The gross domestic product (GDP) of a nation is an estimate of the total value of all the goods and services it produced during a specific period, usually a quarter or a year. Its greatest use is as a point of comparison: Did the nation's economy grow or contract compared to the previous period measured?

Key Takeaways

• GDP can be calculated by adding up all of the money spent by consumers, businesses, and government in a given period.
• It may also be calculated by adding up all of the money received by all the participants in the economy.
• In either case, the number is an estimate of "nominal GDP."
• Once adjusted to remove any effects due to inflation, "real GDP" is revealed.

There are two main ways to measure GDP: by measuring spending or by measuring income.

And then there's real GDP, which is an adjustment that removes the effects of inflation so that the economy's growth or contraction can be seen clearly.

Calculating GDP Based on Spending

One way of arriving at GDP is to count up all of the money spent by the different groups that participate in the economy. These include consumers, businesses, and government. All pay for goods and services that contribute to the GDP total.

In addition, some of the nation's goods and services are exported for sale overseas. And some of the products and services that are consumed are imports from abroad. The GDP calculation accounts for spending on both exports and imports.

Thus, a country’s GDP is the total of consumer spending (C) plus business investment (I) and government spending (G), plus net exports, which is total exports minus total imports (X-M).

Calculating GDP Based on Income

The flip side of spending is income. Thus, an estimate of GDP may reflect the total amount of income paid to everyone in the country.

This calculation includes all of the factors of production that make up an economy. It includes the wages paid to labor, the rent earned by land, the return on capital in the form of interest, and the entrepreneur’s profits. All of these make up the national income.

This approach is complicated by the need to make adjustments for some items that don't always appear in the raw numbers. These include:

• Indirect business taxes such as sales taxes and property taxes;
• Depreciation, a measure of the decreasing value of business equipment over time;
• Net foreign factor income, which is foreign payments made to Americans minus American payments made to foreigners.

In this income approach, the GDP of a country is calculated as its national income plus its indirect business taxes and depreciation, plus its net foreign factor income.

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Real GDP

Since GDP measures an economy’s output, it is subject to inflationary pressure. Over a period of time, prices typically go up, and this will be reflected in GDP.

A nation's unadjusted GDP can't tell you whether GDP went up because production and consumption increased or because prices went up.

Real GDP is a measure of an economy's output adjusted for inflation. The unadjusted figure is referred to as nominal GDP.

Real GDP adjusts nominal GDP so that it reflects the price levels that prevailed in a reference year, called“the "base year.”

How GDP Is Used

GDP is an important statistic that indicates whether an economy is growing or contracting. In the U.S., the government releases an annualized GDP estimate for every quarter and every year, followed by final figures for each of those periods.

Tracking GDP over time helps a government make decisions such as whether to stimulate the economy by pumping more cash into it or to cool it by pulling money out.

Businesses may use GDP as a factor when deciding whether to expand or contract production or whether to undertake major projects.

Investors watch GDP to get a sense of where the economy may be headed in the weeks ahead.

Drawbacks of GDP

While GDP is a useful way to get a sense of the state of an economy, it is by no means a perfect approach. One criticism is that it does not account for activities that are not part of the legalized economy. The proceeds of off-the-books labor, some cash transactions, drug dealing, and more are not factored into GDP.

Another criticism is that some activities that provide value are not factored into GDP. For instance, if you hire a maid to keep your house clean, a cook to prepare your meals, and a nanny to care for your children, you will pay these hired helpers and the payments will factor into GDP. If you do those jobs yourself, your contribution is not counted in GDP.

So, while GDP can provide a sense of an economy’s performance over time, it doesn’t tell the whole story.