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.
- 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).
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 trade surplus. If the opposite situation occurs–if the amount that domestic consumers spend on foreign products is greater than the total sum of what domestic producers are able to sell to foreign consumers–it is called a trade deficit. In this situation, the GDP of a country tends to decrease.
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.
What Is GDP?
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.
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.
The income approach factors in some adjustments for those items that are not considered a 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 wear down with use–is also added to the national income. All of this together constitutes a given 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), the gross national product (GNP) is a measurement of the overall production of persons 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 or not 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 those 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 figures are much higher than the figure that represents their GNI.
For example, in 2018, Luxembourg's GDP was $70.9 billion while its GNI was $45.1 billion. The discrepancy was 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. On the contrary, in the U.S., GNI and GDP do not differ substantially. In 2018, U.S. GDP was $20.6 trillion while its GNI was $20.8 trillion.
There are a number of adjustments that can be made to a country's GDP in order to improve the usefulness of this figure. For economists, a country's GDP reveals the size of the economy but provides little 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 very 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 China, however, the worker in China has a higher real income.
Using 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 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 amount of time has already elapsed between the quarter end and GDP data release. However, GDP data can have an impact on markets if the actual numbers differ considerably from expectations. For example, the S&P 500 had its biggest decline in two months on Nov. 7, 2013, on reports that U.S. GDP increased at a 2.8% annualized rate in Q3, compared with economists’ estimate of 2%. The data fueled speculation that the stronger economy could lead the U.S. Federal Reserve (the Fed) to scale back its massive stimulus program that was in effect at the time.
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 Federal Reserve 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 in an effort 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 policymakers. The advance release of the latest data will almost always move markets, though 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 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 nearly 165% for 2017 (the latest year for available figures), while China had a ratio of just over 71% and Hong Kong had a ratio of 1274%.
However, the utility of this ratio lies in comparing it to historical norms for a particular nation. As an example, the U.S. had a market-cap-to-GDP ratio of 130% at the end of 2006, which dropped to 75% by the end of 2008. 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
GDP first came to light 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. 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, though ironically the U.S. continued to use GNP as its official measure of economic welfare until 1991, after which it switched to GDP.
Beginning in the 1950s, however, some economists and policymakers 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 Kennedy’s Council of Economic Advisers, held firm to the belief that GDP is as 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:
- It does not account for several unofficial income sources – GDP relies on official data, so it does not take into account the extent of informal economic activity. GDP fails to quantify the value of under-the-table employment, black market activity, volunteer work, and household production, which can be significant in some nations.
- 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 GDP of $210.3 billion and GNP of $164.6 billion in 2012, the difference of $45.7 billion (or 21.7% 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 example, 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.
Sources for GDP Data
The World Bank hosts one of the most reliable web-based databases. It has one of the best and most comprehensive lists 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 provides not only historical data but also forecasts for 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 Federal Reserve collects data from multiple sources, including a country's statistical agencies and the World Bank. The only drawback to using a Federal Reserve 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.
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 policymakers 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 so as to keep up with evolving measurements of industry activity and the generation and consumption of new, emerging forms of intangible assets.