What is Gross Domestic Product (GDP)?

Gross domestic product, known as GDP, measures the value of final goods and services a region or country produces in a certain time frame. Final goods and services mean that the item or service is ready to be purchased by the final user, like a consumer purchasing a loaf of bread at the grocery store.

GDP doesn’t include all activities within the border, specifically related to services. Unpaid work, like volunteer hours, is difficult to assign a cost to, therefore unpaid work is excluded from GDP.

For example, if a mechanic fixed a customer’s car, the amount the customer paid would be included in GDP. However, if the mechanic fixed their own car and did not make any payments to their business, it would not be included in the calculation.

Additionally, GDP does not consider any factors that go into producing the output, like machine maintenance in a manufacturing business. When these expenditures are calculated and subtracted from gross GDP, the result is net GDP.

Why is GDP Important?

GDP is an important value to track to understand economic growth and how the country compares to the world economy. For example, if other countries have a real GDP growth rate of 5%, but the US GDP decreases, it can indicate underlying economic issues, which could sway the decision-making process surrounding investments and purchases. This is why real GDP is often used to evaluate the overall financial health of a country.

Increases in GDP indicate that the economy is doing well, as more goods and services are being purchased. Unemployment and disposable income are also correlated to GDP. As GDP grows, unemployment decreases, and disposable income rises. However, when GDP shrinks, the opposite impact is true. Unemployment might increase, goods might become more expensive, and citizens generally have less disposable income.

GDP does move in cycles, much like the financial markets. Economies will have both expansionary periods and recessionary periods. During expansionary periods, businesses are producing more goods and services for the end consumer and imports might be lower. On the contrary, recessionary periods are coupled with higher prices and cheaper imports.

Since GDP is a crucial measurement in evaluating the health of an economy, two or more periods with GDP declines are considered a recession. Tracking GDP is a great way to understand where the economy is headed.

Real GDP vs Nominal GDP

There are two main types of GDP: real GDP and nominal GDP. Nominal GDP is found by taking the standard GDP calculation, while real GDP is adjusted for inflation. The adjustment from nominal GDP to real GDP takes into account price changes, allowing transparency in how the actual output has changed for the period.

For example, if a gallon of milk jumped from $4 to $5, GDP will increase. Without factoring in inflation, you might draw the conclusion that the output has increased. However, if milk prices rose 10%, the actual output might remain unchanged from the prior period even though the total value of the gallon of milk increased. Adjusting nominal GDP for inflation allows you to understand the real GDP growth rate.

How is GDP Measured?

Measuring gross domestic product can be done in a few different ways. GDP figures are generally calculated on a quarterly and annual basis by a nation’s statistical agency. This is because government agencies have access to numerous sources of information to accurately track economic growth and issue GDP data. Nevertheless, here are three ways of calculating GDP:

• Production Approach – This method adds up the “value-added” in each stage of the production cycle. Value-added is gross sales minus the value of inputs. For example, oil used in an oil change could be an intermediate input.
• Expenditure Approach – This approach adds up the value of purchases made by the final user. For example, an individual purchasing a gallon of milk from the grocery store. The backend work that went into producing that gallon of milk is excluded, with only the final purchase by the consumer being recorded.
• Income Approach – This method adds all of the income generated during the production cycle. For example, the wages paid to employees for milking cows.

Each of these approaches will generate different GDP data. Many sources will track economic statistics related to GDP using one or more of these methods, allowing for greater comparability. Remember, each country will report GDP in its functional currency. If you are looking to compare GDP between countries, you will need to ensure the values are in the same currency.

Moreover, it’s important to evaluate the method used to calculate GDP and if the figure is real GDP or nominal GDP. Ensuring all factors are the same increases accuracy in your comparisons and helps you gauge the true conditions of a country.

Gross Domestic Product vs Gross National Product

GDP is not the same as GNP. Gross national product measures the outputs of the residents in a country. For example, let’s say that a Spanish-owned company has a manufacturing plant in the United States. The United States’ GDP would include the output of the factory, while Spain’s GDP would not. However, Spain’s GNP would include the factory output.

Both GDP and GNP can shed insights into the activities of a country and its residents. For example, if you notice GNP is much higher than GDP, it can indicate that businesses are moving operations overseas. When GDP increases at a higher rate than GNP, it tells economists that more goods and services are being produced within the borders, both from domestic and international businesses.

Limitations of GDP

GDP figures aren’t the tell-all factor in an economy. In fact, GDP does have some notable limitations. For one, GDP doesn’t capture the impact of economic conditions on citizens. Even though real GDP might be higher, it doesn’t mean the average national income per citizen has grown. Overall well-being might be stagnant or worse compared to the prior period.

Moreover, increases in GDP output can have negative impacts on the environment, such as the depletion of natural resources or the increase in carbon emissions. GDP only focuses on the value of final outputs without considering the long-term effects on the environment and communities.

For example, if a company decides to use a 10-acre corn field to build a new factory, output might increase, but what’s the true cost? How will that new factory impact the community? How about the actual cost of building the factory? These items are not considered in the GDP measurement.

Due to these shortcomings, there are other data sets that look to provide a better outlook on individual well-being, like the Human Development Index. This index tracks a variety of factors, including life expectancy, literacy, and school enrollment. Using multiple sources of information is the best way to determine the overall health of an economy.

Summary

• Gross domestic product (GDP) is the measurement of the outputs of goods and services a country has for a defined period.
• GDP is useful when evaluating the growth or recession of an economy; however, the calculation doesn’t always depict the entire picture, as environmental and individual economic impacts aren’t factored into GDP.
• Real GDP is nominal GDP adjusted for inflation.
• There are three main methods for measuring GDP: the production approach, the expenditure approach, and the income approach.
• GDP calculates all the outputs within the country, while GNP includes all of the outputs of the country’s residents, regardless of physical location.