What is the Gross Domestic Product (GDP)?

Gross domestic product (GDP) is the value of services and goods produced in the economy of a country. It’s usually calculated yearly or quarterly. GDP measures the state and health of a specific economy. You could look at it alone, but also use it to make comparisons with other countries.

GDP consists of the goods and services made for sale on the market. It doesn’t include unpaid work, the black market, or transfer payments. Some educational and defense services provided by the government also count as GDP.

When calculating economic activity, experts use GDP as a starting point most of the time. Tracking how much the GDP grew helps determine the current state of the economy.

Types of GDP measurements

The most common types of GDP measurements include nominal GDP, real GDP, GDP growth rate, and GDP per capita.

Nominal GDP

Nominal GDP shows the value of the goods and services produced in an economy in a year. It uses current prices, which is why it’s called “current-dollar GDP”. It also doesn’t adjust for inflation or deflation. This means that it can show growth when there’s just been a change in prices.

Even though the nominal GDP isn’t very accurate, it’s useful in some cases. For example, when comparing production to debt or looking at the economy within the same year. In that case, you’re usually comparing one quarter of the year to the previous ones. It’s much better to use it to measure current value and use real GDP to make comparisons throughout the years.

Real GDP

Real GDP shows a country’s production while removing the effects of inflation. That's why it portrays a much more realistic picture than the nominal GDP. Without it, if the prices go up, it manifests as if the country is producing more. This is why one of its names is also “inflation-corrected GDP”.

Economists start calculating real GDP by setting a base year and using its prices. It’s helpful when making comparisons. They then calculate the nominal GDP first. Usually, it’s by multiplying the amount of produced goods in a year by their prices. After determining the inflation rate, they compare the numbers to the base year. The formula for real GDP is nominal GDP/GDP deflator x 100. GDP deflator cancels out the influence of inflation.

Comparing the real GDP from two consecutive years tells which way the economy of a country is going. Because it’s not changed by inflation, it can track economic growth with fewer mistakes.

GDP growth rate

The GDP growth rate is an indicator of how quickly the economic components are growing.

It compares the GDP from one year to the previous one and shows the difference in percentages. Also, the GDP growth rate is great for judging economic policies and their effect.

A positive GDP growth rate is good, but it shouldn’t progress too fast - around 2%-3% is ideal. Anything more is not sustainable and can lead to a recession in the future. An increase in demand from abroad and technological advances can boost the growth rate.

A growth rate that is too slow is not ideal either. It shows that the business or the economy is not doing well. If the growth is negative, that means that the country’s economy is going through a recession.

GDP per capita

GDP per capita is the number you get when you divide the country’s GDP by its population. Like the name says, it gives you the average GDP “per head” or person. It roughly shows the economic output of every person in the country.

Calculating GDP per capita of a country can show how high the standard of living is there. It’s the highest in small, rich countries. It can also be useful when comparing the prosperity of countries that are different in size. The most accurate one is the real GDP per capita since it removes the effects of price changes.

Yet, it’s not a good indicator of the distribution of money. Even if a country’s GDP per capita is high, that could mean that there’s a small percentage of very rich people. The rest could have problems with income inequality.

GDP formula

There are 3 methods for calculating GDP. They're called the expenditure, income, and production approach. If your calculations are correct, you should get the same number with all three.

The expenditure approach

This approach is the most popular one. It shows the value of everything bought inside the country along with the exports. The formula used to calculate it is Consumption (C) + Investment (I) + Government spending (G) + Net exports (NX). Let’s clarify what these mean.

Consumption is the spending of consumers. Each consumer spends money on both goods and services which helps the economy and contributes to the GDP.

Investment refers to businesses investing in their development. Also, a country’s investment in housing and capital equipment. This helps improve the productivity and employment levels.

Government spending includes the infrastructure, schools, government employees, and the military. This is usually not the most important part of the equation.

You get net exports by subtracting total exports from total imports. Both domestic and foreign companies are part of this.

The production approach

The production approach determines the value of the economic production of a country. It also takes away the costs you get along the way and during the process. Some of them are the cost of materials and services.

This method is the least correct one since it excludes some parts of the economy. Some of them are imports and exports and the services sector.

The income approach

The income approach measures the income of all the factors of production in one economy. The formula is Total national income + Sales taxes + Depreciation + Net foreign factor income.

The net foreign factor income shows the difference between two things. One is the income that the country’s citizens make abroad. The other is the income foreign citizens make in the country.

