Gross Domestic Product (GDP)

Gross Domestic Product (GDP)

By 

JASON FERNANDO

Updated Apr 7, 2021

TABLE OF CONTENTS

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 What Is Gross Domestic Product (GDP)?

 Understanding Gross Domestic Product (GDP)
 Types of Gross Domestic Product
 Ways of Calculating GDP
 GDP vs. GNP vs. GNI
 Adjustments to GDP
 How to Use GDP Data
 GDP and Investing
 History of GDP
 Criticisms of GDP
 Sources for GDP Data
 The Bottom Line
 Frequently Asked Questions

What Is Gross Domestic Product (GDP)?

Gross domestic product (GDP) is the total monetary or market value of all the
finished goods and services produced within a country's borders in a specific
time period. As a broad measure of overall domestic production, it functions as a
comprehensive scorecard of a given country’s economic health.

Though GDP is typically calculated on an annual basis, it is sometimes

calculated on a quarterly basis as well. In the U.S., for example, the government
releases an annualized GDP estimate for each fiscal quarter and also for the
calendar year. The individual data sets included in this report are given in real
terms, so the data is adjusted for price changes and is, therefore, net of inflation.
In the U.S., the Bureau of Economic Analysis (BEA) calculates the GDP using
data ascertained through surveys of retailers, manufacturers, and builders, and
by looking at trade flows.

KEY TAKEAWAYS

 Gross Domestic Product (GDP) is the monetary value of all finished goods
and services made within a country during a specific period.
 GDP provides an economic snapshot of a country, used to estimate the
size of an economy and growth rate.
 GDP can be calculated in three ways, using expenditures, production, or
incomes. It can be adjusted for inflation and population to provide deeper
insights.
 Though it has limitations, GDP is a key tool to guide policymakers,
investors, and businesses in strategic decision-making.
 What Is GDP?

Understanding Gross Domestic Product (GDP)

The calculation of a country's GDP encompasses all private and public
consumption, government outlays, investments, additions to private inventories,
paid-in construction costs, and the foreign balance of trade. (Exports are added
to the value and imports are subtracted).

Of all the components that make up a country's GDP, the foreign balance of
trade is especially important. The GDP of a country tends to increase when the
total value of goods and services that domestic producers sell to foreign
countries exceeds the total value of foreign goods and services that domestic
consumers buy. When this situation occurs, a country is said to have a trade
surplus. If the opposite situation occurs–if the amount that domestic consumers
spend on foreign products is greater than the total sum of what domestic
producers are able to sell to foreign consumers–it is called a trade deficit. In this
situation, the GDP of a country tends to decrease.

GDP can be computed on either a nominal basis or a real basis, the latter
accounting for inflation. Overall, real GDP is a better method for expressing long-
term national economic performance since it uses constant dollars. For example,
suppose there is a country that in the year 2009 had a nominal GDP of $100
billion. By 2019, this country's nominal GDP had grown to $150 billion. Over the
same period of time, prices also rose by 100%. In this example, if you were to
look solely at the nominal GDP, the economy appears to be performing well.
However, the real GDP (expressed in 2009 dollars) would only be $75 billion,
revealing that, in actuality, an overall decline in real economic performance
occurred during this time.
Types of Gross Domestic Product
GDP can be reported in several ways, each of which provides slightly different
information.

Nominal GDP
Nominal GDP is an assessment of economic production in an economy that
includes current prices in its calculation. In other words, it doesn't strip out
inflation or the pace of rising prices, which can inflate the growth figure. All goods
and services counted in nominal GDP are valued at the prices that are actually
sold for in that year. Nominal GDP is evaluated in either the local currency or in
U.S. dollars at currency market exchange rates in order to compare countries'
GDP in purely financial terms.

Nominal GDP is used when comparing different quarters of output within the
same year. When comparing the GDP of two or more years, real GDP is used.
This is because, in effect, the removal of the influence of inflation allows the
comparison of the different years to focus solely on volume.

Real GDP
Real GDP is an inflation-adjusted measure that reflects the quantity of goods and
services produced by an economy in a given year, with prices held constant from
year to year in order to separate out the impact of inflation or deflation from the
trend in output over time. Since GDP is based on the monetary value of goods
and services, it is subject to inflation. Rising prices will tend to increase a
country's GDP, but this does not necessarily reflect any change in the quantity or
quality of goods and services produced. Thus, by looking just at an economy’s
nominal GDP, it can be difficult to tell whether the figure has risen as a result of a
real expansion in production, or simply because prices rose.

