Gross Domestic Product (GDP)

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.

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).

In addition, there are several types of GDP measurements:

  • Nominal GDP: GDP evaluated at current market prices
  • Real GDP: Real GDP is an inflation-adjusted measure that reflects both the value and the quantity of goods and services produced by an economy in a given year.
  • GDP Growth Rate: The GDP growth rate compares one quarter of a country’s GDP to the previous quarter in order to measure how fast an economy is growing.
  • GDP Per Capita: GDP per capita is a measurement of the GDP per person in a country’s population; it is a useful way to compare GDP data between various countries.

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.

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.

Overall, real GDP is a better method for expressing long-term national economic performance. 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) Calculations

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 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 refers to a calculation that involves subtracting 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 consumer, 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.

By JIM CHAPPELOW / investopedia

AdamFlorenzi

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