RV Blog Macro What is GDP?

What is GDP?

What is GDP?

GDP, or gross domestic product, refers to the total market value of all the final goods and services produced within a given period. It is usually reported every year or quarterly and is considered a strong indicator of a country’s overall productivity and economic output. Economists typically compare GDP year-over-year to measure economic growth. GDP can also fall due to labor shortages, public health emergencies, natural disasters, and other factors affecting production and employment.

Learn more about GDP, how it’s measured, and what it means for the economy at large.

What Does GDP Mean?

Every country has an economy that produces products and services. These goods and services translate into money earned for a company or individual. A country’s GDP refers to the total monetary value of all the finished goods and services produced within a given period.

GDP is often a sign of economic strength — the larger the population, the more goods and services a country can produce. Technology can also increase efficiency, helping countries produce more goods and services with fewer resources.

GDP can also be measured per capita, which shows, on average, the amount of income each person earns within a given period. For example, a country with five million people may have a GDP of $100 billion. If you divide $100 billion by five million, you get $20,000 per year per person.

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What Does GDP Measure?

GDP measures total economic output. The final total includes all the products and services manufactured during a given time frame. It encompasses all types of businesses, organizations, and individuals in the country, including private companies, government contracts, and anything else produced of value.

It also measures foreign trade. All exports are added to the GDP, and all imports are subtracted. GDP tends to improve when the total value of the country’s exports exceeds the value of its imports. This is what’s known as a trade surplus. When the total value of the country’s imports exceeds that of its exports, it is known as a trade deficit.

GDP can be measured on a nominal or real basis. Nominal GDP tracks the overall value of the monetary value of all goods and services produced without adjusting for inflation. For example, a country may have a nominal GDP of $5 billion one year and a nominal GDP of $6 billion the next. When looking at just the nominal GDP, the country’s economy seems to have grown by $1 billion.

The real GDP would adjust the previous year’s number for inflation. Let’s assume prices rose 5% over that period. When looking at the real GDP, last year’s GDP would go up to $5.25 billion, which means the country’s economy only grew by $750 million instead of a billion. The real GDP tends to be more accurate than the nominal figure, including the average cost of living.

What’s Included in GDP?

  • All newly finished goods and services produced within the country’s physical borders
  • Government spending and services
  • Construction and infrastructure
  • Exports to other countries
  • All imports are then subtracted from the total

What’s Not Included in GDP?

  • The resale of used goods
  • Products and services produced outside of the country’s physical borders
  • Goods and services sold on the black market, including illegal substances
  • Intermediate goods that are then used to create other products
  • Transfer payments

How to Calculate GDP

There are several different ways to calculate GDP. There’s the expenditure approach, the output approach, and the income approach. Each method should result in the exact figure when appropriately calculated.

The Expenditure Approach

One way to look at GDP is to analyze a company’s total expenditures. To calculate the total GDP, you will need to add up all the goods and services that buyers consume domestically, total government spending, business investments, and net exports. This thought is the primary approach used in the U.S.

The equation would be GDP = Consumption + Gov. Spending + Investments + Net Exports.

Consumer spending tends to make up the most significant portion of GDP. It tends to vary the most from year to year compared to the other components that make up GDP. Consumer spending varies based on how much money companies and consumers have to spend and how they feel about the economy’s future. When most people believe the economy is headed in the right direction, consumer spending is high. If people believe the economy isn’t doing well or are afraid they will lose their jobs, they will likely save their money instead of spending it on goods and services.

Government spending encompasses all the money used to run the local, state, and federal government, including payroll, equipment, and infrastructure.

Investments refer to all the money private companies invest in their operations, including payroll, equipment, and capital expenditures.

Net exports represent the total value of all the goods and services sold to consumers overseas minus all the imports consumed domestically.

The Output Approach

The output approach, or production approach, measures all of the costs that contribute to the economy, including all the money spent on products and services and investments, infrastructure, and government spending. Instead of measuring everything consumed, the output approach estimates how much everyone in the economy spends within a given time frame. To arrive at the total, you must subtract the cost of all intermediate goods used to make finished products, as these aren’t included in GDP. This approach relies on receipts and expense reports. 

The Income Approach

The income approach merges the other two methods by adding up all the money made within the economy over a given period. It includes all forms of income and wages, including money paid to labor, rent earned by landlords, corporate profits, and the returns made from investments due to interest. This approach doesn’t include sales tax or property taxes, which can affect the cost of production. It does include all money set aside for the depreciation of equipment as it wears down with age.

Adjusting for Cost of Living

The GDP shows us the total value of all the goods and services produced in a given country, but it doesn’t tell us much about what it’s like for the average person to live there. GDP per capita can show roughly how much each person would make per year, but this method doesn’t account for income inequality. A better method would be to calculate the purchasing power parity, examining GDP by comparing how much goods and services tend to cost between countries. 

Economists will often adjust GDP based on living costs using the PPP method. For example, a country of five million people has a GDP of $100 billion. The GDP per capita shows us that each person may make around $20,000 a year, on average. A smaller country with 100,000 people may have a GDP of $1 billion, with each person making, on average, $10,000 a year. Residents of the larger country may make twice as much per year as those living in the smaller country. But the picture changes when we adjust for the cost of living. If essential goods and services in the large country cost three times as much as they do in the smaller country, those living there would be better off.

The Bottom Line

GDP is an essential concept in economics. Keep this information in mind when considering a country’s gross domestic product.

RELATED CATEGORIES: Macro