Gross domestic product, or GDP, is one of the most common measures on the state of the economy for any nation. Unfortunately, unless you took an Economics 101 class in college and managed not to fall asleep, you may not know exactly what GDP is — or why it is important.
Put simply, GDP is the total market value of all goods and services produced in a country for a given time period. The time period most often used is one year, which is then compared to past years as a way to measure the improvement or decline of a country’s economic situation.
Some of the measurable items used in GDP calculations are the sales of automobiles, food, salon services, financial services, and movie tickets. Generally, the higher a country’s GDP, the better its economy is doing.
Why GDP Matters
GDP is a major economic indicator and a chief factor in examining a country’s economic health. When the GDP is growing, a country is generally improving economically — companies are hiring and people are working. It is like using the Dow Jones Industrial Average to measure the stock market. The Dow provides a quick read of the market, while the GDP provides a quick read of the economic health of a country.
Often, the GDP numbers are used to determine whether we are in a recession or an expansion. If a country experiences two consecutive quarters of declining GDP, it is in a recession. If the country shows increasing GDP numbers over two quarters, then it is expanding.
Methods of Calculating GDP
The general definition of GDP is rather simple. However, economists seldom accept simplicity, so there are three different ways to calculate GDP.
1. Production Method
The production approach to GDP is the market value of all final goods and services. Also called the “net product” method, it includes three statistics:
- Gross Value Added: An estimation of the gross value of various domestic economic activities.
- Intermediate Consumption: The cost of materials, supplies, and labor used to create goods and services.
- Value of Output: A calculation of the intermediate consumption subtracted from the gross value, which gives you the GDP value via the production method.
Weakness of the Production Method
The major problem with the production method of measuring GDP is that there is no 100% accurate way to determine true production. Services like babysitting have no way of being measured and therefore are not included — although it can be argued that a babysitter allows parents to go out and spend money on a service, like dinner at a restaurant, thereby having a positive effect on the economy.
Also, if you make baked goods or have a small garden, you are still producing goods, but your output is likely not included in the GDP, especially if you do not sell your outputs.
This method fails to factor in the product of the underground economy. For example, if you pay a friend cash “under the table” to fix your car, it does not count toward GDP, even though a service has been rendered.
2. Income Approach
Many economists dislike the production method as a means to measure GDP because it does not include income. Rather, these economists believe the money each family brings home is a better way to evaluate the economic strength of the country. Therefore, the income approach measures the annual incomes of all individuals in a country.
Incomes included in GDP are:
- Wages, salaries, and supplementary labor income
- Corporate profits
- Interest and miscellaneous investment income
- Farmers’ income
- Income from non-farm unincorporated businesses
Once these numbers are totaled, two further adjustments must be made to arrive at the GDP via this method. Indirect taxes — such as sales taxes at a convenience store — minus tax subsidies (tax breaks or credits) are added to arrive at the market prices for goods and services.
Then, depreciation on various hard assets, such as buildings and equipment, is added to that to arrive at the final GDP calculation. The idea behind the income method is that it can more effectively measure productivity than trying to track all production and services in an economy.
Weakness of the Income Approach
Unfortunately, production, saving, and investment are not included in the income method.
When you sit with an investment advisor and invest money in a mutual fund, you are participating in economic activity. However, that is not counted in the income approach.
Similarly, increased production at factories can occur without the workers receiving higher wages, and because there is a delay from the time the increased production of goods hits the marketplace and the company’s sales are recorded, the increased income may not show up in the corporate profits for some time.
3. Expenditure Approach
There are economic theorists who believe that neither the income approach nor the production method is sufficient. In theory, income is not generated to be hoarded. Some people might save and invest, but everyone will definitely purchase needed and desired goods.
The expenditure approach was developed from this basic viewpoint. This approach measures all expenditures by individuals within one year.
The components of this method are:
- Consumption: All purchases of durable goods, nondurable goods, and services. Examples include food, rent, gas, clothes, dental expenses, and hairstyling. The purchase of a new house, however, is not included as consumption. Consumption is the largest component of this method of determining GDP.
- Investment: All capital investments, such as equipment, machinery, software, or digging a new coal mine. It does not mean investments in financial products, like stocks or mutual funds.
- Government Spending: The total of government expenditures on goods and services, including all costs of government employee salaries, weapons purchased by the military, and infrastructure costs. For example, the money spent on the war in Iraq is included, as is the money spent on economic stimulus. Social Security and unemployment benefits, however, are not included.
- Net Exports: The difference between the value of all imports and the value of all exports. Exports are goods that are created in this country for other nations to consume, while imports are created in other nations and consumed domestically.
Weakness of the Expenditure Method
The weakness of this method is similar to the weakness of the income approach. First, savings are not included in the equation — savings accounts and stock investments are not accounted for.
Also, deeply discounted and even free services from government, business, and nonprofit organizations are included. This presents a problem because the calculation estimates the actual value of these services — not what is charged for them. For this reason, the final GDP number is likely to be inaccurate.
Lastly, some services are counted based on their costs, but that value can be substantially higher than is estimated or reported. For example, when a major infrastructure collapse happens — such as after the 9/11 attacks or in the wake of a large-scale natural disaster — medical and building costs go up.
This creates a temporary increase in infrastructure costs, which increases the final GDP number. This skews the numbers by creating a spike in expenditures — but not a growth curve that is sustainable.
Consider this: When you buy a new house, you may spend a lot of money at first on new furniture — but you do not continue to buy new furniture every month.
The Problems With GDP
GDP has several problems when it comes to using it to measure the economic standing of a country. The primary problem is generality.
