What Is GDP and Why Is It so Important?

Infographic that explains what GDP is, its formula and its components, the different types, and its importance.

“GDP growth rate to turn positive in Q3.”

World GDP recovery to strengthen mid-2021.”

Headlines like these often catch attention in the media. While it may make complete sense to some, it may not mean much to others. However, actual GDP numbers and growth forecasts impact our everyday lives and influence our future financial plans. Gross Domestic Product, inflation, and growth rates are macroeconomic indicators that offer a birdseye view of the economy from an ordinary person’s perspective.

What Is GDP?

GDP calculates the final market value of all the finished goods and services produced in a country during a specific period, usually one year. Gross Domestic Product measures the well-being of a nation and acts as a scorecard to show how the country’s economy is performing. It is the most common way we measure the size and growth rate of an economy. Even though it has its limitations, GDP is a crucial metric for the government, policymakers, investors, and businesses. Many decisions are made based on whether an economy is growing or in a recession.

Gross Domestic Product is perhaps the most closely watched and crucial macroeconomic indicator for economists and investors alike because it represents the total monetary value of all goods and services produced by an economy. Aggregate demand is the demand or desire for those goods. Typically, GDP and aggregate demand rise and fall together.

The percentage of Gross Domestic Product growth or decline from one period to another indicates how the economy is doing. As a result, it affects jobs, businesses, and investments. 

Globally, one of the most valuable GDP data sources is the World Bank, as it tracks Gross Domestic Product data for most countries. Another good source is the International Monetary Fund (IMF) that stabilizes the international monetary system and monitors the world’s currencies. A third reliable source is the Organization of Economic Cooperations and Development (OECD), although it does not track Gross Domestic Product for nonmember countries.

Please note that US Gross Domestic Product is globally used as THE economic barometer.

Who Calculates and Reports Gross Domestic Product in the USA?

The U.S. Bureau of Economic Analysis (BEA) calculates and estimates US GDP numbers. The BEA is part of the Department of Commerce and is a nonpartisan and nonpolitical statistical agency. BEA’s primary goal is to produce data on general economic activity in the United States. It does so through its National Income and Product Accounts (NIPA) which is the system of national accounts of the United States. Measuring GDP is NIPA’s most important metric. Besides GDP, it also measures the various types of income generation and how that income is being used.

The BEA defines Gross Domestic Product as:

U.S. GDP = The total market value in US dollars of the final goods and services produced in the United States in one year (without double counting the intermediate goods and services used to produce them).

The Bureau of Economic Analysis collects data used for GDP calculation from thousands of sources outside of the BEA. For example, much of the data comes from other federal agencies such as the Treasury, Census Bureau, and Bureau of Labor Statistics. Other data comes from government sources managing the federal budget, collecting taxes, or Social Security. Furthermore, the private industry provides some GDP data. For example, data companies and trade groups assist in sharing sales data on particular products such as prescription drugs.  

After the BEA obtains all of this information and analysis it, it calculates various Gross Domestic Product numbers. Then, the Department of Commerce releases those numbers on a quarterly and yearly basis. The BEA also estimates the nation’s GDP for every month. It publishes an advance estimate of quarterly numbers about four weeks after the quarter ends. This number is based on the best information available at that time. The 2nd and 3rd estimates incorporate additional data that wasn’t available the month before, improving accuracy.

Although the advance estimate release of quarterly GDP  data will typically move financial markets, its impact is often limited. However, when actual numbers significantly differ from expectations, the effect on markets can be substantial.

How to Calculate a Nation’s Gross Domestic Product

There are several ways to calculate Gross Domestic Product. The two most widely used methods are the Expenditure approach and the Income approach. In theory, both of them should produce the same number.

Expenditure Approach 

The expenditure approach or spending approach is the most common way to calculate Gross Domestic Product. It adds up the value of all purchases made by various groups within a nation and the difference between its exports and imports. 

US GDP is measured primarily based on the expenditure approach. Following this approach, Gross Domestic Product can be calculated by adding up consumer spending (C), business investment (I), government expenditure (G), and net exports (exports minus imports).

