Gross Domestic Product or GDP is the total financial or monetary market value of all ready-made goods and services produced within a country’s borders during a given period. As a general measure of aggregate domestic production, it functions as a comprehensive dashboard of the economic health of a given country.
Although GDP is generally calculated on an annual basis, it is sometimes also calculated on a quarterly basis. For example, in the United States of America, the government publishes an estimate of annually finalized GDP for each fiscal quarter and also for the calendar year. The individual data bundles included in this report are given in real terms, so the data is adjusted or managed for price changes and therefore is net of inflation. In United States of America, the Bureau of Economic Analysis (BEA) measures GDP using data obtained through surveys of retailers, manufacturers and builders and by looking at trade flows.
LOOK AT A GLANCE
— Gross domestic product or GDP is the total financial or monetary market value of all ready-made goods and services produced in a country during a given period.
— GDP provides an economic snapshot of a country, used to estimate the size of an economy and its rate of growth.
— GDP can be calculated in three ways, using expenditure, output or income. It can be adjusted for inflation and population to provide more in-depth information.
— Although it has limitations, GDP is a key tool in guiding policymakers, investors and businesses in making strategic decisions.
What is GDP? Meaning of GDP.
The calculation of a country’s GDP includes all private and public consumption, government spending, investment, private inventory additions, construction costs paid, and the external trade balance. (Exports are included or added to the value and imports are excluded or subtracted).
Of all the components that make up a country’s GDP, the external trade balance is particularly important. A country’s GDP 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 purchased by domestic consumers. When this happens, a country is said to have a trade surplus. If the reverse situation occurs – if the amount that domestic consumers spend on foreign products is greater than the total sum of what domestic producers can sell to foreign consumers – this is called a trade deficit. In this condition, the Gross Domestic Product of a country tends to decline.
GDP can be calculated either on a nominal basis or on a real basis, the latter taking inflation into account. Overall, real GDP is a better method of expressing long-term national economic performance since it uses constant dollars. For example, suppose there is a country that in 2009 had a nominal GDP of $ 100 billion. By 2019, the country’s nominal GDP had grown to $150 billion. During the same period, prices also increased by 100%. In this example, if you only look at nominal GDP, the economy appears to be performing well. However, real GDP (expressed in 2009 dollars) would only be $ 75 billion, revealing that in reality an overall decline in real economic performance occurred during this period.
Types of Gross Domestic Product
Gross Domestic Product (GDP) can be reported in various ways, each of which provides slightly different information.
Nominal GDP is an estimate of economic output in an economy that includes current prices in its calculation. In other words, it doesn’t suppress inflation or the pace of price increases, which can inflate the growth figure. All goods and services included in nominal GDP are valued at the prices that are actually sold in that year. Nominal GDP is valued either in local currency or in US dollars at currency market exchange rates in order to compare countries’ GDP in purely financial terms.
Nominal GDP is used to compare different quarters of production in the same year. When we compare GDP from two years or more, real GDP is used. Indeed, removing the influence of inflation allows the comparison of different years to focus only on volume.
Real Gross Domestic Product (GDP) is an inflation-adjusted measure that reflects the amount of goods and services produced by an economy in a given year, with prices held constant year over year in order to separate the impact of inflation or deflation of the production trend over time. As GDP is dependent on the monetary value of goods and services, so it is the subject matter of inflation. Rising prices will tend to increase a country’s GDP, but this does not necessarily reflect a change in the quantity or quality of goods and services produced. In this process, by looking only at the nominal GDP of an economy, it can be hard to say whether this figure has increased due to an actual expansion in production and manufacturing or simply because prices have increased.
Generally, Economists are used to a process that adjusts for inflation to arrive at an economy’s real GDP. By adjusting output in a given year to price levels that prevailed in a base year, called the base year, economists can adjust to the impact of inflation. This way, it is possible to compare a country’s GDP from year to year and see if there is real growth.
Real GDP is calculated using a GDP price deflator, which is the price difference between the current year and the base year. For example, if prices increased 5% from the base year, the deflator would be 1.05. Nominal GDP is divided by this deflator, which gives real GDP. Nominal GDP is usually higher than real GDP because inflation is usually a positive number. Real GDP explains changes in market value and thus reduces the gap between production figures from year to year. If there is a large gap between a country’s real GDP and its nominal GDP, it can be an indicator of significant inflation or deflation in its economy.
