Gross Domestic Product (GDP): All You Need to Know

For understanding and assessing economic conditions, the best tool at your disposal is the Gross Domestic Product (GDP).


Understand the concept and grow your business.

While starting a new business, it is extremely important to understand the state of economy. And for understanding and assessing economic conditions, the best tool at your disposal is the Gross Domestic Product (GDP). It is the by far the most effective measure available for calculating a country’s overall economic strength and capacity.  It is closely connected with the size of a country’s economy – Nominal GDP, and the purchasing power of a country’s consumers- GDP per capita.

So, before starting your business, get your concepts clear about the economy and GDP. 

What is GDP?

By definition, gross domestic product, commonly abbreviated as GDP, is the monetary or market value of all finished goods and services produced in a country over a particular period. This monetary value is then used to analyse and inspect a country’s economic condition. Following parameters are taken into account for calculating the GDP of any nation: 

Personal Consumption (Expenditure): Personal consumption is indicative of all the goods and services that are purchased by individual consumers of a country. This parameter is essential for calculating as it is the indicator of the purchasing power of any given economy.

Government Consumption (Expenditure): Government spending means the amount of money spent by the government in any given year. This expenditure does not include transfer payments by the government, i.e., charges for social security or unemployment benefits.

Investment: Investment represents the valuation of capital goods added by a country to its assets in a given year. Capital Goods are the physical assets used for production processes and manufacturing of goods and services. Infrastructure, buildings, machinery, equipment, vehicles, tools, etc. are some of the examples of capital goods and investment.

Net Exports: Total value of goods and services that are sold to a foreign market- to consumers, businesses, or governments in another country accounts for the net exports of a country. These exports bring money into the country, increasing the GDP of exporting nations.

Foreign Direct Investment (FDI): Suppose an American multinational company produces and manufactures goods, and generates physical capital like cash, real estate, equipment, etc. in India. This adds to the Indian economy and therefore, is taken into account while calculating. 

GDP Growth Rate

GDP is calculated to track the size and direction of any country’s economy. GDP Growth Rate is calculated quarterly and used to compare a country’s economic growth or decline with previous quarters. By comparing the one-quarter of a country’s GDP to the last quarter, the economic growth (or decline) is measured. For example, India’s growth rate for the first quarter of 2020 was 3.1 per cent, and for the second quarter it fell to 23 per cent (according to data by the Government of India) this means that the economy not only slowed down but contracted significantly too. 

High Growth Rate – Economy is growing fast

Low Growth Rate – Economy is growing slow

Negative Growth Rate – Economy is contracting 

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GDP is the by far the most effective measure available for calculating a country’s overall economic strength and capacity.

How is the GDP of India calculated?

GDP calculation includes the summation of the total value of all goods and services produced over a particular period. This calculation includes goods and services that are produced by domestic businesses and companies, as well as the physical capital goods created by foreign companies in India. Generally, two simple methods are used to calculate the GDP, which are:

Income Method: This method adds up the total income generated within a year by businesses, workers and asset owning entities, and

Expenditure Method: This method adds up consumer spending, investment, government expenditure, and net exports.

GDP
India’s GDP over the years

Industry sectors contributing to India’s GDP calculation

The following sectors are taken into account:

Agriculture, Forestry and Fishing

Mining and Quarrying

Manufacturing

Electricity, Gas and Water Supply

Construction

Trade, Hotels, Transport and Communication

Financing, Insurance, Real Estate and Business Services

Community, Social and Personal Service

Different types of GDP

GDP is broadly classified into four types based on the methods used for its measurements. These types are:

Nominal GDP: This is calculated by evaluating the current market prices of goods and services. Nominal GDP estimates are commonly used to determine the economic performance of a whole country or region, and to make international comparisons. This method of measurement fails to take into account the differences in the cost of living in different countries.

Purchasing Power Parity (PPP) GDP: This is calculated by comparing economic growth and standards of living among different countries. This comparison is more accurate as it tells the exchange rate at which the currency of one country is converted to that of another country while purchasing the same amount of goods and services.