In a nutshell, everything produced within a country (final goods and services) has to be purchased by someone. Goods that remain unsold are included in the purchases of the producer. 

The expenditure approach uses the following Gross Domestic Product formula:

GDP = C + I + G + (X – M) 

where;

  • C = consumer spending by households 
  • I = Investment expenditure by businesses 
  • G = Government expenditures 
  • X = Exports to other countries
  • M = Imports from other countries
Infographic that shows that consumer spending makes up 67.2% of U.S. GDP, government spending 18.5%, business investments 17.4%, and net exports negative 3.1%.

Consumer spending (C) – Personal consumption represents all the tangible goods and services purchased by individual consumers and households. Therefore, consumer expenditure is the best measure to show an economy’s purchasing power.

Typically, consumer spending is the largest component of Gross Domestic Product. In the US, it makes up over 2/3rds of GDP.

Personal consumption includes durable goods such as cars, furniture, and appliances and non-durable goods such as clothing, food, and fuel. In addition, it includes services, such as health care, education, and banking.

Business Investments (I) – This component includes any purchase a business makes to produce consumer goods. However, not every purchase should be included. For example, if a company replaces an existing product, it doesn’t add to the Gross Domestic Product number. Therefore, only purchases that contribute to creating a new product for the consumer get included. Business investment is another critical component of Gross Dometic Product because it has a significant impact on employment.

Business investments consist of two sub-components, fixed investments and changes in private inventory. In 2019, business investments made up 17.4% of US Gross Domestic Product.

Fixed investments generally constitute non-residential purchases such as business equipment, software, machinery, and capital goods. This data comes from monthly shipment order reports. The change in private inventory accounts for all the saleable goods, semi-finished goods, and raw materials that a company adds to its inventories. Companies usually stock enough inventory so they don’t have to turn away potential customers.

An increase in inventory orders positively contributes to GDP. Alternately, a decrease in inventory orders signals a lack of demand, forcing companies to cut back on production. If demand stays low for a long time, layoffs will soon follow. Therefore, a change in inventory is an essential indicator of Gross Domestic Product.

Government Spending (G) – This component includes government expenditure of goods and services by federal, state, and local governments.

Government expenditure includes the costs of building infrastructure, salaries to government employees, maintenance of public buildings, and buying new software for the local government office. One-way transfer payments in which no goods or services are provided or exchanged are not included in government spending numbers.

Government spending is a key element of a healthy economy because it regulates the business cycle. Thus, increasing government spending will boost demand and the economy, while a decrease will slow down economic growth. In 2019, government spending was 18.5% of U.S. Gross Domestic Product.

Net Exports of Goods and Services (X – M) – Exports (X) and imports (M) create an opposite effect on Gross Domestic Product. Simply put, exports contribute to GDP while imports reduce it. For example, in 2019, imports were larger than exports, and net exports reduced the U.S. Gross Domestic Product by 3.1%.

Please note that some things are not included in Gross Domestic Product. For example, services that parents provide to their children, volunteer work, and illegal activities.

Income Approach

The income approach is another way to calculate Gross Domestic Product. This approach assumes that all expenditure in an economy should equal the total income generated by production. So, the income approach takes all income earned by all the factors of production. The factors of production are the resources needed for the production of goods and services. The four factors of production are land, labor, capital, and entrepreneurship. Land earns rent, labor earns wages and benefits, capital earns interest, and entrepreneurship earns profits. 

All this income together is called Total National Income.

The Gross Domestic Product formula based on the income approach is:

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

For more details and further explanation of the various forms of income, please check out our Circular Flow article.

Types of GDP & How They Are Used

There are several different types of GDP, and it is crucial to understand what differentiates them because they all show the economy from a different perspective.

Nominal GDP – This is the market value of goods and services in current dollars. In other words, it has not been adjusted for inflation or deflation. It is also known as current or historic GDP.

Real GDP – This is nominal GDP that has been adjusted for inflation or deflation. It is also known as constant-dollar GDP.  Real GDP is considered to be the most accurate measurement of an economy’s growth rate. Adjusting for inflation truly indicates if an economy is growing, shrinking, or staying constant. Real Gross Domestic Product allows for easy comparisons between different years. The prices of goods and services are measured at a constant price level derived from a predetermined base year or by taking last year’s price levels.