GDP Per Capita
GDP per capita is a measure of the GDP per person in the population of a country. It indicates the amount of production or income per person in an economy can indicate average productivity or average standard of living. GDP per capita can be expressed in nominal, real (inflation-adjusted) or PPP terms. In a basic interpretation, GDP per capita shows how much the value of economic output can be attributed to each citizen. It also translates into a measure of overall national wealth since the market value of GDP per person is also easily used as a measure of prosperity.
GDP per capita is often analyzed alongside more traditional measures of GDP. Economists use this metric to gain insight into both the domestic productivity of their own country and the productivity of other countries. GDP per capita takes into account both a country’s GDP and its population. Therefore, it may be important to understand how each factor contributes to the overall result and how each factor affects the growth of GDP per capita. If a country’s per capita GDP grows with a stable population level, for example, it could be the result of technological advancements that produce more with the same population level. Some countries may have a high GDP per capita but a small population, which usually means that they have built a self-sufficient economy based on an abundance of special resources.
The GDP growth rate compares the annual (or quarterly) change in a country’s economic output to measure the speed of an economy’s growth. Usually expressed as a percentage, this measure is popular with economic policymakers, as GDP growth is seen to be closely tied to key policy goals such as inflation and unemployment rates.
If GDP growth rates accelerate, this may indicate that the economy is “overheating” and that the central bank may seek to raise interest rates. Conversely, central banks see a declining (or negative) GDP growth rate (i.e., a recession) as a signal that rates should be lowered and that a stimulus may be needed.
GDP Purchasing Power Parity (PPP)
Although not directly a measure of GDP, economists look at purchasing power parity (PPP) to see how a country’s GDP is measured in “international dollars” using a method which adjust for differences in local prices and cost of living in order to make country comparisons of real production, real income and standard of living.
Ways of Calculating GDP
GDP can be determined using three main methods. All three methods should give the same number when correctly calculated. These three approaches are often referred to as the expenditure approach, the production (or production) approach, and the income approach.
The Expenditure Approach
The expenditure approach, also called the expenditure approach, calculates the expenditure of the different groups that participate in the economy. US GDP is primarily measured on the basis of the expenditure approach. This approach can be measured using the following formula:
GDP = C + G + I + NX
All of these activities contribute to a country’s GDP. Consumption refers to private consumption expenditure or consumer expenditure. Consumers spend money on goods and services, such as groceries and haircuts. Consumer spending is the largest component of GDP, accounting for over two-thirds of US GDP. Consumer confidence therefore has a very significant influence on economic growth. A high level of confidence indicates that consumers are willing to spend, while a low level of confidence reflects uncertainty about the future and reluctance to spend.
Public expenditure represents public consumption expenditure and gross investment. Governments disburse money on equipment, infrastructure and payroll. Public disbursing or spending can accelerate relative to other components of a country’s Gross Domestic Product when consumer spending and business investment both go down sharply. (This can happen following a recession, for example.)
Investment refers to private domestic investment or capital expenditure. Businesses disburse money to invest in their business operations. For example, a business can buy machinery. Business investment is an essential component of GDP because it increases the productive capacity of an economy and stimulates employment levels.
Net exports subtract total exports from total imports (NX = Exports – Imports). The goods and services that an economy produces are exported to other countries, less imports purchased by domestic consumers represent a country’s net exports. All expenses of businesses located in a given country, even if they are foreign businesses, are included in this calculation.
The (Output) Approach of the Production
The production approach is essentially the reverse of the expense approach. Rather than measuring the costs of inputs that contribute to economic activity, the production approach estimates the total value of economic output and deducts the cost of intermediate goods consumed in the process (such as materials and services) while the spending approach projects forward from costs, the production approach looks backward from the point of view of a state of complete economic activity.
The Approach of the Income
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 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 measure, there are other ways to measure a country’s economic growth. While GDP measures economic activity within a country’s physical boundaries (whether producers are from that country or from foreign-invested entities), gross national product (GNP) is a measure of global production of people or companies from a country. Countries including those based abroad. GNP excludes domestic production of foreigners.
Another measure of economic growth is gross national income (GNI). It is the sum of all income earned by citizens or nationals of a country (regardless of whether the underlying economic activity takes place in the country or abroad). The relationship between GNP and GNI is similar to the relationship between the production (production) approach and the income approach used to calculate GDP. The GNP uses the production approach, while the GNI uses the revenue approach. With GNI, a country’s income is calculated as its internal income, plus its indirect business taxes and depreciation (as well as its net income from foreign factors). The net foreign factor income figure is calculated by subtracting all payments to foreign businesses and individuals from those to domestic businesses.
