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Guide to Economics

ECONOMY

ECONOMICS

Gross Domestic Product (GDP)

By
JASON FERNANDO
Updated September 08, 2021

Reviewed by
MICHAEL J BOYLE
Fact checked by
TIMOTHY LI

TABLE OF CONTENTS
Gross Domestic Product (GDP)
Understanding GDP
Types of GDP
Ways of Calculating GDP
EXPAND +
GDP vs GNP vs GNI

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.

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Though GDP is typically calculated on an annual basis, it is sometimes calculated on a
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quarterly basis
Guide toasEconomics
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.

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 policy-makers, investors, and
businesses in strategic decision-making.

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What Is GDP?
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Guide to Economics

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
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trade surplus.
If the opposite situation occurs—if the amount that domestic consumers spend on foreign
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products is greater
Guide than the total sum of what domestic producers are able to sell to foreign
to Economics
consumers—it is called a trade deficit. In this situation, the GDP of a country tends to
decrease.

GDP can be computed on 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.
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Nominal GDP
Nominal GDP is an assessment of economic production in an economy that includes current
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
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valuedGuide
at the to
prices that those goods and services are actually sold for in that year. Nominal
Economics
GDP is evaluated in either the local currency or U.S. dollars at currency market exchange rates
to compare countries’ GDPs 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 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 because of a real
expansion in production or simply because prices rose.
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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
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
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compare a country’s
Guide GDP from one year to another and see if there is any real growth.
to Economics

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, then 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 nominal GDP, this may be an indicator of 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
that 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 (purchasing power parity) 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
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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
Per-capita GDP is often analyzed alongside more traditional measures of GDP. Economists use
this metric for insight into their own country’s domestic productivity and the productivity of
other countries. Per-capita GDP considers both a country’s GDP and its population. Therefore,
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it can be important
Guide to understand how each factor contributes to the overall result and is
to Economics
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 a 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 Rate

The GDP growth rate compares the year-over-year (or quarterly) change in a country’s
economic output to measure how fast an economy is growing. Usually expressed as a
percentage rate, this measure is popular for economic policy-makers 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 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
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approach, the output (or production) approach, and the income approach.

Th E dit A h
The Expenditure Approach

The expenditure approach, also known as the spending approach, calculates spending by the
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different groups
Guide that participate in the economy. The U.S. GDP is primarily measured based on
to Economics
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. [1] 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 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.

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The net exports formula 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
i h h db d i ’ ll
imports that are purchased by domestic consumers, represent a country’s net exports. All

expenditures by companies located in a given country, even if they are foreign companies, are
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included in this
Guide to calculation.
Economics

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. 
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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
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
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wear down
Guide with use—is also added to the national income. All of this together constitutes a
to Economics
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), gross
national product (GNP) is a measurement of the overall production of people 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 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 all 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 figure is much higher
than the figure that represents their GNI.

For example, in 2019, Luxembourg had a significant difference between its GDP and GNI,
mainly 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. [2] On the contrary,
in the U.S., GNI and GDP do not differ substantially. In 2019, U.S. GDP was $21.7 trillion [3]
while its GNI was $21.7 trillion also. [4] Ad

Adjustments to GDP
 j

A number of adjustments can be made to a country’s GDP to improve the usefulness of this
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figure.Guide
For economists, a country’s GDP reveals the size of the economy but provides little
to Economics
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 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, then the worker in
China has a higher real income.

How to Use GDP Data

Most nations release GDP data every month and quarter. In the U.S., the Bureau of Economic
Analysis (BEA) publishes an advance release of quarterly GDP four weeks after the quarter Ad
ends, and a final release three months after the quarter ends. The BEA releases are exhaustive
and contain a wealth of detail, enabling economists and investors to obtain information and
insights on various aspects of the economy.

GDP’s market impact is generally limited, since it is “backward-looking,” and a substantial

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amount of time
Guide to has already elapsed between the quarter-end and GDP data release. However,
Economics
GDP data can have an impact on markets if the actual numbers differ considerably from
expectations.

Because GDP provides a direct indication of the health and growth of the economy,
businesses can use GDP as a guide to their business strategy. Government entities, such as the
Fed in the U.S., use the growth rate and other GDP stats as part of their decision process in
determining what type of monetary policies to implement. If the growth rate is slowing, they
might implement an expansionary monetary policy to try to boost the economy. If the growth
rate is robust, they might use monetary policy to slow things down to try to ward off inflation.

Real GDP is the indicator that says the most about the health of the economy. It is widely
followed and discussed by economists, analysts, investors, and policy-makers. The advance
release of the latest data will almost always move markets, although that impact can be
limited, as noted above.

