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What really means Gross domestic product (GDP)

by on 20/01/2019

What really means Gross domestic product (GDP)

According to Investopedia, Gross domestic product (GDP) is the monetary value of all the finished goods and services produced within borders of politically sovereign entity, in a specific time period.

But before to continue with our analysis, we need to differentiate between two different measures of the GDP change, the Nominal GDP and the Real GDP measure.

Nominal Gross Domestic Product represents economic output produced during a particular time period, usually a financial year, in aggregate monetary terms, at prevailing current market prices. Monetary value of economic output, means GDP accounted as the total value of commercialized production of goods and services, changing ownership in particular time period, (usually a year) expressed by monetary means, (money), plus changes in aggregate inventory.

Real Gross Domestic Product is GDP measure at prices prevalent at certain particular time period in the past, known as base year prices. Real GDP accounting measures the economic output change in a particular time period in relation to the economic output of the base year, at constant prices, while cancelling the price changes between the two time periods. When economic data speak about GDP change between base year and current year, it is usually percentage change, expressing change in economic output in real terms.

Price increase, (in economic terminology inflation), brings increase in nominal GDP, that by itself enables nominal increased yield on investments, that doesn’t have to be satisfactory for investors, who eventually expect yield increase in real terms. More than that, the invested capital loses its value in real terms and this may have additional negative effect on the propensity to invest in production capacity. But the disposable capital will not be left for too long time deposited in current bank accounts. It will look for speculative investments, meaning value holding assets, without any influence on the production capacity of real GDP. The result will be souring price increase of these assets, as for example gold, real estate, art items, corporate share prices and lately even cryptocurrencies.

The radical technological changes, brought unprecedented reduction in production costs, by more efficient production and distribution processes, introduction of new materials, redesign of the products themselves, and increased competition of new producers, adopting these new technologies and production processes. The new technologies also decreased dramatically the entry bar for new competitors in the economy. Consequently, due to fierce competition, it caused price decrease of many final products, and introduction of new products to the market. From the point of view of the consumers, this process increases their purchase capacity of goods and services, (assuming their income doesn’t change). The result is relative price increase in service sectors, where the technological changes didn’t change the production capacity, as personal services, where the service is provided from individual to individual.

If to assume that the GDP in real terms does not change, the price decreases will decrease the nominal GDP. What effect, if at all, it will have on the macroeconomy, except of the obvious positive impact on the consumers, whose relative disposable income will increase?

To try to cope with this question, we will have to check the influence of the nominal GDP decrease separately on Government sector (defined by having authority to collect taxes), private households sector (defined as consumers) and the business sector (include all the suppliers of goods and services). Other sectorization of the economy is between employees whose income is out of wages and investors, whose income is from capital, as interest, dividends, rents, royalties, etc.

Capital based economy, must satisfy continuous expectation of investors to increasing capital gain, as interest and dividends payments on their investments. To secure these increasing yield expectation on capital investments, the businesses must generate profit, that is a monetized expression of increasing additional economic value creation. This demand for ever growing yield, can be satisfied either from reduced costs, namely wage decrease on the macroeconomic level, or by increasing GDP in its monetary form, or in other words Nominal GDP growth.

Economic crisis is eventually other verbal expression for stagnant or decreasing GDP in real terms, while the nominal GDP is increasing (inflation) or decreasing (deflation). Deflation can be defined as GDP decrease in nominal and real terms. Inflation as nominal GDP growth higher than GDP growth in real terms, and stagflation is nominal GDP growth with stagnant or decreasing GDP in real terms.

While economic models speak about sustainable, balanced economy, meaning smooth flow of commerce, expressed on one side as goods and services circulation, on the other side continuous increase of money circulation, the models speak in the same breath about sustainable economy growth, if not in real GDP terms, at least in nominal GDP terms.

But what happens if there is process of price reduction, that brings lower nominal change in GDP than real term GDP change? The nominal GDP decrease, caused by price decreases, if not offset by GDP growth in real terms, causes destabilization of economy, by causing relative changes in income level between the three sectors of the economy, the government, private households and the business, as well as between capital income and the wages. On one hand the nominal GDP decrease due to price decrease, increases the disposable income of the private households, on the other hand reduces the government’s capacity of tax collection and the business profits out of their business activities, translated later to reduced capital gains.

Other effect of nominal price decrease is
wage stagnation, that can deepen the deflation in nominal GDP, and necessarily causes decrease in nominal aggregate demand in the economy. The result is less tax collection and lower profitability of the businesses, and difficulty of economic entities to pay the expected yield on capital, namely interest payments. This may cause bankruptcies and stagnation of investments. These two phenomena usually come together, with positive feedback on each other, and deepening deflationary effect on the real economy.

How come, that nominal decrease in GDP, caused by price decrease, that should eventually increase the economic activity, has deflationary effect? The answer lays in the different effect of price decrease on different kinds of income in the economy.

If nominal price decrease reduces the businesses profits and potential tax income, the interest payments, anchored in long term contracts between financial institutions and the borrowers remain constant in the short term. As to the nominal wages, they are also irreducible in the short term because of the unionization of the labour and wage level agreements achieved between representatives of the employees and the employers. The only way to balance this discrepancy caused by nominal GDP decrease, that has different outcome for different kind of income in the economy, is layoff of employees and increased tax rates, compensating for the lost income. These events, with additional negative effect on the propensity of the capital to invest in the production capacity, can have strong destabilising effect on the social political environment, and can wake up the most dangerous demons, buried deep in the social-political subconsciousness.

3 Comments
  1. Interesting post. I just wrote a short post about GDP myself. Feel free to check it out. Keep up the great work!

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  2. I am not an economy expert, I am just trying to understand some basic economy processes.
    If a price decrease are the result of improvement of implementations of a new technologies, it does not have to effect profitability of the producer. Also, the result of the price decrease is the increases the disposable income of the private households – it increases the real aggregate demand.

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    • As written in the article, : …… If nominal price decrease reduces the businesses profits and potential tax income, the interest payments, anchored in long term contracts between financial institutions and the borrowers remain constant in the short term….

      As written, while prices decrease increases the consumers disposable income, it has negative impact on relative income of the government and borrowers, who are bound to pay interest according to long term loan agreements. As to business profitability, since the major impact of new technologies is reducing entrance costs for new competitors, it improves the capacity of new enterprises to compete the old established original producers, most of the technological advance intensifies competition for already existing products. The very best recent example of such an event happened in mobile phone industry, where Huawei caused losses to Apple. In competitive economy, with freely available information for all, free access to market for very low price and available capital, the marginal profits from economic activity tend to become zero, and only monopolies, or companies, who created competitive advantage have profits. In most of the cases competitive advantages are temporary state, hardly defensible on the long run.

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