Level 1 CFA® Exam:
Gross Domestic Product

In this lesson, we will define Gross Domestic Product (GDP) and discuss aggregate output, aggregate income, and aggregate expenditure.

Let’s start with some definitions.

Aggregate output is the value of all goods and services produced in an economy.

Aggregate income is the value of income earned by suppliers of factors of production in an economy.

aggregate output = aggregate income

Aggregate expenditure is the value of money spent on goods and services produced in an economy.

If we assume that there is no import or export of goods in an economy, the aggregate expenditure will be equal to both the aggregate output and the aggregate income.

Gross Domestic Product (GDP) is:

• a measure of the volume of the goods and services produced in a specified period of time by production factors located in a country, irrespective of who owns the factors of production.
• the most popular measure of the size of an economy. It only takes into consideration the purchases of newly produced goods and services. GDP does not include such components as the re-sale of products manufactured in preceding periods or transfer payments from the government.

Nominal GDP vs Real GDP

In your exam, you should be able to distinguish between nominal GDP and real GDP. Perhaps you have already watched the Quantitative Methods videos, where we said that the nominal interest rate is equal to the sum of the real interest rate and inflation premium. In the case of nominal and real GDP, the idea is very similar.

Nominal GDP is measured using current prices, that is prices from the period in which the income making up GDP was earned:

Real GDP equals nominal GDP times 100 divided by GDP deflator. So, the GDP deflator equals nominal GDP divided by real GDP times 100.

According to the expenditure approach, GDP is equal to the total spending on final output.

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There are 2 methods of computing GDP using the expenditure approach:

• sum of value added method, and
• value of final output method.

Value added method:

The value added is defined as the difference between an enterprise's receipts from the sale of products and its expenditure on any intermediate goods manufactured by other businesses.

In other words, as the name 'value added method' suggests, it's a measure of how much a business adds to a product at each stage of the production process.

According to the sum of value added method, GDP is equal to the sum of value added in all sectors of an economy.

Value of final output method:

Of course, instead of computing all value added for all products, we can focus only on the value of final products.

According to the value of final output method, we pay attention only to the sum of the total value of the final goods or services.

Note 1: Both methods should give us the same amount of GDP.

Note: 2: Because total expenditure and total income for the entire economy should be equal, GDP calculated with the aid of the 2 approaches we discussed above, namely the income approach and the expenditure approach, should be the same.