What Is Gross Domestic Product (GDP)? Definition and FAQ

What Is Gross Domestic Product (GDP)?    

Put simply, gross domestic product (GDP) seeks to measure a country's economic output during a specific time period. GDP represents the total monetary or market value of all final goods and services produced (and sold on the market) within a country's borders during a period of time (typically one year). Intermediate goods and services—those used in the production of final goods and services—are left out of GDP to prevent double-counting.

The calculation of a country's GDP encompasses all private and public consumption, government outlays, investments, additions to private business inventories, paid-in construction costs, and the foreign balance of trade. (Exports are added to the value, and imports are subtracted.) The foreign balance of trade is an especially important component of GDP.

A country's GDP tends to increase when the total value of goods and services that domestic producers sell to foreign countries (exports) exceeds the total value of foreign goods and services that domestic consumers buy (imports). This situation constitutes a trade surplus. A trade deficit occurs if the amount spent on imports is greater than the total revenues produced by selling exports. Running a trade deficit can decrease a country's GDP.

While not directly a measure of GDP, economists also consider purchasing power parity (PPP) to see how one country's GDP measures up in "international dollars." The calculation of PPP adjusts for differences in local prices and costs of living to make cross-country comparisons of real output, real income, and living standards.

What Do High and Low GDPs Mean?

Countries with larger GDPs generate more goods and services within their borders. They also typically have a higher standard of living. Many political leaders see GDP growth as an important measure of national success and often use "GDP growth" and "economic growth" interchangeably. However, many economists argue that GDP has too many limitations to be an effective proxy for overall economic success, much less the more general success of a society.

GDP growth is often looked at as a measure of the overall health of an economy. A figure in the range of 3% GDP growth is considered healthy, whereas a GDP growth factor anywhere from 0% to about 2.7% is viewed as mediocre.

A negative GDP growth rate can indicate an economy that's struggling. A rough rule of thumb is that two consecutive quarters of negative GDP growth constitute a recession. However, it's important to keep in mind that a negative GDP figure can result from temporary factors such as adverse weather, an inventory correction, or a global pandemic like COVID-19.

How Do Investors Use GDP?

GDP's market impact is generally limited because it is a "backward-looking" measure, also known as a lagging indicator. However, GDP data can affect markets if the actual numbers differ considerably from expectations. GDP provides a direct indication of the health of the economy, so businesses can use GDP as a guide to their business strategy.

The U.S. Federal Reserve (the Fed) considers the growth rate and other GDP statistics when determining what monetary policies to implement. If the growth rate is slowing, the Fed might use an expansionary monetary policy to try to boost the economy. If the growth rate is robust, the Fed might use monetary tools to slow things down with the goal of preventing inflation.

Investors use GDP as one framework for decision-making. The corporate profits and inventory data in the U.S. Commerce Department's quarterly GDP reports are a great resource for equity investors because both categories show total growth during the period. The corporate profits data also provides pretax profits, operating cash flows, and breakdowns for all major sectors of the economy.

Those interested in international investing can compare the GDP growth rates of different countries when considering asset allocation. International investors can also use GDP data when choosing whether to invest in fast-growing economies abroad—and, if so, which ones. The Organisation for Economic Co-operation and Development (OECD) offers a customizable chart where you can explore many facets of GDP by country.

When Is GDP Measured?

In the United States, the government releases an annualized GDP estimate for each fiscal quarter and for the calendar year. The Commerce Department releases estimates of GDP once per quarter. But it's a bit more complicated than that because the Commerce Department releases three different estimates each quarter.

The first estimate, called the Advance Report, comes out on the last business day of the following months:

• January for the fourth quarter of the previous year
• April for the first quarter
• July for the second quarter
• October for the third quarter

The second estimate, called the Preliminary Report, is released one month later, on the last business day of the following months:

• February for the fourth quarter of the previous year
• May for the first quarter
• August for the second quarter
• November for the third quarter

The third and last estimate is fittingly called the Final Report. Final Reports are released one month after the Preliminary Reports, on the last business day of the following months:

• March for the fourth quarter of the previous year
• June for the first quarter
• September for the second quarter
• December for the third quarter

There are lots of estimates of U.S. GDP to choose from! But what exactly do these estimates capture, and how is that information used?

What Does GDP Leave Out?

As we've said, gross domestic product is solely a monetary measure of the market value of all the final goods and services produced within a country in a specific time period. GDP is considered the most important indicator of economic activity, but it falls short of providing a good measure of people's material well-being.

A higher GDP is typically associated with greater economic opportunities and an improved standard of living. However, a country might have a high GDP while still being an undesirable place to live due to issues such as pollution, restricted freedoms, or overall environmental degradation. This is why economists, analysts, and politicians often consider other measurements in addition to GDP.

For example, if a country has a high overall GDP but a low per-capita GDP, significant wealth might be concentrated in the hands of very few people. The United Nations' Human Development Index (HDI) is one assessment of economic development that can be considered alongside GDP to get a more robust picture of the quality of life for a country's citizens.

Other measurements that attempt to address the shortcomings of GDP include the Genuine Progress Indicator and the Gross National Happiness Index. Here's one look at how such measurements were affected by the COVID-19 global pandemic.

