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Gross Domestic Product (GDP) – What Is This Economic Indicator?


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Gross domestic product (GDP) is one of the most commonly used measures of economic production in the world. Despite its popularity, many people don’t know exactly what GDP is, how to calculate it, or how it affects you.

Put simply, GDP is the total value of everything produced by an economy, typically a country, over a period, typically one year. This allows economists to compare the size of different economies. In general, the higher a country’s GDP, the stronger its economy.

GDP can be important for everyday people for a number of reasons.


What Is Gross Domestic Product (GDP)?

GDP is a measure of the total market value of everything an economy produces. That includes both physical goods as well as intellectual property and services produced by an economy. GDP is typically measured over the course of a quarter or year and based on political borders, such as for countries or states.


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You can think of GDP as being like a report card or scoreboard for the health of an economy. If a country’s GDP is rising, it means its economy is becoming more productive. If GDP is shrinking, its economy is becoming less productive. You can compare the size of two countries’ GDP to compare the output of their economies.

There are multiple ways to calculate GDP but they all aim to produce a similar result: a measure of the size of an economy.


Factors That Affect GDP

Because GDP measures the size of a country’s economy, it is influenced by numerous economic factors.

GDP is the sum of the market value of everything an economy produces. The more valuable goods and services an economy produces, the higher its GDP will be. Keep in mind, GDP is a measure of the current value of goods and services. If inflation causes prices to rise, a country’s GDP will also rise because goods are more expensive.

The primary way economists determine the value of goods produced by an economy is to add all government spending, personal consumption, private investing, and net exports. 

The more the government spends, the more private businesses and people invest, and the more consumers spend, the higher a country’s GDP will be. Exporting more than it imports will also increase a country’s GDP, whereas importing more than it exports will reduce its GDP.


Types of Gross Domestic Product

GDP is used in multiple different contexts. Economists have designed different types of GDP to help them measure different aspects of the economy.

Nominal GDP

Nominal GDP is one of the most common measures of gross domestic product. It is the value of all goods and services an economy produces using current prices, unadjusted for inflation. This means it is less useful for comparing the same economy across different years because inflation can cause GDP to rise due to price increases, even if an economy’s output does not change. 

However, it is useful for measuring output in current terms and is often the simplest to calculate because you don’t have to adjust for inflation.

Real GDP

Real GDP is an inflation-adjusted measure of gross domestic product. It measures the output of an economy using constant prices.

For example, imagine an economy that produces $1,000 worth of goods in a year. The next year, it produces the exact same goods, but those goods sell for $1,050 because inflation for the year is 5%. 

The real GDP in both years will be the same because real GDP adjusts for inflation using the value of the economy’s currency in the base year to determine the GDP for future years.

For real GDP to increase, the output of an economy must increase rather than prices increasing due to inflation.

This makes real GDP useful for comparing changes in the same economy over time or comparing growth in different countries’ GDPs over time.

GDP Per Capita

GDP per capita is a measure of economic production per population. GDP per capita can be expressed in multiple forms, including nominal, real, and purchasing power parity.

Determining GDP per capita requires calculating an economy’s GDP then dividing it by the economy’s population.

For example, if an economy has a GDP of $10 million and a population of 2,000 people, its GDP per capita is: $10 million ÷ 2,000 = $5,000 per capita.

GDP Growth Rate

GDP growth rate measures economic growth over time. Usually, economists measure this on a quarterly or annual basis. This is typically expressed as a percentage rate.

For example, if an economy’s GDP is $10 million in one year and $10.5 million the next, its GDP growth rate is 5%.

GDP growth rate is a popular measure for economists for a few reasons. One is that it can help economists see the speed of an economy’s expansion or contraction. An economy that is growing too quickly may lead to inflation and prompt central banks to raise interest rates. If growth slows, the economy might be heading toward recession, prompting policymakers to attempt to bolster the economy.

A negative GDP growth rate indicates an economy that is shrinking or in recession.

GDP Purchasing Power Parity (PPP)

Purchasing power parity is a measure of the different standards of living between economies. It analyzes the price of a “basket of goods” that contains different common products and services people purchase. Higher PPP indicates a more powerful currency that can purchase more goods or a higher standard of living.

GDP PPP adjusts an economy’s GDP for exchange rates and the purchasing power of its currency compared to other currencies, letting economists compare the output of an economy to its cost of living.


How GDP Is Calculated

There are multiple different ways to calculate GDP but they all aim to measure an economy’s output. Each formula tries to account for the same factors, just in different ways. 

There are three methods economists use to calculate economic activity and determine GDP.

Expenditure Approach

The expenditure approach looks to determine the GDP of an economy by finding the total of all spending in that economy. The idea is that all of an economy’s outputs are purchased by someone, so finding out how much money is spent by individuals, businesses, and the government will tell you the value of all the goods an economy produces during a period of time.

To find GDP using the expenditure approach, you can use this formula:

Consumption + Investment + Government Exports + Net Exports = GDP

Consumption refers to consumer spending on items like food, rent, gas, clothing, and any other goods and services that they might need. It does not include capital investments like equipment, machinery, or real estate.

