What Gross Domestic Product (GDP) Is

GDP, or gross domestic product, is an economic indicator that represents the total monetary value of all the goods and services manufactured in a specific country and sold on the market. GPD is used to measure that country’s domestic production, which directly correlates to its overall economic performance. GDP is most commonly cited as a measure of annual economic output, but it can also be used to calculate economic progress quarterly.

GDP accounts for all products produced within a country, including products intended for consumption, investment, and even asset replacement. GDP also includes products manufactured in the country for foreign-owned firms.

The History of GDP

The first attempts to implement a macro indicator similar to GDP were made in the 1700s, but the modern Gross Domestic Product was proposed by American economist Simon Kuznets in 1934. Amid a boom in government programs to overcome the Great Depression and limit its negative impact on the economy, there emerged a need to measure the success of these efforts. That’s when Kuznets introduced the idea of measuring all the goods and services produced in the US, but it wasn’t until the Bretton Woods Conference ten years later that the US GDP was officially adopted.

It took Simon Kuznets that long to develop the perfect formula to make GDP a gold standard for measuring overall economic performance (rising GDP vs. falling GDP), and in the years that followed the entire world adopted the metric. Efforts to perfect it are still underway.

Types of Gross Domestic Product

GDP does not offer detailed insight into a country’s economic development. In and of itself, GDP can only show whether the economy is growing or not. However, it doesn’t reveal much about the standard of living in a country or whether economic growth can compete with rising inflation. To provide some higher-resolution data, there are multiple subtypes of GDP, as well as other relevant indicators that offer different economic outlooks.

Nominal GDP

Nominal GDP assesses a country’s economic performance and overall output by using the current prices, without taking inflation into account. Not considering rising prices can lead to the indicator showing more inflated growth than there actually is. Because of this, nominal GDP is mainly used to compare economic growth in consecutive quarters. A better metric for comparing the output between different years is real GDP.

Real GDP

Real GDP is used to measure the economic activity of a country in a particular year, taking inflation into account. In nominal GDP, inflation can interfere with the data and make it seem like a country’s economic output has increased, while in reality it could have stayed exactly the same or even decreased.

With real GDP, economists choose a base year and adjust the current year’s output to the price levels of the base year. To calculate real GDP, economists use a GDP price deflator: the difference between the prices of the current year and the base year. Doing this helps to exclude the impact that inflation leaves on the economy from the calculation, and see the real economic performance year over year.

Net Domestic Product

Net domestic product (NDP) is another economic indicator that measures the economic output of a country. However, unlike GDP, it takes into account the costs of updating or replacing deteriorated tools, machinery, housing, vehicles, and other expenses required to keep production running.

NDP is calculated by subtracting these costs (depreciation) from the overall GDP. NDP is often seen as more detailed because it provides information about whether a country’s economic performance covers the resources it has to spend to support current production rates.

Potential GDP

When economists need to estimate how much an economy could produce if it employed all available resources at the most sustainable level, they calculate potential GDP. Potential GDP is used as a benchmark to which current economic output is compared. This enables economists to see if the economy of a country is experiencing weak demand and supply levels, or if the aggregate demand exceeds the aggregate supply, which may lead to inflation. Potential GDP signals policymakers on how to improve economic output.

GDP Per Capita

In order to see how current economic performance relates to the population of a country, economists calculate GDP per capita. This indicator is measured by dividing the total GDP of a country (nominal or real, depending on the objectives of the study) by its total population.

This shows how much of the value of national economic production can be attributed to an individual citizen. This metric can further be used to determine the national wealth of the country, average income per capita, work productivity, and even living standard.

GDP Growth Rate

GDP growth rate measures how the GDP of a country changed compared to the preceding period of time. This helps economists and policymakers understand how fast the economy is growing and whether there is anything to be concerned about.

If the GDP growth rate shows that an economy is growing disproportionately fast, this might indicate impending inflation. On the other hand, if GDP growth is slow or even negative, the authorities might need to stimulate the economy before it gets swallowed by a recession.

Purchasing Power Parity (PPP)

Purchasing power parity (PPP) is an indicator used to compare the economic performance of different countries. To calculate PPP, economists compare the prices of a specific basket of goods by converting them into one currency. PPP is the ratio of the prices. This metric enables economists to analyze the differences between economic outputs and living standards of different countries.

How to Calculate GDP

There are three approaches to calculating GDP.

• The income approach measures GDP by factoring in the total national income (wages, rent, interest, and other types of profit) and sales taxes, as well as depreciation of assets and net foreign factor income (the difference between the total income generated by all citizens, including outside their country, and the income earned only within the country’s bounds).
• The expenditure approach focuses on the calculated spending of all participants in the economy. This includes consumer spending, government spending, investments and net exports (the difference between the total exports and total imports of a country).
• The production approach involves calculating the total value of a country’s economic output at the time of production, then subtracting intermediate goods (materials and resources) that are used in the production process.

How to Use Gross Domestic Product

GDP is primarily used for measuring the economic performance of a country. However, the data provided by GDP has many practical applications including ones that reach beyond the scope of the economy.

• GDP can help governments and policymakers analyze the current state of the economy and the velocity of money, predict future tendencies, and make changes to a country’s monetary policy to influence the trajectory of economic development.
• GDP is a useful source of information for business owners. Knowing about the current health and growth rate of the economy can help them adjust their business strategies to offset potential setbacks.
• GDP data can provide a well of information for traders and investors. If GDP shows rapid economic growth, traders can expect interest rates to grow as well, which will in turn cause currency appreciation and provide more trading opportunities for Forex traders interested in the highest currencies in the world. Conversely, a weak economy might lead to a decrease of interest rates and consequently, a decline of the value of currency.

Disadvantages of GDP

Though GDP is the ultimate metric for economic output, it has a few drawbacks.

• GDP excludes unrecorded economic activity that can contribute significantly to the overall economic performance of a country, such as volunteer or unofficial work.
• GDP doesn’t account for welfare or the well-being of the population, which are important factors in determining whether an economy is sustainable or not.
• GDP fails to include environmental abuses happening because of high production volume, which is in itself an important sign that such production is unsustainable in the long run.
• GDP doesn’t count the earnings made by overseas companies, which leads to overestimation of the actual economic output of the country of manufacture.
• It focuses only on final goods production and does not factor in economic transactions related to intermediate spending between businesses.

While attempts to create new indicators have been made, GDP is still considered one of the most reliable indicators for economic performance. The metric continues to be used by countries all over the world.

FAQ

What is a simple definition of GDP?

GDP is an indicator that measures a country’s economic activity by calculating the total price of all goods and services produced and sold in that country.

What country has the highest GDP?

Currently, the USA has the highest GDP in the world, followed by China and Japan.

Is a high GDP good?

A high GDP means that the economy is doing well. However, if GDP increases too rapidly, it can lead to inflation and increase of prices.