Real GDP: It is an ‘inflation-adjusted’ method of calculating the GDP of a country. By ‘inflation-adjusted’, it is meant that this calculates the real value of all goods and services produced in a country in a given year while comparing and adjusting the value of said goods and services from previous years’ prices called base-year prices.

GDP per Capita: It is calculated by dividing the GDP of a country by its population. It is calculated to determine a country’s economic output per person. It is a useful way to compare data of various countries.

Why does it matter for your business?

GDP matters for your business because it tells you if the economy is under stress, contracting, growing fast, etc. It is undoubtedly an essential tool for analysing a country’s economy. For businesses, investors and economists, GDP is the representation of economic production and growth. And economic output and growth significantly impact your business- be it a large company or a start-up. 

Positive growth is indicative of the growth of the economy, which means that the necessary resources are available to people in the country, due to which goods and services, wages and profits increase. In a healthy economy, there is lower unemployment, and wages tend to increase as businesses hire more labour to meet the growing demand of the economy. 

With the growth of economic activity in the country, the spending capacity of consumers increases more. And if you are a consumer-facing business, this gives a boost to your business as more sales take place.  

One of the significant benefits of positive growth is that it boosts the small business and start-up industry. Investors rely on GDP growth while formulating an investment strategy. Big enterprises make a higher investment into expanding their assets as well as in new ventures. This gets the economic growth moving faster, and more increase triggers even more significant investments by investors into start-ups and new businesses. 

Investments are closely associated with the GDP because a significant change in the GDP- either up or down– primarily impacts the stock market. A good economy, indicated by high growth, translates into higher earnings for companies and the stock value goes up. The reverse is also true, and a reduction in GDP ultimately translates into lower stock prices and loss of investors.

What happens when the economy underperforms? GDP Dips

An upward economic growth means a higher GDP and downward financial curve results in the dipping of GDP figures. When a country’s GDP is calculated to be negative, or when a decline is recorded for two quarters in a row, these are seen as the signs of an economic slowdown. 

Remember, GDP is a tool, not something tangible like economic assets and capital goods. When economic activities start to go on a downward scale- a sharp fall in growth, employment, production and businesses- the economy is said to be underperforming. The economic slowdown is further identified when bankruptcies, reduced trade and crippling commerce become apparent; these are the confirmatory points of an economic downturn. This economic downturn is captured in the sharply falling GDP figures and negative growth rates. 

An anomaly of economic slowdown or depression is that some businesses start to pick up in the slow economy. Factors like cheap labour and business’s cost positivity, as the bi-products of an economic downturn, are taken advantage of by some entrepreneurs.

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Small businesses’ share in the GDP is indispensable. They play a significant role in most economies, particularly in India.

GDP & Small Businesses – A Symbiotic Relationship

Association between small enterprises and the economy is unique. Where small businesses provide the much-needed impetus at the grass-root level, the economy protects them, fulfils their needs and provides extra care at the time of crisis in the form of loans.

Small businesses’ share in the GDP is indispensable. They play a significant role in most economies, particularly in India. They are essential contributors to job creation and production & manufacturing processes. Small businesses (MSMEs and SMEs) represent about 90% of companies and more than 50% of employment in India (source: Press Information Bureau, Government of India). These businesses create job opportunities and drive the country’s economic growth in smaller geographic areas. They make the market more competitive and productive.

GDP, therefore, is a critical topic for anyone who wants to have a detailed understanding of the economy before setting up a business. While starting a business, the ultimate goal is to attain financial gains. And for that, a thorough understanding of the economy and tools that help understand the economy, particularly GDP, is essential.

Read about GST, EPFO and other financial topics on our website.

Aakash Sharma
Aakash Sharma
Aakash writes on Startup Ecosystem, Policies, Legal and Regulatory aspects of business planning. An alumnus of Delhi University, he is assistant editor at Dutch Uncles.

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