Investment is the portion of the calculation that accounts for investment in equipment, land, machinery, and the like by both individuals and businesses. It doesn’t include investment in financial products like stocks, bonds, or mutual funds.

Government spending is the aggregate of all the money the government spends on goods and services, including government employee pay, military spending, and infrastructure. Things like Social Security benefits aren’t included because they are transfer payments — a reallocation of money from one group to another. Unemployment, subsidies, and welfare are similarly excluded.

Finally, net exports measures the value of all goods an economy exports minus the value of the goods it imports. A country that exports more than it imports will have a positive value for net exports, whereas one that imports more will have to subtract the difference when finding its GDP.

The drawback of the expenditure approach is that it ignores some forms of investment, such as putting money in savings accounts or buying stocks. It also values goods and services at the price the purchaser pays, even if they pay a heavily discounted price below the true value of that good or service or an inflated price above its true value.

Production (Output) Approach

The production, or output, approach to calculating GDP uses the value of all the final goods that an economy produces. Here’s how this method of calculating GDP looks:

Gross Value Added – Intermediate Consumption = Value of Output (GDP)

  • Gross Value Added. How much value different economic activities add to goods and services.
  • Intermediate Consumption. The cost of the supplies and labor used to produce finished goods and services.
  • Value of Output. This calculation gives you the GDP of an economy by subtracting intermediate consumption from the gross value of an economy.

The drawback of using this approach is that it is nearly impossible to determine the true amount of production in an economy or the true value of that production. Some services are difficult to measure monetarily and may not wind up in the calculation, even though they have a major impact on the economy.

For example, someone who babysits children for a family probably won’t show up in this calculation. However, their babysitting lets the parents go out and spend money at restaurants, movie theaters, or other businesses.

People who produce goods at home, especially those who don’t sell them, also won’t have their production included, even though goods like home-grown vegetables have real value that should be included in GDP.

Finally, this method fails to account for the underground economy, which is not reported to the government. Services performed under the table — those done outside of the formal economy through barter or cash payments that aren’t reported to tax authorities — are excluded even though they add value to the economy.

Income Approach

The income approach to determining GDP looks at all the money individuals and businesses in an economy earn. To find GDP using this method, you can use the following formula:

Wages, salaries, and bonuses + Corporate profits + Interest and investment income + Farm income + income from unincorporated businesses – Depreciation of assets – (indirect taxes – tax subsidies) = GDP

Indirect taxes are those collected by intermediaries and then paid to the government, such as sales taxes. Tax subsidies include the various tax credits and deductions people and businesses can claim on their income taxes.

The benefit of this approach is that it can be easier to measure income than production. It stands to reason that the amount of income in an economy will be similar to its economic output because that output is what produces the income.

The drawback of this approach is that it fails to account for savings and investment. Also, income does not always perfectly correlate with production. For example, productivity at a factory can rise without workers seeing an increase in their incomes.


How GDP Affects You

GDP is one of the economic indicators groups like the Bureau of Economic Analysis and the Organization for Economic Cooperation and Development (OECD) use to analyze economies. However, it may not be obvious how GDP can affect you.

The truth is, macroeconomics and measures like GDP can have a major impact on people’s day-to-day lives and well-being.

Interest Rates

One way GDP can impact people is in the interest rate market.

Countries usually have central banks or other organizations tasked with managing the economy — helping it to grow while avoiding high inflation and recessions. If GDP begins to rise quickly, inflation can become a risk, which can cause central banks to raise interest rates.

Those rate increases impact individuals by making borrowing and credit more expensive, such as with mortgages, auto loans, and credit cards.

If GDP falls, the central bank may take the opposite approach, lowering rates and making it cheaper to borrow, encouraging individuals to spend.

Investing

GDP is one of the most popular measures of an economy’s output. You can use it to see how an economy is growing over time.

Investors typically want to buy investments in companies that are experiencing increases in production, and therefore value. When GDP is growing, it’s easier for investors to find opportunities in that economy. When an economy’s GDP is falling, it can be a sign that companies in that economy are facing a difficult financial future.

Wages

Because GDP is a measure of economic output, it makes sense that wages would correlate with GDP. When production and output rise, workers should earn more. Similarly, wages might decrease when output also falls.

According to a study by the Economic Policy Institute, this was largely true for a long period of time. Between 1950 and 1980, productivity and wages increased similarly. Since 1980, productivity has increased while wages have not seen significant changes in real terms.

Unemployment

Modern economies rely on constant growth, with periods of shrinking GDP referred to as recessions. Typically, when GDP growth is strong, unemployment falls. Recessions can lead to significant amounts of unemployment as employers lay off workers or go out of business.

According to data from Pew Research, recessions directly lead to rising unemployment, with the 1990-1991 recession causing unemployment to rise from just under 6% to about 8%. Similarly, the Great Recession of 2007-2009 caused unemployment to rise from just over 4% to a high of nearly 10%.


As GDP began to grow again after these recessions, employment began to rise.