Since the latter half of the 20th century, economists and others have been looking for ways to account for the fact that GDP leaves out all volunteer and other unpaid work. This means that all of the following are left out of GDP figures:

• Unpaid work performed within the family, such as childcare, housework, and yard work
• Caregiving provided by family members for people with disabilities or infirm elderly people
• All volunteer work
• Nonmonetary-compensated work, such as work done in lieu of rent
• Goods not produced for sale in the marketplace, such as artwork produced as a gift or as a prize for a charity event
• Bartered goods and services
• Black market activity such as pirated films and music
• Illegal activities such as drug sales
• Sales of used goods

Unreported transactions, such as simply working illegally (not registered for tax and social security), are included in GDP through estimates. An example would be cash payments to a housecleaner whose work is not declared.

3 Different Types of GDP

GDP can be measured in several ways, including nominal GDP, real GDP, and GDP per capita.

1. Nominal GDP

Nominal GDP is an assessment of economic production in an economy that includes current prices in its calculation. In other words, it doesn't strip out inflation or the pace of rising prices, which can inflate the growth figure. All goods and services counted in nominal GDP are valued at the prices that those goods and services actually sold for in that year. Nominal GDP is evaluated in either the local currency or U.S. dollars at currency market exchange rates to compare countries' GDPs in purely financial terms.

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.

2. Real GDP

Real GDP is an inflation-adjusted measure that reflects the quantity of goods and services produced by an economy in a given year, with prices held constant from year to year to separate out the impact of inflation or deflation from the trend in output over time. 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 because 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, then 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 nominal GDP, this may be an indicator of significant inflation or deflation in its economy.

3. GDP per Capita

GDP per capita is a measurement of the GDP per person in a country’s population. It indicates that the amount of output or income per person in an economy can indicate average productivity or average living standards. GDP per capita can be stated in nominal, real (inflation-adjusted), or PPP (purchasing power parity) terms.

At a basic interpretation, per-capita GDP shows how much economic production value can be attributed to each individual citizen. This also translates to a measure of overall national wealth since GDP market value per person also readily serves as a prosperity measure.

Per-capita GDP is often analyzed alongside more traditional measures of GDP. Economists use this metric for insight into their own country’s domestic productivity and the productivity of other countries. Per-capita GDP considers both a country’s GDP and its population. Therefore, it can be important to understand how each factor contributes to the overall result and is affecting per-capita GDP growth.

If a country’s per-capita GDP is growing with a stable population level, for example, it could be the result of technological progressions that are producing more with the same population level. Some countries may have a high per-capita GDP but a small population, which usually means they have built up a self-sufficient economy based on an abundance of special resources.

GNI (Gross National Income) is a metric similar to GNP since both are based on nationality rather than geography. The difference is that, when calculating the total value, GNI uses the income approach whereas GNP uses the production approach to calculate GDP. Both GNP and GNI should theoretically yield the same result.

How Is GDP Calculated?

GDP can be calculated in three ways, using expenditures, production, or incomes. It can be adjusted for inflation and population to provide deeper insights. All three calculation 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

C = consumption
G = government spending
I = investment
NX = net exports

Consumption refers to consumer spending. As a consumer, you spend money to acquire goods and services, such as groceries and haircuts. Consumer spending makes up more than two-thirds of the U.S. GDP, so consumer confidence has a significant effect on economic growth. Confident consumers are typically willing to spend, whereas anxious consumers might feel uncertain about the future and therefore be afraid to spend.

Government spending represents both government consumption expenditures and gross investment. Government spending includes equipment, infrastructure, and payroll.

Investment refers to domestic investment or capital expenditures by private businesses. For example, a business might buy additional machinery or invest in research and development for a new product. Business investment is important because it increases the economy’s productive capacity and often improves employment levels.

To arrive at net exports, subtract total imports from total exports (NX = exports − imports). 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 expenditure approach and the production approach. 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, some taxes—such as sales taxes and property taxes—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 nation’s income.

When Did GDP Measurement Originate? 

An initial concept of GDP was invented at the end of the 18th century. American economist Simon Kuznets developed the modern concept in 1934 as he worked on a report to Congress in the aftermath of the Great Depression. Kuznets’s concept of GDP later was adopted as the main measure of a country's economy at the Bretton Woods conference in 1944.

Where Can I Learn More About GDP? 

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 Co-operation and Development (OECD). The OECD not only provides historical data but also forecasts GDP growth. The disadvantage of using the OECD database is that it tracks only OECD member countries and a few nonmember countries.

The U.S. Fed collects data from multiple sources, including a country’s statistical agencies and The World Bank. The only drawback to using a Fed 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. The BEA analysis is a great investor tool for understanding figures and trends and getting highlights of the lengthy GDP document.

The Bottom Line

In their seminal textbook, Economics, Paul Samuelson and William Nordhaus compare GDP’s overall picture of the state of the economy to that of a space satellite that surveys the weather across an entire continent.

GDP enables policy-makers and central banks to judge whether the economy is contracting or expanding. If GPD suggests either a coming recession or developing inflation, central banks can deploy tools to boost or cool the economy. Similarly, investors use GDP when considering the overall health of the economy or of a particular business sector.

Like any measure, GDP has its imperfections. In recent decades, governments have developed modifications with the aim of increasing GDP accuracy and specificity. Means of calculating GDP have also evolved continually since its conception. New calculations seek to keep pace both with evolving measurements of industry activity and with emerging forms and consumption of intangible assets.