007,” www.bea.gov (cited March 2009);
- Guide to Economic Indicators: Making Sense of Economics (Bloomberg Press, 2007);
- Charles I. Jones, “Using Chain-Weighted NIPA Data,” Federal Reserve Bank of San Francisco, Economic Letter, no. 2002-22 (2002);
- Francois Lequiller and Derek Blades, Understanding National Accounts (OECD, 2006);
- Christine Lindstrom and Martin Lindstrom, “Social Capital, GNP per Capita, Relative Income, and Health: An Ecological Study of 23 Countries,” International Journal of Health Services (v.36, 2006);
- David A. Moss, A Concise Guide to Macroeconomics: What Managers, Executives, and Students Need to Know (Harvard Business School Press, 2007);
- World Bank, 2005 International Comparison Program: Tables of Final Results (World Bank, 2008).
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