Measuring GDP...

1. GDP can be measured as total income in the economy. Is that before tax? If yes, are all kinds of taxes included?
2. Why are inventories included in final goods? -Guo

To answer your questions, remember that GDP is a measure of the total value of all production in the economy. When we measure this production by adding up income, we want to include all income earned in the production process, including that earned by the Government via taxes. So yes, we wish to include all taxes. Typically we do this by including income before taxes are deducted (i.e. gross income rather than net income), except for indirect taxes paid by firms which we add back to correctly calculate GDP.

Inventories are included as a way to match production correctly. Recall that Y=C+I+G+NX. If a good is produced in year1 but consumed in year 2, it is included in I (inventories, a part of investment) in year 1. When it is consumed in year 2, inventories decline by the value of the good, while consumption increases by the value of the good; these cancel out, so there is no net effect on GDP.

Of course if the good is sold for more than its value as inventory, then GDP will also increase in year 2, but only by the increased value of the good when it was sold. We can think of this as the value of the service of selling the good, which rightly belongs in year 2's GDP, not year 1's.

Taxes and GDP

"We can calculate GDP by summing total wages, interests, rent and profits received by householders. Should we include taxes as well?" - Mandy

Yes- we should include all sources of income that are derived from the production of goods and services, and that includes income received by the Government. Normally we capture this by summing up gross, or before tax, sources of income when we calculate GDP.

Mis-measuring Trade

While we're on the subject of mis-measurement, what do Mongolia, Papua New Guinea, Angola, and Libya all have in common? According to the World Trade Organisation they all trade a greater value of goods and services than they produce- see this link, for example.

This is news to me. The only way a country is likely to trade in excess of production is if it is a major re-exporter, like Hong Kong or Singapore. Yes it is possible for other countries to enjoy a trade:GDP ratio exceeding 100%- if you export every good and service you produce, and import every good and service you consume, the ratio could theoretically hit 200% without any re-exports- but I hardly think that is likely for the countries listed here.

If the ratio is incorrect, it is most likely due to mis-measurement of GDP, with the countries concerned exporting goods produced in the informal sector that slip under the radar of the statistics agency beancounters, and paying for imports with income earned in that same informal sector.

Thanks to Lolita for the pointer.

Mis-measuring GDP....

"The different approaches to measuring GDP (income approach, product approach, etc) are supposed to all give the same answer. But some activities are hard to measure- for example drug dealing- and are likely to be excluded from the product approach for lack of data. Might this explain why the different approaches give different answers?" - Chen

This shouldn't be too much of a problem, as we likely miss-measure both the income approach and the product approach by a similar amount. We don't measure the consumer's purchases of illegal drugs, but we don't measure the income earned by the drug dealer either! Since the amounts are identical, ignoring parts of the economy should not systematically bias one measure of GDP relative to another.

GDP vs. GNP

"In China, a large part of GDP takes place in foreign-owned factories. If we want to mesaure the standard of living in China, wouldn't it be better to use GNP than GDP to allow for this?"

In prinicple you are right. Any profits earned by foreign firms in China ultimately benefit the owners of the foreign firm, rather than people in China. These profits are included in China's GDP, but not in China's GNP. GNP would therefore make a better measure of Mainland China's standard of living.

Ultimately, however, this is an empirical matter, and the difference between GDP and GNP is typically small. For example, in 2005, Mainland Chinese GDP was larger than GNP by 1.5%. The reason for this is that just as the rest of the world owns lots of assets in Mainland China, Mainland China owns lots of assets in the rest of the world. In fact, Mainland China owns more foreign assets ($1218 Billion USD in 2005) than the rest of the world owns Chinese assets ($931 Billion USD) according to the IMF's International Financial Statistics. Many of the Chinese assets earn only small returns (for example, US Government issued Treasury Bills), hence the income flow favours the rest of the world.

Hong Kong is a more extreme case: in 2005, Hong Kong entities owned the equivalent of 8.5 times Hong Kong's GDP in foreign assets, while the rest of the world owned 6.0 times Hong Kong's GDP in Hong Kong assets. Both these numbers are huge by comparison with most other countries, but the difference (Hong Kong's net asset position with the rest of the world) is a whopping 2.5 times Hong Kong's GDP! Yet in 2005, the difference between Hong Kong's GDP and GNP was a miserly 0.2% of GDP. That was low compared with most other years, but as the following graph shows, the differences are usually small, even for Hong Kong.

Household Production and Measured GDP

"The value of the household production is hard to measure. But can I draw the conclusion that the value of real GDP plus household production is lower in the recession than in the expansion because the standard of living is lower?"

That's not clear. If I produce something in my home to consume (such as a home cooked meal), it clearly increases my standard of living, yet the value added by cooking my own meal is excluded from GDP. In a recession, if consumers are more inclined to consume household produced goods, then measured GDP will systematically exaggerate the negative effects of recession. This is plausible, especially if you think about the effect of recessions on the service sector (restaurants and entertainment in particular).