Growth Rate GDP – Growth Rate GDP is the most important indicator of a nation’s economic health. It compares the change in a nation’s economic output quarterly or yearly. In other words, It measures how fast an economy is growing. It is usually expressed as a percentage of total output. In the US, a steady growth rate of between 2% and 3% is preferred. If the GDP growth rate keeps increasing, it might be a sign that an economy is overheating, and eventually, the bubble will burst. On the contrary, if the economy’s growth rate keeps declining or even becomes negative, it is a sign of a recession. 

The Bureau of Economic Analysis uses real and not nominal Gross Domestic Product to calculate the GDP Growth Rate. Real GDP is a better indicator because it is adjusted for inflation and considers purchasing power.

GDP Per Capita – Gross Domestic Product Per Capita is the generally accepted measure of the standard of living in a nation. It is calculated by dividing a country’s Gross Domestic Product by its total population. This metric determines economic output per individual and is globally accepted as a measure of a nation’s prosperity. GDP per capita can be expressed in nominal, real, or PPP (Purchasing Power Parity) terms. Typically, this number is higher when using PPP versus market exchange rates for developing and emerging countries because many nontraded goods and services, such as haircuts, are cheaper in developing than in developed countries.  

According to the World Bank, the two countries with the highest Gross Domestic Product are the USA and China. When using nominal GDP, the U.S. ranks first in 2020 with a GDP of $20.9 trillion, followed by China with a GDP of $14.7 trillion. However, China ranks first when using Purchasing Power Parity GDP (when GDP is adjusted for differences in local prices and cost of living). Its PPP GDP in 2020 was a little over $24 trillion, while the U.S. ranked second with a PPP GDP of almost $21 trillion.

Potential GDP – This is the measurement of an economy under ideal conditions. An ideal economy has inflation around 2%, full employment, and a stable currency value.

Real GDP vs. Nominal GDP

Infographic that shows the differences between Nominal GDP and Real GDP. The main difference is that Real GDP is adjusted for inflation and deflation and Nominal GDP is not.

While both quantify the total value of goods produced, real GDP is adjusted for inflation or deflation while nominal Gross Domestic Product isn’t. Therefore, real Gross Domestic Product is lower than its equivalent nominal GDP figure when inflation is present.

In most cases, real GDP depicts a more accurate picture of a country’s economic performance when compared to previous years’ figures. In addition, real Gross Domestic Product is a better metric because without adjusting for inflation, it may seem like an economy is overproducing when in reality, only the prices have gone up.

The formula to calculate real Gross Domestic Product is;

Real GDP = Nominal GDP / GDP Price Deflator

We know that Gross Domestic Product reflects the total value of goods and services produced. However, when it grows or falls, the impact of inflation, or rising prices, is not factored into the GDP metric.

The GDP deflator addresses this gap and indicates how much a change in Gross Domestic Product relies on changes in the price level. For example, the nominal GDP in 2019 was $21.427 trillion, and the price deflator was 1.1234 trillion. So, real GDP in 2019 was $21.427 trillion / $1.1234 trillion = $19.073 trillion.

GDP vs. GNP vs. GNI

Gross Domestic Product is not the only way to measure a nation’s economic growth. Here is a comparison between GDP, GNP, and GNI.

As we know, GDP measures economic output within a country.

GNP (Gross National Product) measures economic output by a country’s residents inside and outside the country. It excludes domestic production by foreigners.

GNI (Gross National Income) measures total income produced by nationals, irrespective of whether they are in the country or not. It also includes income from foreigners inside the nation. Its formula is:

GNI = GDP + earned wages, salaries, plus other income of citizens living abroad.

The main difference between GDP and GNP is that GDP includes economic output by foreigners inside the nation but excludes economic output by nationals residing outside of the nation. In contrast, GNP excludes output by foreigners inside the country but includes output by nationals outside of the nation. 