GDP and Investing

Investors watch GDP since it provides a framework for decision-making. The “corporate
profits” and “inventory” data in the GDP report are a great resource for equity investors, as
both categories show total growth during the period; corporate profits data also displays pre-
tax profits, operating cash flows, and breakdowns for all major sectors of the economy.
Comparing the GDP growth rates of different countries can play a part in asset allocation,
aiding decisions about whether to invest in fast-growing economies abroad—and if so, which
ones.

One interesting metric that investors can use to get some sense of the valuation of an equity
market is the ratio of total market capitalization to GDP, expressed as a percentage. The
closest equivalent to this in terms of stock valuation is a company’s market cap to total sales
(or revenues), which in per-share terms is the well-known price-to-sales ratio.

Just as stocks in different sectors trade at widely divergent price-to-sales ratios, different Ad
nations trade at market-cap-to-GDP ratios that are literally all over the map. For example,
according to the World Bank, the U.S. had a market-cap-to-GDP ratio of 158% for 2019, while
China had a ratio of just over 59% and Hong Kong had a ratio of 1,349%. [5]

However, the utility of this ratio lies in comparing it to historical norms for a particular nation.
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As an example,
Guide tothe U.S. had a market-cap-to-GDP ratio of 141% at the end of 2006, which
Economics
dropped to 78% by the end of 2008. [5] In retrospect, these represented zones of substantial
overvaluation and undervaluation, respectively, for U.S. equities.

The biggest downside of this data is its lack of timeliness; investors only get one update per
quarter, and revisions can be large enough to significantly alter the percentage change in GDP.

History of GDP
The concept of GDP was first proposed in 1937 in a report to the U.S. Congress in response to
the Great Depression, conceived of and presented by an economist at the National Bureau of
Economic Research, Simon Kuznets. [6]

At the time, the preeminent system of measurement was GNP. After the Bretton Woods
conference in 1944, GDP was widely adopted as the standard means for measuring national
economies, although ironically, the U.S. continued to use GNP as its official measure of
economic welfare until 1991, after which it switched to GDP. [6]

Beginning in the 1950s, however, some economists and policy-makers began to question GDP.
Some observed, for example, a tendency to accept GDP as an absolute indicator of a nation’s
failure or success, despite its failure to account for health, happiness, (in)equality, and other
constituent factors of public welfare. In other words, these critics drew attention to a
distinction between economic progress and social progress.

However, most authorities, like Arthur Okun, an economist for President John F. Kennedy’s
Council of Economic Advisers, held firm to the belief that GDP is an absolute indicator of
economic success, claiming that for every increase in GDP, there would be a corresponding
drop in unemployment.

Criticisms of GDP
There are, of course, drawbacks to using GDP as an indicator. In addition to the lack of
timeliness, some criticisms of GDP as a measure are: Ad

It ignores the value of informal or unrecorded economic activity GDP relies on recorded
It ignores the value of informal or unrecorded economic activity — GDP relies on recorded
transactions and official data, so it does not take into account the extent of informal
economic activity. GDP fails to account for the value of under-the-table employment,
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underground market activity, or unremunerated volunteer work, which can all be
Guide to Economics
significant in some nations and cannot account for the value of leisure time or household
production, which are ubiquitous conditions of human life in all societies.
It is geographically limited in a globally open economy — GDP does not take into account
profits earned in a nation by overseas companies that are remitted back to foreign
investors. This can overstate a country’s actual economic output. For example, Ireland had
a GDP of $398 billion [7] and GNI of $308 billion in 2019, [8] the difference of approximately
$90 billion (or over 20% of GDP) largely being due to profit repatriation by foreign
companies based in Ireland.
It emphasizes material output without considering overall well-being — GDP growth
alone cannot measure a nation’s development or its citizens’ well-being, as noted above.
For instance, a nation may be experiencing rapid GDP growth, but this may impose a
significant cost to society in terms of environmental impact and an increase in income
disparity.
It ignores business-to-business activity — GDP considers only final goods production and
new capital investment and deliberately nets out intermediate spending and transactions
between businesses. By doing so, GDP overstates the importance of consumption relative
to production in the economy and is less sensitive as an indicator of economic fluctuations
compared to metrics that include business-to-business activity.
It counts costs and waste as economic benefits — GDP counts all final private and
government spending as additions to income and output for society, regardless of whether
they are actually productive or profitable. This means that obviously unproductive or even
destructive activities are routinely counted as economic output and contribute to growth
in GDP. For example, this includes spending directed toward extracting or transferring
wealth between members of society rather than producing wealth (such as the
administrative costs of taxation or money spent on lobbying and rent-seeking); spending
on investment projects for which the necessary complementary goods and labor are not
available or for which actual consumer demand does not exist (such as the construction of
empty ghost cities or bridges to nowhere, unconnected to any road network); and
spending on goods and services that are either themselves destructive or only necessary to
offset other destructive activities, rather than to create new wealth (such as the production
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of weapons of war or spending on policing and anti-crime measures).
Sources for GDP Data

The World Bank hosts one of the most reliable web-based databases. It has one of the best
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and most comprehensive
Guide to Economicslists of countries for which it tracks GDP data. The International
Money Fund (IMF) also provides GDP data through its multiple databases, such as World
Economic Outlook and International Financial Statistics.

