Question

Discuss the change in the importance of sectors in terms of their contribution to GDP. Do you think that this change is essential for a developing economy?

Answer 1

Why GDP is Important

Samuelson and Nordhaus neatly sum up the importance of the national accounts and GDP in their seminal textbook “Economics.” They liken the ability of GDP to give an overall picture of the state of the economy to that of a satellite in space that can survey the weather across an entire continent. GDP enables policymakers and central banks to judge whether the economy is contracting or expanding, whether it needs a boost or restraint, and if a threat such as a recession or inflation looms on the horizon.

The national income and product accounts (NIPA), which form the basis for measuring GDP, allow policymakers, economists and business to analyze the impact of such variables as monetary and fiscal policy, economic shocks such as a spike in oil price , as well as tax and spending plans, on the overall economy and on specific components of it. Along with better informed policies and institutions, national accounts have contributed to a significant reduction in the severity of business cycles since the end of world War II.

 

GDP Calculations

GDP can be calculated either through the expenditure approach (the sum total of what everyone in an economy spent over a particular period) or the income approach (the total of what everyone earned). Both should produce the same result. A third method – the value-added approach — is used to calculate GDP by industry.

Expenditure-based GDP produces both real (inflation-adjusted) and nominal values, while the calculation of income-based GDP is only carried out in nominal values. The expenditure approach is the more common one and is obtained by summing up total consumption, government spending, investment and net exports.
Thus, GDP = C + I + G + (X – M), where

C is private consumption or consumer spending;

I is business spending;

G is government spending;

X is exports, and

M is imports.
Why GDP Fluctuates

GDP fluctuates because of the business cycle. When the economy is booming, and GDP is rising, there comes a point when inflationary pressures build up rapidly as labor and productive capacity near full utilization. This leads the central bank to commence a cycle of tighter monetary policy to cool down the overheating economy and quell inflation.

As interest rates rise, companies and consumers cut back their spending, and the economy slows down. Slowing demand leads companies to lay off employees, which further affects consumer confidenceand demand. To break this vicious circle, the central bank eases monetary policy to stimulate economic growth and employment until the economy is booming once again. Rinse and repeat.

Consumer spending is the biggest component of the economy, accounting for more than two-thirds of the U.S. economy. Consumer confidence, therefore, has a very significant bearing on economic growth. A high confidence level indicates that consumers are willing to spend, while a low confidence level reflects uncertainty about the future and an unwillingness to spend.

Business investment is another critical component of GDP, since it increases productive capacity and boosts employment. Government spending assumes particular importance as a component of GDP when consumer spending and business investment both decline sharply, as, for instance, after a recession. Finally, a current account surplus boosts a nation’s GDP, since (X – M) is positive, while a chronic deficit is a drag on GDP.

Drawbacks

Some criticisms of GDP as a measure of economic output are:

It does not account for the underground economy – GDP relies on official data, so it does not take into account the extent of the underground economy, which can be significant in some nations.

It is an imperfect measure in some cases – Gross National Product (GNP), which measures output from the citizens and companies of a particular nation regardless of their location, is viewed as a better measure of output than GDP in some cases. For instance, GDP does not take into account profits earned in a nation by overseas companies that are remitted back to foreign investors. This can overstate a country's actual economic output. For example, Ireland had GDP of $210.3 billion and GNP of $164.6 billion in 2012, the difference of $45.7 billion (or 21.7% of GDP) largely being due to profit repatriation by foreign companies based in Ireland.

It emphasizes economic output without considering economic well-being – GDP growth alone cannot measure a nation's development or its citizens' well-being. For example, a nation may be experiencing rapid GDP growth, but this may impose significant cost to society in terms of environmental impact and increase in income disparity.

Answer 2

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