Economists use a process that adjusts for inflation to arrive at an economy’s real
GDP. By adjusting the output in any given year for the price levels that prevailed
in a reference year, called the base year, economists can adjust for inflation's
impact. This way, it is possible to compare a country’s GDP from one year to
another and see if there is any real growth.

Real GDP is calculated using a GDP price deflator, which is the difference in
prices between the current year and the base year. For example, if prices rose by
5% since the base year, the deflator would be 1.05. Nominal GDP is divided by
this deflator, yielding real GDP. Nominal GDP is usually higher than real GDP
because inflation is typically a positive number. Real GDP accounts for changes
in market value, and thus, narrows the difference between output figures from
year to year. If there is a large discrepancy between a nation's real GDP and its
nominal GDP, this may be an indicator of either significant inflation or deflation in
its economy.

GDP Per Capita

GDP per capita is a measurement of the GDP per person in a country's
population. It indicates the amount of output or income per person in an economy
can indicate average productivity or average living standards. GDP per capita
can be stated in nominal, real (inflation-adjusted), or PPP terms. At a basic
interpretation, per capita GDP shows how much economic production value can
be attributed to each individual citizen. This also translates to a measure of
overall national wealth since GDP market value per person also readily serves as
a prosperity measure.

Per capita GDP is often analyzed alongside more traditional measures of GDP.
Economists use this metric for insight on both their own country's domestic
productivity as well as the productivity of other countries. Per capita GDP
considers both a country's GDP and its population. Therefore, it can be important
to understand how each factor contributes to the overall result and how each
factor is affecting per capita GDP growth. If a country’s per capita GDP is
growing with a stable population level, for example, it could be the result of
technological progressions that are producing more with the same population
level. Some countries may have high per capita GDP but a small population
which usually means they have built up a self-sufficient economy based on an
abundance of special resources.

GDP Growth
The GDP growth rate compares the year-over-year (or quarterly) change in a
country's economic output in order to measure how fast an economy is growing.
Usually expressed as a percentage rate, this measure is popular for economic
policymakers because GDP growth is thought to be closely connected to key
policy targets such as inflation and unemployment rates.

If GDP growth rates accelerate, it may be a signal that the economy is

"overheating" and the central bank may seek to raise interest rates. Conversely,
central banks see a shrinking (or negative) GDP growth rate (i.e., a recession) as
a signal that rates should be lowered and that stimulus may be necessary.

GDP Purchasing Power Parity (PPP)

While not directly a measure of GDP, economists look at purchasing Power
Parity (PPP) to see how one country's GDP measures up in "international
dollars" using a method that adjusts for differences in local prices and costs of
living in order to make cross-country comparisons of real output, real income,
and living standards.
Ways of Calculating GDP
GDP can be determined via three primary methods. All three methods should
yield the same figure when correctly calculated. These three approaches are
often termed the expenditure approach, the output (or production) approach, and
the income approach.

The Expenditure Approach

The expenditure approach, also known as the spending approach, calculates
spending by the different groups that participate in the economy. The U.S. GDP
is primarily measured based on the expenditure approach. This approach can be
calculated using the following formula:

GDP = C + G + I + NX
where

 C=consumption;
 G=government spending;
 I=Investment; and
 NX=net exports

All of these activities contribute to the GDP of a country. Consumption refers to

private consumption expenditures or consumer spending. Consumers spend
money to acquire goods and services, such as groceries and haircuts. Consumer
spending is the biggest component of GDP, accounting for more than two-thirds
of the U.S. GDP. Consumer confidence, therefore, has a very significant bearing
on economic growth. A high confidence level indicates that consumers are willing
to spend, while a low confidence level reflects uncertainty about the future and
an unwillingness to spend.

Government spending represents government consumption expenditure and

gross investment. Governments spend money on equipment, infrastructure, and
payroll. Government spending may become more important relative to other
components of a country's GDP when consumer spending and business
investment both decline sharply. (This may occur in the wake of a recession, for
example.)

Investment refers to private domestic investment or capital expenditures.

Businesses spend money in order to invest in their business activities. For
example, a business may buy machinery. Business investment is a critical
component of GDP since it increases the productive capacity of an economy and
boosts employment levels.
Net exports subtracts total exports from total imports (NX = Exports - Imports).
The goods and services that an economy makes that are exported to other
countries, less the imports that are purchased by domestic consumers,
represents a country's net exports. All expenditures by companies located in a
given country, even if they are foreign companies, are included in this calculation.

