0
$\begingroup$

The income method of calculating GDP is as follows: GDP = wages + profits + rents + interest + depreciation + taxes + NFFI. If an economy has high external debt, for instance, because it used external financing to buy machinery and equipment, then foreign interest payments will be high. In that case, wouldn't GDP (per capita) be a poor measure of economic well-being since a significant portion of the generated income is leaving the home economy?

Wouldn't excluding foreign interest payments in calculating GDP/ income give us a better measure since this represents what income is available to the home economy?

$\endgroup$
2
  • $\begingroup$ Do we need to keep the assumption in the title that GDP is a measure of economic well being? Is this a better re-statement of your question... Would a GDP measure be improved by excluding foreign interest paid? $\endgroup$
    – H2ONaCl
    Oct 5, 2023 at 5:28
  • $\begingroup$ You're right, that is a better formulation. $\endgroup$
    – Hatanga
    Oct 5, 2023 at 16:29

1 Answer 1

1
$\begingroup$
  1. GDP is measure of output not a direct measure of wellbeing. You can use it as a proxy for wellbeing because it has very high correlation with broader measures of well being (e.g. see this OECD explainer).

  2. If country, on net basis, pays income to foreigners such as interest payments NFFI will be negative.

NFFI= Income of our citizens from foreign countries - Income of foreign citizens from our country.

So in your example, GDP is lower if the interest income is paid to other countries.

$\endgroup$
8
  • $\begingroup$ Thanks for your answer. In this way, the interest paid to home investors vs foreign investors can be discriminated. But how would (high) foreign interest rate payments be reflected in the expenditure method? $\endgroup$
    – Hatanga
    Oct 5, 2023 at 16:26
  • $\begingroup$ @Hatanga with spending method they are not reflected directly but indirectly. For example through lower consumption, investment or government spending (i.e. when consumers pay part of their income abroad they cannot use the same money for consumption etc) $\endgroup$
    – 1muflon1
    Oct 5, 2023 at 18:03
  • $\begingroup$ Thanks again! But I still have a doubt. For instance, in a hypothetical 3-person economy, person A is producing one unit of a good per year, selling it to B for 10. A retains 5 as profits for herself and pays 5 to C who gave her a loan in the past for buying machinery etc. Expenditure and income method yield the same, i.e., y=C=10 and y=profits (5) + interest (5)=10. But what if C is now a foreigner (i.e., we have a 2-person domestic economy)? Expenditure would still be 10 as C=10, but income would be 5: profits (5) + interest (5) + NFFI (-5) = 5. What do I miss? $\endgroup$
    – Hatanga
    Oct 14, 2023 at 17:27
  • $\begingroup$ @Hatanga what you miss is that your numbers are inconsistent. What you do is basically tantamount to saying: how come Y= C + I + G if I assume that Y=10 and that C = 1 and I = 1 and G= 1… that simply cannot happen in reality, since Y=C+I+G holds by construction. Simply in your example domestic expenditure cannot be still 10. You can’t just make any random numbers. Take another analogy on every firms balance sheet Assets = liabilities + euqiity… well of course if you just assume A = 10; L = 2 and E = 3 then the equality will be violated but IRL that cannot happen if all rules of accounting are $\endgroup$
    – 1muflon1
    Oct 14, 2023 at 18:25
  • $\begingroup$ Followed to the letter. In your example domestic consumption cannot be 10 if domestic income is just 5 and there aren’t any other financial flows, because GDP is accounting identity the same as A= L+ E. It simply must hold by construction. Similarly IRL we constructed relationship between Celsius and Fahrenheit to be exactly (°C × 9/5) + 32 = °F. You simply cannot make a measurement of 0 Celsius and 100 Fahrenheit at the same time and place. Your calculations or instruments would be wrong. Similarly in your example you are just assuming inconsistent measurements $\endgroup$
    – 1muflon1
    Oct 14, 2023 at 18:25

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service and acknowledge you have read our privacy policy.

Not the answer you're looking for? Browse other questions tagged or ask your own question.