GDP of the US

In the US, the Bureau of Economic Analysis (BEA) is in charge of the GDP calculations. They measure the GDP of the entire country, of all the states and metropolitan areas. According to the BEA, the GDP of the US was 21.4 trillion USD in 2019. The GDP growth was 2.3%, which is stable. Around three-quarters of the GDP is personal consumption. Like everywhere else in the world, the Covid-19 pandemic affected the US economy in the first quarter of 2020.

The US is the world’s largest economy. They’re an example of a country with a high GDP and also a high standard of living. They have the world’s highest real GDP and nominal GDP at the moment. Some other countries with a high GDP are China, India, the UK, and Russia.

China is in second place when it comes to nominal and real GDP with 14.3 trillion USD in 2019. Many estimate that it will surpass the US in the future. Its GDP per capita is much lower than the US’s because it has a larger population. But, it beats the US when it comes to GDP based on purchasing power parity (PPP). That refers to how much you can buy when you convert the currency of one country to that of the other.

When it comes to PPP, India is in 3rd place, right behind China and the US.Its nominal GDP is in 5th place with 2.9 trillion USD. The country’s most profitable sectors are manufacturing and service industry.

The UK is in 6th place with 2.8 trillion USD. When you compare it to the US, it’s much smaller. A good example is the state of California which has a higher GDP than the entire UK.

The GDP of the largest country in the world, Russia, is somewhat weak compared to the US, but still in the top 20. With 1.7 trillion USD in 2019, it relies on its natural resources, such as natural gas.

GDP deflator

The GDP deflator shows the change in prices within a certain economy. It applies to all services and goods and includes exports to other countries. When the GDP rises, the GDP deflator shows how much of that is due to inflation and how much is real progress.

The GDP deflator is the main tool for turning nominal GDP to real GDP. That’s why you can calculate it in one step if you have those two values. You can do it by using the following equation: nominal GDP/real GDP x 100.

The method is like the real GDP method. The first thing economists do is establish a base year. Then they compare the current prices to the ones from the year they use as a base. This will show whether the change of GDP is due to price change or not.

GDP vs. GNP

Like we mentioned before, GDP is the value of goods and services produced within a country’s borders. Everything made outside the territory doesn’t count and is not included. The main standard here is the location of the business.

Gross national product (GNP) uses nationality as a basis, not borders. That means that it measures the output of residents of a country. So, if your factory has a branch in a foreign country, you’re still contributing to your home country’s GNP. Economists calculate it by adding the net income from abroad to the country’s GDP.

For example, if you’re an American doing business in France, your production is part of the GNP of the US. Your passport is what includes it in the US GNP statistics. But, because the location of the business is within French borders, it counts as France’s GDP.

GDP vs. GNI

Gross national income (GNI) is much like GNP. It shows how much money the country receives from its residents. So, the difference is that GNI counts income and not production or output. GNI is the income of a country’s residents, even if it wasn’t made within the borders. It’s only important that they spend it inside the country.

GNI might be the most accurate representation of a country’s economy. For example, let’s say there’s a lot of foreign companies working in a certain country. The money they make will show in the country’s GDP. In reality, the company will send most of it abroad, to other countries. GNI will show this change. It only includes the income made by the country, even if the location of businesses is abroad.

GNI is also more precise because it includes foreign investments. If a country receives a lot of foreign aid, it will show in the difference between GDP and GNI.

GDP limitations

Even though GDP is a good base for economic analysis, it’s not perfect. It doesn’t describe the standard of living in an accurate way. Also, economic growth doesn’t always equal a better quality of life for the people.

GDP doesn’t acknowledge unequal income distribution. Even if the GDP is high, if there’s inequality, most of the people won’t feel the progress. They still won’t be able to afford most of the things, despite the fact the numbers say so. Inequality has great consequences for society and it’s invisible in GDP reports.

The official institutions that measure GDP don’t keep track of the black market. The underground production is not recorded, but it can be significant. The government doesn't include some illegal goods in its reports, such as weapons or drugs. But, they without a doubt boost the economic output of some nations.

The sector of non-market production is also hard to keep track of. The activities that don’t involve real market transactions have no official records. So, for example, the people that grow their own produce won’t make it into the GDP calculation. If a country has many similar workers, this can have certain consequences. One is that the GDP might be smaller and the country might seem poorer than it is in reality.

One of the side effects that GDP reports don’t notice is the environmental damage. Although GDP might show prosperity, people might experience a lower quality of life. The use of resources leads to a loss of balance in the environment. Not only is the health of people damaged by this, but it also brings new expenses. This type of growth is not sustainable in the long run.