A common definition of GDP states it as the total monetary value of all goods and services produced within the country. There are many longer variations to this, but you get the picture.
Because of the circular nature of an economy, we can conclude that at equilibrium, where the injections equal withdrawals, the following must hold true:
GDP = Output = Income = Expenditure
You can read more on why here.
So therefore when a country’s GDP improves, we can assume that personal incomes improve too. But of course, the answer is often not so simple.
Real GDP matters.
Take the example of a country that has only 2 people, with one of whom producing an orange a year, and the other owning a single physical dollar bill in 2019.
Barring any possibility of outside trade, because both persons can only trade with each other, the orange will be worth exactly $1 in 2019.
Now let’s say another physical dollar bill was found in the country in 2020, the orange produced in that year will now be worth $2. The seller (and therefore this teeny-weeny economy) will now earn more in monetary terms.
In “real” terms however, the output has remained the same – just ask the consuming party’s stomach. So from the country’s perspective, such an increase in GDP is an illusion in “real” terms.
Back to our more realistic world, real GDP measures output in real terms, by removing similar distortion effects by prices. Assuming equilibrium, and prices stay constant, because of the circular flow of income, an increase in real GDP increases national income levels.
Money is an intermediary.
There is another intuitive aspect to how an increase in real GDP improves national income.
In reality, for our material standard of living to improve, the amount of physical output must actually increase (i.e. real GDP increase).
Money can’t be consumed as an end in itself. In an extreme scenario, if all of us were speculating in bitcoins rather than actually producing real goods, financialisation may cause us to be rich (nominally) but destitute (in real terms) at the same time.
National Income improvements may not always “trickle down” to all of us.
Also known as the scourge that is inequality – I had written a piece about it before, and you can read it here.
This is one scenario where an increase in real GDP may not translate to your personal income increasing as the wealth gets captured by the wealthy.
GDP ignores trans-boundary economic activities.
Astute students should recognise that GDP, by definition ignores net income from (to) abroad, because the output counted into it ignores how:
- Foreigners operate in the country and will likely remit earnings back to their origins.
- Citizens working overseas remit money back the country.
Particularly in the first instance, an increase in GDP can be negated by net outflow of income to abroad, and therefore will not contribute to any increase in local incomes.
This is the reason why GNP appears at times in national income statistics.
Interpreting real GDP growth.
For reasons stated above and more, real GDP growth do not always lead to personal incomes growing. Also, what matters most to us in the end, is the improvement to real personal incomes.
Still, improvements in real GDP can be interpreted generally as an increase in productive economic activity, which often lays the foundation to improvements in our personal incomes, in real terms, over time.