In an increasingly globalized economy, GNI has been touted as a potentially better measure of overall economic health than GDP. Since some countries see most of their income withdrawn abroad by foreign companies and individuals, their GDP figures are much higher than those which represent their GNI.
For example, in 2018, Luxembourg’s GDP was $70.9 billion while its GNI was $45.1 billion. The gap was due to large payments made to the rest of the world through foreign companies doing business in Luxembourg, drawn by the small country’s favorable tax laws. On the contrary, in the United States, GNI and GDP do not differ significantly. In 2018, America’s GDP was $20.6 trillion while its GNI was $20.8 trillion.
How to Use the practical Data of GDP?
Most countries publish GDP data on a monthly and quarterly basis. In the United States, the Bureau of Economic Analysis (BEA) publishes an advance release of quarterly GDP four weeks after the end of the quarter and a final version three months after the end of the quarter. BEA news releases are comprehensive and contain a wealth of detail, allowing economists and investors to gain information and insights into various aspects of the economy.
The impact of GDP on the market is generally limited, as it is “retrospective”, and a considerable time has already elapsed between the end of the quarter and the release of the GDP data. However, GDP data can have an impact on markets if actual numbers differ significantly from expectations. For example, the S&P 500 experienced its largest decline in two months on November 7, 2013, following reports that US GDP grew at an annualized rate of 2.8% in the third quarter, compared to estimate of economists by 2%. The data fueled speculation that a stronger economy could lead the US Federal Reserve (the Fed) to scale back its massive stimulus package that was in effect at the
Since Gross Domestic Product provides a direct indication of the health and growth of the economy, companies can use GDP as a guide for their business strategy. Government entities, such as the US Federal Reserve, use the growth rate and other statistics of GDP as part of their decision-making process to determine the type of monetary policy to implement. If the growth rate slows, they could implement an expansionary monetary policy in an attempt to revive the economy. If the growth rate is robust, they could use monetary policy to slow things down in order to stave off inflation.
Real Gross Domestic Product is the indicator that tells the most regarding the overall health of the economy. It is broadly followed and analyzed by economists, analysts, investors, and policy makers. The early release of the latest data will almost always move the markets, although this impact may be limited as noted above.
Adjustments to GDP
A number of adjustments can be made to a country’s Gross Domestic Product to upgrade the effectiveness of that figure. For economists, a country’s Gross Domestic Product expresses the size and area of the economy but provides little information regarding the standard of living in that country. Part of the reason is that population size and cost of living are inconsistent around the world. For example, comparing China’s nominal GDP to Ireland’s nominal GDP would not provide much meaningful information about the realities of life in these countries, as China has about 300 times the population of Ireland.
For solving this problem, statisticians occasionally weigh up GDP per capita between countries. Gross Domestic Product per capita is evaluated by dividing a country’s total Gross Domestic Product by its population, and this figure is frequently cited to assess the country’s standard of living. Even so, the measurement is still imperfect. Suppose China has a Gross Domestic Product per capita of $1,500, whereas Ireland has a GDP per capita of $15,000. This does not necessarily mean that the average Irishman is 10 times better off than the average Chinese. GDP per capita does not take into account the cost of living in a country.
Purchasing Power Parity (PPP) attempts to solve this problem by comparing the number of goods and services that an exchange-adjusted currency unit can buy in different countries – by comparing the price of an item, or basket of articles, in two countries after adjustment for the exchange rate between the two, in force.
Real GDP per capita, adjusted for purchasing power parity, is a highly refined statistic for measuring real income, which is an important component of well-being. An individual in Ireland can earn $100,000 per year, while an individual in China can earn $50,000 per year. In nominal terms, the Irish worker is better off. But if a year of food, clothing and other items costs 3 times bigger in Ireland than in China, the worker in China has a higher real income.
Investment Opportunities and GDP
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 grabbed 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
The concept of GDP was first proposed in 1937 in a report to the United States Congress in response to the Great Depression, designed and presented by an economist from the National Bureau of Economic Research, Simon Kuznets. At the time, the measurement system par excellence was GNP. After the Bretton Woods conference in 1944, GDP was widely adopted as the standard way to measure national economies, although, ironically, the United States continued to use GNP as the official measure of economic well-being until 1991, after which they switched to GDP.