The Dow presents a similar problem: It is the average of 30 companies, which is a small sliver of the total number of companies trading on the stock exchange. Even the S&P 500 is only an average of 500 companies. Using an average figure from a limited subset of examples omits many other factors that may tell a different story, and it likely excludes pertinent information that should be included.
Economists label items that fit this description “externalities,” and they fall into the following categories:
- Recessionary Hangovers. There are times when a country is technically out of a recession according to GDP numbers but is still functionally in a recession. For instance, according to economists using GDP as a measure, the Great Recession in the United States ended in 2009. However, even into 2012, the unemployment rate remained above 8%. That is a functional recession — especially to those still unable to find work. If the goal is to measure economic health, then you cannot count 8% unemployment as healthy, particularly when drops in the unemployment rate for two quarters straight only occur because of people giving up and dropping out of the job search.
- Credit-Based Spending. Another problem is that spending on goods and services does not always come from income generated. Both the American public and the government routinely spend money on credit, and the effects of chronic debt are not factored into GDP. During the run-up to the mortgage crisis, millions of Americans got home equity loans. These loans were used for everything from renovations, college tuition, new cars, vacations, and more. All those expenditures counted toward positive GDP growth, but the country was not in a healthy state. When the housing bubble burst, the effects of that debt spending hit the nation hard — and the GDP numbers did not reflect that hidden time-bomb.
- Underground Economy. From economic calamities like the housing bubble and the COVID-19 pandemic, we get high unemployment and an increase in what is called the “underground economy.” If you pay cash for a good or service to someone who does not have a formal business or does not report the income, this contributes to the underground economy. This economic activity is not included in the GDP.
- Non-monetary Economy. GDP numbers omit production and services where no money comes into play. Bartering is no longer a large part of the American economic model, but it does increase in severe recessions. Exchanges of goods for services and vice-versa are not recorded, resulting in skewed GDP figures. GDP also ignores the immeasurable unpaid work of full-time parents and family members caring for aging relatives.
- Growth Sustainability. The effect that production — particularly industrial production — has on the environment has become a concern, as maximizing short-term output may be unsustainable and can cause long-term damage. For instance, a logging company could make a huge output in the harvesting of trees, but if they overharvest, replenishing the forest’s supply of quality lumber could become problematic or impossible, affecting future GDP. Other examples include overfishing a body of water or overfarming a tract of land. A country may achieve a temporarily high GDP from abusive usage of natural resources or by improper allocations of investments.
Comparing Countries’ GDPs
Aside from measuring economic growth within a country, GDP is also used as a benchmark to measure the economies of competing countries.
According to the International Monetary Fund, the 10 countries with the largest nominal GDP in 2020 were:
- United States
- United Kingdom
- South Korea
Economists often observe countries’ changes in GDP to compare the strength of their economies. There are, of course, some issues with this method, and different ways to account for those shortcomings.
One difficulty of comparing gross domestic product is that each country measures its GDP in the local currency. You can look up the United States’ GDP in dollars, but the United Kingdom will measure its own GDP in pounds and Mexico will measure GDP in pesos.
You can always convert between currencies to compare two countries’ GDP, but conversion rates change on a daily basis. If there are significant changes in currency values, you could get vastly different comparisons using the same GDP numbers.
GDP Per Capita
Another consideration is that different countries have different populations. China’s population is roughly 1.4 billion people while France has roughly 67 million people. If both countries have the same GDP, that means France has much more money to go around for each person than does China.
Because a larger population often leads to more production, more populous countries tend to have higher GDP. Some economists use a measure called GDP per capita to compare countries’ economic productivity. To find GDP per capita, divide a country’s GDP by its population.
To continue with France and China as examples, China’s GDP is around $24.2 trillion. That puts its GDP per capita at $10,839. France’s GDP is $2.954 trillion, giving it a GDP per capita of $39,257.
GDP per capita is a popular measure of living standards in a country. Higher GDP per capita indicates a more productive populous and more wealth for the average citizen there. However, GDP per capita doesn’t account for factors like wealth disparity within a country and the quality of goods available to the populace.
The top 10 countries by GDP per capita are:
- United States
Purchasing Power Parity (PPP)
Another factor to consider when using GDP to measure economic strength and quality of life is the purchasing power of a currency. Someone making $10,000 per year in the United States will likely struggle to get by, but a $10,000 per year income could pay for a lavish lifestyle in other countries.
Purchasing Power Parity (PPP) measures the price of a specific basket of goods and services — such as food, housing, clothes, medical care, and other common living expenses — in different countries to help with the comparison of the purchasing power of currencies. This leads many economists to use GDP at PPP per capita to measure the relative living standards of countries.
The top countries by GDP per capita at PPP are:
- United States
- Brunei and Macau (tie)
- United Arab Emirates and Hong Kong (tie)
It is best to view GDP numbers as a quick snapshot of which direction a country is heading when it comes to economic growth and stability. The measure is not as accurate as it could be, nor is there any way to truly capture all the dynamic forces that affect the economy. Depending on what method a politician, pundit, or economist uses, you can get vastly different views of the economy based on the same raw data.
However, becoming caught up in spin or methodology is counterproductive for most people who wish to understand GDP and use it as a simple read of a country’s economic health. Let economists and the pundits interviewing them wade into the weeds — the average person on the street should keep it simple.
The production method is the one that is used most often, and it’s one of the benchmarks upon which every presidential administration has been evaluated for the past 60 or so years. It may not be perfect, but if you accept its limitations, then you understand it is a decent way to look at the country to see whether it is getting stronger or if there are serious weaknesses.