In financial and policy circles, "GDP"—Gross Domestic Product—is a commonly used term. GDP is a straightforward concept: it represents the total value of goods and services produced within a country or region over a specified time period. Essentially, it captures the economic output generated using the country’s own resources. When raw materials are imported and processed domestically, GDP is calculated by deducting the import costs (including customs duties) from the finished product's value to reflect the value added locally. It’s important to note that customs duties collected on imported raw materials also contribute to GDP, as do all types of taxes and government fees – but more of that later.
The prosperity of a nation is often measured by its Gross Domestic Product (GDP), which provides a straightforward ranking of countries based on economic output. However, GDP alone doesn’t fully capture a country’s economic landscape. It is a broad measure that doesn’t account for income inequality, individual earnings, or wealth distribution. As the term implies, GDP only reflects the total value of goods and services produced within a country. Nevertheless, GDP serves as a foundational metric for evaluating economic conditions. It also forms the basis for more detailed indicators, such as GDP per capita, which divides GDP by the population to offer insights into average economic output per person.
GDP & PPP
Another way to measure a country’s GDP is by using Purchasing Power Parity (PPP), which adjusts for price differences between countries. GDP by PPP calculates economic output by considering that the same amount of money buys different quantities of goods and services in various countries. The PPP theory suggests that exchange rates should adjust to balance purchasing power across currencies. PPP exchange rates reflect the relative costs of identical goods and services across countries, making GDP comparisons more accurate by accounting for cost of living, inflation rates, and price levels.
Example: Imagine a pair of Levi's jeans of the same make and size in two countries, the United States and France. If the jeans cost $70 in New York and €104 in Paris, and the exchange rate is €1 = $1.08, then the price in Paris is $112.32 in USD. Clearly, the jeans are more expensive in France, with a PPP rate of $112.32/$70 = 1.60. This means a person in New York has higher purchasing power for this item than someone in Paris.
Calculating GDP with PPP: Since gathering exact exchange rates for all products and services is impractical, economists use a representative "basket" of goods and services in each country. By comparing similar baskets across countries and taking a weighted average, a PPP exchange rate is established.
Tools like the "Big Mac Index" or "KFC Index" use the price of specific items (like a Big Mac or KFC bucket) in different countries to approximate purchasing power and living standards.
By dividing a country's nominal GDP by its PPP exchange rate, we obtain GDP on a PPP basis.
But when a country’s GDP on PPP basis is indicated as a percentage contribution to the world economy, it shows the share of global economic output produced by that country in terms of purchasing power.
Here’s how it works:
1.Calculate Country's GDP on PPP Basis: The GDP on a PPP basis is calculated for each country. PPP adjustments are made to account for cost-of-living differences, so prices for goods and services are comparable across countries.
2.Calculate Global GDP on PPP Basis: The total global GDP is computed on a PPP basis by summing the PPP-adjusted GDPs of all countries.
3.Compute Percentage Contribution:
Percentage Contribution = (Country’s GDP PPP/ Global GDP PPP) X 100
This percentage shows how much of the world’s economic activity (adjusted for purchasing power) is accounted for by the particular country.
Why It Matters
The PPP-based percentage contribution reflects real purchasing power and economic influence globally, providing a more accurate representation than nominal GDP for comparing economic strength across countries with different cost structures. This method, therefore, often highlights the significant contributions of emerging economies with lower cost structures, such as China and India, relative to developed nations.
GDP & Ratios
As mentioned before the GDP is a key metric for assessing a country's economic performance, but various GDP-related ratios provide a more nuanced view of the economy:
Debt-to-GDP Ratio: Calculated as Total Government Debt / GDP.
This ratio reflects a country’s ability to repay its debt. A higher debt-to-GDP ratio suggests a greater risk of a debt crisis. Developed countries typically have a high debt-to-GDP ratio, but due to their substantial revenue generation compared to developing economies, managing large debts is generally sustainable. However, in countries like Japan, with an aging population, there is a risk of future cash shortages. As the elderly typically do not contribute to the production of goods and services but have high consumption needs, this could strain financial resources over time. For underdeveloped economies, a debt-to-GDP ratio above 50% signals a need for careful review of financial practices and discipline.
Deficit-to-GDP Ratio: Calculated as Budget Deficit / GDP.
This measures the government’s fiscal discipline. A ratio exceeding 4% suggests an unsustainable fiscal policy.
Tax-to-GDP Ratio: Calculated as Total Tax Revenue / GDP.
This ratio assesses the government’s revenue generation. A low tax-to-GDP ratio implies limited resources for development, while a very high ratio may indicate excessive taxation. Generally, developed countries have a higher tax-to-GDP ratio, allowing them to invest more in public welfare and development, characteristic of welfare states.
Investment-to-GDP Ratio: Calculated as Total Investment / GDP.
This ratio indicates the level of investment in the economy. A ratio below 15% may signal insufficient investment, potentially stifling economic growth.
Trade-to-GDP Ratio: Calculated as Total Trade / GDP.
This ratio shows a country's openness to international trade.
Education-to-GDP Ratio: Calculated as Education Expenditure / GDP.
Reflecting investment in human capital, an education-to-GDP ratio below 2% may limit a country's future growth prospects.
Health-to-GDP Ratio: Calculated as Healthcare Expenditure / GDP.
This ratio measures the level of investment in healthcare.
Military Expenditure-to-GDP Ratio: Calculated as Military Expenditure / GDP.
This reflects the cost of maintaining a military relative to GDP, often influenced by a country's security needs. For example, Armenia’s military expenditure-to-GDP ratio was 5.4%, reflecting a high threat perception, compared to the United States, at 3.4%.
A nation's GDP growth rate affects daily life in both direct and indirect ways. Directly, GDP growth boosts employment opportunities, income levels, and potentially reduces tax burdens, while influencing inflation. Indirectly, a strong GDP provides economic stability, funds public services, and attracts foreign investments, which can increase access to credit and business opportunities. With steady growth of GDP, impact on stock market is also visible.
GDP also tangibly impacts housing affordability, healthcare, education, and infrastructure. It influences social benefits, interest rates, and job availability. Intangibly, it contributes to national pride, perceived security, and optimism for the future. Overall growth of GDP and economic development are directly related to each other.
When GDP declines, job losses, reduced incomes, limited credit access, and cuts in public services can follow, exacerbating poverty and inequality. For instance, a 1% GDP increase might create 100,000 jobs and raise household income by $1,000, while a 10% decrease could lead to 1 million job losses and a $10,000 income drop.
But it’s important to keep in mind that GDP figures are just one indicator of a nation's economic performance. Other factors, like income inequality and poverty rates, provide a more comprehensive picture.