Criticisms of GDP

GDP is a useful economic measure used by organizations like the World Bank, International Monetary Fund (IMF), United Nations, and economists across the world. However, that doesn’t mean GDP is a perfect measure of the economy. There are many criticisms of GDP and situations where using GDP data to make decisions might not be a good idea.

These important economic factors are overlooked in traditional measurements of GDP:

  • Recessionary Hangovers. By definition, a recession ends when an economy’s GDP begins to rise after a period of decreasing. However, even when a recession technically ends, it can take years before the economy returns to its pre-recession level. For example, despite the Great Recession’s end in 2009, it took nearly a decade for unemployment to return to pre-recession levels.
  • Impacts of Credit. Not all spending in an economy comes from the income it generates. Individuals, corporations, and governments borrow money to spend on goods and services. The costs and impacts of this debt are not fully accounted for in GDP even though they can have massive impacts on an economy.
  • The Underground Economy. For many reasons, economic activity can occur outside of the usual channels, making it hard to track. The sale of illegal goods, for example, is rarely tracked and included in GDP even though those are technically goods produced by an economy. Similarly, someone working under the table or without an officially incorporated business might not report their income or sales, causing that production to be excluded from GDP.
  • Bartering. Related to the underground economy, some economic activity relies on bartering or the exchange of valuables other than cash. This type of activity usually doesn’t show up in GDP even though it can play a significant role in an economy, especially in the middle of a recession.
  • Unpaid Work. Many people perform valuable work, such as caring for children or older relatives, without any compensation. This work produces immense value but isn’t counted in GDP calculations.
  • Sustainability. GDP is purely a measure of economic production. It does not account for damage to the local environment or whether actions that are causing growth now will cause the economy to shrink in the long run. Nations that raze their forests, strip-mine their land, and build factories that pollute the air can see major GDP growth, but will likely find that growth unsustainable as they drain or degrade the natural resources that are available.

Gross Domestic Product FAQs

What’s the Difference Between GDP vs. GNP vs. GNI?

Gross domestic product (GDP), gross national product (GNP), and gross national income (GNI) are all macroeconomic measures that look at slightly different things.

GNP adjusts GDP for net income earned from outside the country’s borders. For example, if some of the income produced by a multinational organization within a country is sent to another nation, it is subtracted from GNP even though it is included in GDP.

GNI measures all of a nation’s income, including income earned by its residents and businesses including all income from foreign sources. It includes income its residents earn while abroad but excludes income earned by foreign residents within its borders.

Does GDP Include Inflation?

GDP measures the value of an economy’s output based on current values. That means changes in inflation impact GDP. If inflation makes goods cost more, those higher prices will cause GDP to rise.

Real GDP is a measure of GDP that adjusts for inflation, calculating the value of goods and services at a set monetary value. This measure is more useful for measuring GDP changes over time because it removes the rise in GDP caused by inflation.

What Does GDP Not Measure?

One of the criticisms of GDP is that it fails to measure many important aspects of economic activity.

One major factor GDP excludes is the underground economy, which includes everything from the sale of illegal goods and services to unreported cash transactions and barter transactions.

GDP is also limited in that it is solely an economic measure. GDP doesn’t account for important quality-of-life measurements like the availability of quality health care and education, equality, opportunity, or the environment.

This limitation has led to other measures that provide a more complete look at people’s well-being. For example, Bhutan’s government has designed the concept of Gross National Happiness, which tries to account for economic development alongside sustainability, environmentalism, preservation and promotion of culture, and good governance.

What Countries Have the Highest GDP?

There are multiple types of GDP, including nominal GDP, GDP per capita, and GDP PPP, which all measure slightly different things.

According to the World Bank, in terms of nominal GDP, which simply measures economic output, the top three countries are:

  1. United States ($20.953 trillion)
  2. China ($14.722 trillion)
  3. Japan ($5.057 trillion)

For GDP per capita, a measure of output compared to population, the top three are:

  1. Liechtenstein ($175,813 per capita)
  2. Monaco ($173,688 per capita)
  3. Luxembourg ($116,014 per capita)

For GDP PPP, which measures output while controlling for the purchasing power and cost of goods in different currencies, the top three are:

  1. China ($24.283 trillion)
  2. United States ($20.953 trillion)
  3. India ($8.975 trillion)

Final Word

GDP is a popular macroeconomic measure that tries to calculate the total value of an economy’s outputs. Despite its popularity, there are limits to GDP, and each different way of calculating it has pros and cons.

GDP can have some impacts on people’s everyday lives. Generally, financial times are good when GDP is growing and bad when it’s falling. Most people can feel satisfied understanding that simple fact and leave the more complicated measures and implications of GDP to central bankers and economists.

There are plenty of other economic indicators and measures that have a more direct impact on people’s lives. For example, the Consumer Price Index (CPI) is a measure of inflation and how it impacts the price of goods people buy regularly.

TJ is a Boston-based writer who focuses on credit cards, credit, and bank accounts. When he's not writing about all things personal finance, he enjoys cooking, esports, soccer, hockey, and games of the video and board varieties.

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