The Production (Output) Approach

The production approach is essentially the reverse of the expenditure approach.
Instead of measuring the input costs that contribute to economic activity, the
production approach estimates the total value of economic output and deducts
the cost of intermediate goods that are consumed in the process (like those of
materials and services). Whereas the expenditure approach projects forward
from costs, the production approach looks backward from the vantage point of a
state of completed economic activity.

The Income Approach

The income approach represents a kind of middle ground between the two other
approaches to calculating GDP. The income approach calculates the income
earned by all the factors of production in an economy, including the wages paid
to labor, the rent earned by land, the return on capital in the form of interest, and
corporate profits. 

The income approach factors in some adjustments for those items that are not
considered payments made to factors of production. For one, there are some
taxes—such as sales taxes and property taxes—that are classified as indirect
business taxes. In addition, depreciation–a reserve that businesses set aside to
account for the replacement of equipment that tends to wear down with use–is
also added to the national income. All of this together constitutes a given nation's
income.

GDP vs. GNP vs. GNI

Although GDP is a widely-used metric, there are other ways of measuring the
economic growth of a country. While GDP measures the economic activity within
the physical borders of a country (whether the producers are native to that
country or foreign-owned entities), the gross national product (GNP) is a
measurement of the overall production of persons or corporations native to a
country, including those based abroad. GNP excludes domestic production by
foreigners.

Gross National Income (GNI) is another measure of economic growth. It is the

sum of all income earned by citizens or nationals of a country (regardless of
whether or not the underlying economic activity takes place domestically or
abroad). The relationship between GNP and GNI is similar to the relationship
between the production (output) approach and the income approach used to
calculate GDP. GNP uses the production approach, while GNI uses the income
approach. With GNI, the income of a country is calculated as its domestic
income, plus its indirect business taxes and depreciation (as well as its net
foreign factor income). The figure for net foreign factor income is calculated by
subtracting all payments made to foreign companies and individuals from those
payments made to domestic businesses.

In an increasingly global economy, GNI has been put forward as a potentially

better metric for overall economic health than GDP. Because certain countries
have most of their income withdrawn abroad by foreign corporations and
individuals, their GDP figures are much higher than the figure that represents
their GNI.

For example, in 2018, Luxembourg's GDP was $70.9 billion while its GNI was
$45.1 billion. The discrepancy was due to large payments made to the rest of the
world via foreign corporations that did business in Luxembourg, attracted by the
tiny nation's favorable tax laws. On the contrary, in the U.S., GNI and GDP do not
differ substantially. In 2018, U.S. GDP was $20.6 trillion while its GNI was $20.8
trillion.

Adjustments to GDP
There are a number of adjustments that can be made to a country's GDP in order
to improve the usefulness of this figure. For economists, a country's GDP reveals
the size of the economy but provides little information about the standard of living
in that country. Part of the reason for this is that population size and cost of
living are not consistent around the world. For example, comparing the nominal
GDP of China to the nominal GDP of Ireland would not provide very much
meaningful information about the realities of living in those countries because
China has approximately 300 times the population of Ireland.

To help solve this problem, statisticians sometimes compare GDP per

capita between countries. GDP per capita is calculated by dividing a country's
total GDP by its population, and this figure is frequently cited to assess the
nation's standard of living. Even so, the measure is still imperfect. Suppose
China has a GDP per capita of $1,500, while Ireland has a GDP per capita of
$15,000. This doesn't necessarily mean that the average Irish person is 10 times
better off than the average Chinese person. GDP per capita doesn't account for
how expensive it is to live in a country.

Purchasing power parity (PPP) attempts to solve this problem by comparing how
many goods and services an exchange-rate-adjusted unit of money can
purchase in different countries – comparing the price of an item, or basket of
items, in two countries after adjusting for the exchange rate between the two, in
effect.

Real per capita GDP, adjusted for purchasing power parity, is a heavily refined
statistic to measure true income, which is an important element of well-being. An
individual in Ireland might make $100,000 a year, while an individual in China
might make $50,000 a year. In nominal terms, the worker in Ireland is better off.
But if a year's worth of food, clothing, and other items costs three times as much
in Ireland than in China, however, the worker in China has a higher real income.