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Beginners Guide to Define GDP

Founder and CEO, Transfin.
Nov 30, 2018 11:37 AM 4 min read

Let's attempt to lay a beginners guide to define Gross Domestic Product (GDP). Now understanding the economy is an exercise in data. Ground realities are measured and tracked through numbers, which are adjusted and combined with other pieces of data to derive more numbers. A few layers later, we arrive at metrics whose trends inform our view on the state of the Economy. These metrics are everywhere in the News. Especially the much cited GDP.


However, most people struggle to understand their composition and meaning. 


Side note: With the Central Statistics Office (CSO) recalibrating, and in a way downgrading, GDP growth figures for the 2006-2012 UPA era, the opposition triggers a no holds barred attack on the incumbent government. Deeming this as an adequate signal on the increasingly confrontational relationship of economics with politics, I thought it is worthwhile to start with the much-cited GDP .


The Gross Domestic Product or GDP


An almost abused term – GDP is the total market value of all goods and services produced in a country for a given period. That is the definition. GDP doesn’t necessarily have to be for a country, it can be for a bigger region i.e. a combination of countries like the European Union, or a smaller one like a state – basically bound by the scope of its measurement.


The GDP is supposed to be representative of a country’s income or economic health and is hence an extremely important and a heavily cited Metric. Usually expressed in Dollars, the number on a stand-alone basis makes little sense. It is much more useful when compared vs. other countries to get a notion of how big one’s economy is.


The comparisons can be refined by adding layers. In its raw form, the GDP figure usually cited is the nominal GDP i.e. it doesn’t consider differences in cost of living or inflation between countries. This difference can be accounted for by taking adjusted numbers - termed as GDP at Purchasing Power Parity (PPP) for the former and Real GDP for the latter. The idea for PPP being that considering GDP is a proxy for the country’s economic health/income, it should be measured relative to its cost of living. By that logic, India’s Nominal GDP is 6th largest in the world, but in PPP terms it is 3rd largest. Real GDP in contrast doesn’t add any fundamental changes, but rather adjusts for inflationary effects. The rationale being that in an inflationary environment, the Nominal GDP gets artificially increased due to rising prices of goods and services and hence that effect needs to be stripped off. Real GDP, as the name sounds, is supposed to be a more Real indicator of economic health.

How to Make Sense of the Indian Economy: The Much-Cited GDP! 

More interesting than GDP is the idea of tracking GDP growth (in percentage terms). Low GDP countries normally demonstrate a higher rate of growth, one reason being that their growth rates are calculated on a much smaller base. This base effect is extremely important to understand the context to the numbers.


For instance, we often tend to compare ourselves with China while commenting that India has a comparable GDP growth rate. It is true both India and China demonstrate a 7-8% annual increase in GDP. But in India, the percentage increase is on a base of $2.6tr whereas for China it is on a base of $12.24tr. A 7% annual increase for India would be $182bn, but for China would be $857bn! Its good to keep this context while comparing GDP growth rates and before patting oneself on the back.


How is GDP calculated? Unless you’re an economist or statistician, that question is not important. There are different ways – factor cost, production method, income method, expenditure method etc. Each method has its pros and cons i.e. it is not exactly a science. As said earlier, the GDP number on a stand-alone basis does not make any sense. It needs to be compared. When comparing, you do need to ask if the numbers being compared are calculated on a consistent basis.


Comparing Real GDP with Nominal GDP is wrong! Comparing Nominal GDP with GDP at PPP is wrong! Are the figures in the same currency? Measured during the same period? Did the basis behind calculation change over a period?


That brings us to what has lately been happening in India.


In 2015, the method for calculating India’s GDP was changed from the factor cost method to the expenditure (at market prices) method. Another modification was to switch the "base year" from 2004/05 to 2011/12. Switching the base year broadly means to update the sectoral allocation (i.e. Services, Agriculture, Industry etc.), this making it more "representative" of the current economy. This new methodology was applied to numbers from 2012/13 onwards (i.e. representing a bit of the UPA tenure but the entire NDA tenure). The older series (i.e. 2006-2012 or representing entirely the UPA tenure) was not updated.


Now figures for the UPA tenure (2006-2012) have been updated as well, making the comparison more "like for like." 


Why the Fuss? 


Well, "experimental" estimates were released for 2004-2012 (again entirely UPA tenure) which showed them on average better than the NDA tenure which followed. But the CSO's latest numbers reverses that story. The rest is just politics.   


Shifting gears to Economics, to understand the 2015 change in detail, click this link. To really understand the technical nuances of how GDP is calculated, go to a university!



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