From the 1950s, however, some economists and policymakers began to question GDP. Some have observed, for example, a tendency to accept GDP as an absolute indicator of a nation’s failure or success, despite its inability to account for health, happiness, (in) equality and other factors constituting public welfare. In other words, these critiques have drawn attention to a distinction between economic progress and social progress. However, most authorities, like Arthur Okun, an economist at President Kennedy’s Council of Economic Advisers, have held firm to the belief that GDP is an absolute indicator of economic success, arguing that for every increase in GDP there will be a corresponding drop in unemployment.
Evaluation of GDP
There are, of course, downsides to using GDP as an indicator. Besides the lack of timeliness, some criticisms of GDP as a measure are as follows:
It passes over the value of informal or unregistered economic operations – Gross Domestic Product is based on recorded transactions and official data, so it doesn’t grab into account the range of informal economic activity. GDP does not take into account the value of illegal employment, black market activity or unpaid volunteer work, all of which can be significant in some countries and can’t capture the value of leisure time or household production, which are ubiquitous conditions of human life in all societies.
It is geographically limited in a globally open economy – Gross Domestic Product doesn’t grab into account the profits made in a country by foreign companies that are returned to foreign investors. This can overestimate the actual economic output of a country. For example, Ireland had a GDP of $210.3 billion and a GNP of $164.6 billion in 2012, with the difference of $45.7 billion (or 21.7% of GDP) being large part due to repatriation of profits by foreign companies based in Ireland.
It emphasizes material production without considering overall well-being – GDP growth alone cannot measure a nation’s development or the well-being of its citizens, as noted above. For example, a nation may experience rapid growth in its GDP, but this can come at a significant cost to society in terms of environmental impact and increased income disparity.
It does not take into account business-to-business activities – GDP only takes into account the production of final goods and new capital investment and deliberately excludes intermediate expenditure and business-to-business transactions. In doing so, GDP overestimates the importance of consumption relative to production in the economy and is less sensitive as an indicator of economic fluctuations than measures that include business-to-business activity.
It counts costs and waste as economic benefits – GDP counts all final private and public expenditures as additions to income and production for society, whether they are actually productive or profitable. This means that clearly unproductive or even destructive activities are systematically counted in economic output and contribute to GDP growth. For example, this includes spending geared towards extracting or transferring wealth between members of society rather than the production of wealth (such as administrative costs of taxation or money spent on lobbying and rent-seeking.), spending on investment projects for which the necessary additional goods and labor are not available or for which real consumer demand does not exist (such as the construction of empty ghost towns or bridges unrelated to any road network), and spending on goods and services which are themselves destructive or only necessary to compensate for other destructive activities, rather than creating new wealth (such as the production of weapons of war or expenses for maintaining order and anti-crime measures).
The Sources of GDP Data
The World Bank hosts one of the most reliable web databases. It has one of the best and most comprehensive lists of countries for which it maintains the track of GDP data. The International Monetary Fund (IMF) also provides GDP data through its multiple databases, such as the World Economic Outlook and International Financial Statistics.
Another very reliable source of GDP data is the Organization for Economic Co-operation and Development (OECD). The OECD provides not only historical data, but also forecasts of GDP growth. The downside to using the OECD database is that it only tracks OECD member countries and some non-member countries.
In the United States of America, the Federal Reserve accumulates data from several sources, including a country’s statistical agencies and the World Bank. The only downside to using a Federal Reserve database is the lack of up-to-date GDP data and the lack of data for some countries.
The Bureau of Economic Analysis (BEA), a division of the US Department of Commerce, issues its own analysis-document with each GDP release, which is a great tool for investors to analyze figures and trends and read the aspects highlights of the very extensive full publication.
In their founding manual “Economics“, Paul Samuelson and William Nordhaus perfectly summarize the importance of national accounts and GDP. They compare the ability of GDP to give a holistic picture of the state of the economy to that of a satellite in space that can monitor weather over an entire continent.
GDP allows policymakers and central banks to judge whether the economy is contracting or growing, whether it needs a boost or restraint, and whether a threat such as recession or inflation is emerging profile on the horizon. Like any measure, GDP has its imperfections. Over the past decades, governments have made various nuanced changes in an attempt to increase the accuracy and specificity of GDP. The means of calculating GDP have also evolved continuously since its conception in order to keep up with the evolution of measures of industry activity and the generation and consumption of new emerging forms of intangible assets.