For most countries, there is little difference between their GDP and their GNI. However, some countries have a Gross Domestic Product that is significantly higher than their Gross National Income due to income from foreigners inside the nation not being counted in GNI. In contrast, there are also countries with a significantly lower GDP than their GNI. This is typically the case for developing countries that receive a lot of foreign aid.  As a result, the World Bank and other international organizations often consider GNI a better indicator of a nation’s overall economic health than its Gross Domestic Product. 

Why Is GDP Important?

Gross Domestic Product is probably the most widely-tracked economic measurement of a nation. The pace of economic growth or decline affects almost everyone. It has an enormous impact on employment, businesses, investments, and economic policies. Understanding GDP and the economy helps people, businesses, and policymakers make better decisions. Here are some of the main reasons why Gross Domestic Product is important:

Helps identify recessions and inflation – GDP enables the government and policymakers to determine whether the economy is flourishing or shrinking. A growing economy is great if it is not growing too fast. Conversely, a shrinking economy is undesirable and might need a boost to start increasing again. 

Guides monetary and fiscal policies – GDP rises or falls depending on the business cycle. When an economy flourishes and Gross Domestic Product grows, the pressure of inflation builds up because of labor and production operating at high to full capacity. To slow down the growth of an overheating economy, the Federal Reserve might implement contractionary monetary policies that will slow down economic growth. An example would be an increase in short-term interest rates making short-term credit more expensive.

In contrast, when an economy is in a recession, the government will boost the economy. They can do this by implementing expansionary fiscal policies such as increasing government spending or reducing taxes. Examples of increasing government spending to stimulate economic growth during the pandemic were the 6 Covid-19 relief bills, including the Coronavirus Cares Act.

Impacts Employment – Gross Domestic Product has a significant effect on employment. As GDP rises, business investment will increase, resulting in more production and a decrease in unemployment. This will increase workers’ personal income, which will lead to an increase in demand.

Guides investor decisions – A significant change in a nation’s GDP will affect the stock market. A growing Gross Domestic Product is an indication of a growing, healthy economy. Businesses and consumers are confident and have money to spend. As a result, investments increase, and stock prices will rise. However, confidence is typically low during a recession, resulting in fewer investments and a bear market.

Helpful in comparison of various nation’s economies – GDP and GDP Growth Rate are great metrics that can help compare the U.S. economy with other economies around the world.

Table with the top 10 countries with highest nominal GDP

Limitations of GDP

Gross Domestic Product measures the market value of all finished goods and services produced in a nation. Since this number is based on market price, many aspects of the economy are not included in the Gross Domestic Product numbers. Here are some of them:

It ignores income disparity – Since Gross Domestic Product does not measure income distribution, the top 5% of households could hold 70% of the total income leading to a wide degree of economic inequality. So, although a nation’s GDP might indicate a high standard of living, that is often not true for the majority of the population as the wealth might be in the hands of only a small percentage of the population. For example, China’s Gross Domestic Product indicates that the standard of living is average. However, for most Chinese people, the standard of living is low. 

It does not penalize environmental damage or unproductive activities – In developing economies, producers step up production without caring about the environment to support the growth of their economies. This is not sustainable. In such cases, environmental damage should have a negative impact on a nation’s Gross Domestic Product.

It does not count unpaid and unreported work and services – Unpaid hours spent on volunteer work and work such as childcare and household work are not considered in Gross Domestic Product calculations. These unpaid hours actually reduce Gross Domestic Product because a paid employee could have done the work.

It does not include black market economies – Illegal activities such as gambling, drug trade, weapons trade, and prostitution are not included in a nation’s Gross Domestic Product. However, in some countries, black market trade is significant. As a result, that nation’s Gross Domestic Product might be grossly understated.

It is not an indication of social progress or well-being – Aspects of society such as education, health, freedom of speech, and happiness are not taken into consideration in GDP calculation.

Conclusion

Despite its shortcomings, GDP is still the most widely used indicator to measure a country’s economic health. Gross Domestic Product enables policymakers, businesses, economists, and investors to aid in their decision-making. Moreover, variations in calculating Gross Domestic Product have helped adapt its use to changes in the world economies.

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.