Another highly reliable source of GDP data is the Organization for Economic Cooperation and
Development (OECD). The OECD not only provides historical data but also forecasts GDP
growth. The disadvantage of using the OECD database is that it tracks only OECD member
countries and a few nonmember countries.

In the U.S., the Fed collects data from multiple sources, including a country’s statistical
agencies and The World Bank. The only drawback to using a Fed database is a lack of updating
in GDP data and an absence of data for certain countries.

The Bureau of Economic Analysis (BEA) a division of the U.S. Department of Commerce, issues
its own analysis document with each GDP release, which is a great investor tool for analyzing
figures and trends and reading highlights of the very lengthy full release.

What Is a Simple Definition of GDP?

Gross domestic product (GDP) is a measurement that seeks to capture a country’s economic
output. Countries with larger GDPs will have a greater amount of goods and services
generated within them, and will generally have a higher standard of living. For this reason,
many citizens and political leaders see GDP growth as an important measure of national
success, often referring to “GDP growth” and “economic growth” interchangeably. Due to
various limitations, however, many economists have argued that GDP should not be used as a
proxy for overall economic success, much less the success of a society more generally.

Which Country Has the Highest GDP?

The countries with the two highest GDPs in the world are the United States and China.
However, their ranking differs depending on how you measure GDP. Using nominal GDP, the
United States comes in first with a GDP of $20.93 trillion as of 2020, compared to $14.7 trillion
for China. [9] Many economists, however, argue that it is more accurate to use purchasing Ad

power parity (PPP) GDP as a measure for national wealth. By this metric, China is actually the
world leader with a 2020 PPP GDP of $24.3 trillion, followed by $20.9 trillion for the United
 , y
States. [10]

Is a High GDP Good?

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Guideperceive
Most people to Economics
a higher GDP to be a good thing because it is associated with greater
economic opportunities and an improved standard of material well-being. It is possible,
however, for a country to have a high GDP and still be an unattractive place to live, so it is
important to also consider other measurements. For example, a country could have a high
GDP and a low per-capita GDP, suggesting that significant wealth exists but is concentrated in
the hands of very few people. One way to address this is to look at GDP alongside another
measure of economic development, such as the Human Development Index (HDI).

The Bottom Line

In their seminal textbook Economics, Paul Samuelson and William Nordhaus neatly sum up
the importance of the national accounts and GDP. They liken the ability of GDP to give an
overall picture of the state of the economy to that of a satellite in space that can survey the
weather across an entire continent.

GDP enables policy-makers and central banks to judge whether the economy is contracting or
expanding, whether it needs a boost or restraint, and if a threat such as a recession or inflation
looms on the horizon. Like any measure, GDP has its imperfections. In recent decades,
governments have created various nuanced modifications in attempts to increase GDP
accuracy and specificity. Means of calculating GDP have also evolved continually since its
conception to keep up with evolving measurements of industry activity and the generation
and consumption of new, emerging forms of intangible assets.

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Related Terms
What Is Per Capita GDP?
Per capita GDP is a metric that breaks down a country's GDP per person and is calculated by dividing the
GDP of a country by its population.
more
What Is Real Gross Domestic Product (Real GDP)?
Real gross domestic product (real GDP) is an inflation-adjusted measure of the value of all goods and
services produced in an economy.
more Ad

Gross National Income (GNI)

Gross National Income (GNI), an alternative to GDP as a way to measure and track a nation's wealth, is the
total amount of money earned by a nation's people and businesses.
more

PART OF
Bureau of to
Guide Economic
EconomicsAnalysis (BEA)
The Bureau of Economic Analysis (BEA), a division of the U.S. Department of Commerce, is responsible for
the analysis and reporting of economic data.
more

What Is Aggregate Demand?

Aggregate demand is the total amount of goods and services demanded in the economy at a given overall
price level at a given time.
more

What Are Government Purchases?

Government purchases are expenditures by federal, state, and local governments, which combined are a
key factor in determining GDP.
more

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Investors?
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