5 August 2022
6 mins read

What is Gross Domestic Product?

Gross Domestic Product is the total valuation of final goods and services produced in a country during a specific time frame, a quarter or year. It counts all output generated within the borders of a country.

GDP is the broadest financial measurement of a nation’s total economic activity encompassing all private expenditures, government spending, investments, and net exports.

GDP Measurements

Real GDP

Real GDP, known as inflation-corrected GDP or current price, measures a country’s gross domestic product adjusted to inflation.

It reflects the quantity of goods and services produced by an economy in any given year, with price levels held constant from year to year to separate the impact of inflation or deflation. The prices used are measured with respect to a base year or prior year rather than current prices.

Real GDP provides a precise picture of a country’s economic growth. Strong growth in real GDP shows that employment is increasing and resident individuals have actual income earned. When GDP is shrinking, employment declines, or GDP grows but not fast enough to create sufficient jobs in the economy.

Nominal GDP

Nominal GDP is the economic production in a country measured based on prevailing current market prices without taking into consideration the effects of inflation or deflation.

It looks at the natural movement of prices and tracks the regular pulse of rising and falling (primarily rising) growth in an economy’s value over time. If overall GDP increases by 3 percent in a year and inflation is at 2 percent over the same period, nominal GDP will be +5 percent for the year.

Rising prices in an economy tend to increase the GDP; however, it does not necessarily reflect the change in the quality or quantity of goods and services produced. Therefore, an economy’s nominal GDP does not reflect if it has risen due to real expansion in production or a rise in prices.

GDP growth rate

GDP growth rate is a percentage change in the value of a country’s economic output during a specified time period (quarter or year), i.e., an increase in the GDP of an economy per year or quarter.

When GDP growth rates accelerate, the economy is booming, and central banks seek to raise interest rates. Conversely, if the GDP growth rate is shrinking (negative), it signals that interest rates need to be lowered, and stimulus may be necessary.

GDP per capita

GDP per capita is the per-person gross domestic product in a country’s population. It indicates the economic production or national income attributable to each person, thus demonstrating the average productivity or average living standards in an economy.

Suppose a country’s GDP per capita is increasing with a stable population level. In that case, the economy is producing more due to technological capabilities with the same population level. Conversely, if a country has a high GDP per capita but a small population, the economy is self-sufficient with an abundance of special resources.

Calculation Methodologies of GDP

Expenditure Method

The expenditure approach or spending approach calculates GDP based on how much money was spent by all individuals in an economy. It is the most commonly used GDP formula.

The formula for calculation GDP based on expenditure method: GDP = C + G + I + NX

C = Consumption expenditure, G = Government expenditure, I = Investment, and NX = Net exports

  • Consumption expenditure is the cumulative final private consumption with a country’s economy. It includes durable goods, non-durable goods, and services
  • Government expenditure covers expenses incurred by the government for the nation’s development, such as infrastructure, education, salaries of government employees, military expenditure, medication
  • Investmentsare the total of a country’s investment expenditure on assets such as capital equipment, inventories and housing
  • Net exports are the difference between goods and services produced by a country, exported overseas minus the imports

Income Method

The income method sums the total income generated by the production of all economic goods and services in a country. When GDP is determined using this approach, it’s called gross domestic income (GDI) or GDP (I).

The formula for calculation GDP based on income method:

GDP = Total National Income + Sales Taxes + Depreciation + Net Foreign Factor Income

  • Total National Income is the sum of wages paid to employees by employers, rent, interest and profits during a specific period
  • Sales Taxes are the taxes imposed by the government on the sales of goods and services
  • Depreciation includes depreciation of fixed assets owned by a firm during a financial period
  • Net Foreign Factor is the difference between the total income that a nation’s citizens and companies generate in foreign countries versus the total income foreign citizens and companies generate in the domestic country

Production or Value Added Method

The production method of determining GDP takes into account the total production by a country at each stage of production minus the value of intermediate goods in the production process. This method avoids double counting as only the final value of goods and services are considered during the various production stages.

Importance of GDP

GDP defines a country’s economic progress and development. It also reflects a country’s growth potential as it considers the total resources available in a country. Economists use GDP as an indicator to determine whether an economy is growing or experiencing a recession.

Besides measuring the economy’s health, GDP is useful to frame government policies and helps investors use GDP to make informed investment decisions – a bad economy means lower earnings and lower stock prices.

Drawbacks of GDP

  • Does not a measure of the overall standard of living of a country and income equality
  • Ignore the unrecorded economic activity such as unremunerated voluntary work, black market, under the table employment. Additionally, it does not include goods produced for private consumption.
  • It does not account for externalities that impact industries such as the environment and social welfare
  • It emphasizes material output without considering overall citizens well being
  • It focuses on final goods produced and ignores intermediate business business-to-business transactions. Thus, GDP emphasizes the importance of consumption relative to production in the economy and is less sensitive to economic fluctuations compared to metrics of business-to-business activity
  • GDP counts all final private and government spending as additions to income and output, regardless of whether they are productive or profitable. It means that unproductive or destructive activities are routinely counted as economic output.