What Is Gross Domestic Product (GDP)?

Policymakers need to measure an economy's performance accurately when establishing monetary policy. Without reliable metrics, policies could drive the economy into boom or bust cycles, creating economic chaos. By charting the history of a nation's economic growth, or lack thereof, policymakers can make accurate predictions.

How is GDP calculated?

GDP is often calculated annually, but some countries — including the U.S. — measure it quarterly to gauge the economy more accurately. However, even the more frequent calculations are retrospective because of the delay in calculations. The U.S. releases its preliminary annualized quarterly and final figures 30 days and three months after the quarterly close, respectively.

Countries can calculate two types of GDP:

• Nominal GDP reflects GDP at current prices
• Real GDP reflects GDP adjusted for inflation factored from a base year

Countries calculate GDP in their currency, which is then converted into U.S. dollars at the current exchange rate. In the U.S., the Bureau of Economic Analysis, an agency within the Commerce Department, calculates GDP.

Several entities track GDP and keep databases, including the World Bank, the International Monetary Fund (IMF) and the Organization for Economic Cooperation and Development (OECD). The IMF also calculates and reports global and regional GDPs, and although the OECD only has data for its member countries and a few others, it makes economic predictions.

GDP includes private and public companies, the government, investments and foreign trade. Governments calculate GDP using three methods, which should produce the same result if performed correctly:

The expenditures approach

Also known as the spending approach, this measures the spending of different groups within an economy. The U.S. uses this approach. The expenditures approach generally uses this formula: GDP = C + G + I + NE, where C is consumer spending, G is government spending, I is investments and NE is net exports.

Consumer spending is a major factor in any economy but is particularly important in the U.S., where it accounts for two-thirds of the GDP. Government spending includes spending from all types of government, from federal to local, and covers spending from capital outlays to payroll.
Investments include private and business investments in things such as equipment and buildings. Net exports are total exports minus total imports, which can be negative and reduce GDP; this is usually the case in the U.S.

The production approach

Also known as the output approach, this determines the value added to products or services at each step of production. For instance, the approach calculates the price a farmer receives for wheat, factors in added value when a miller turns it into flour and again when a baker turns that into a loaf of bread.

The income approach

This approach seeks a middle ground between the other methods by determining the income made at each step in the production process. It factors in wages, rent, capital gains and profits and takes into account any taxes and asset depreciation, where companies depreciate the value of equipment over time.

How do economists compare GDP between countries?

Two GDP adjustments help economists compare countries with different income levels and living costs. These enable economists to analyze the standard of living in different countries.

Per-capita GDP

Economists calculate per-capita GDP by dividing GDP by population. A country like China has a much larger GDP than a smaller country like Sweden, but the per-capita GDP is higher in Sweden.

Purchasing power parity

Purchasing power parity (PPP) calculates the cost of certain goods and services in a country's currency before converting them into U.S. dollars to determine buying power. PPP is a fair method of comparing the standard of living between countries. For example, $1,000 would purchase more in China than in Sweden. So, even if Sweden's per-capita GDP were ten times that of China, it would not mean the average Swede has a ten times higher standard of living.

How economists, policymakers and investors use GDP

Changes in GDP have the greatest influence on monetary policy. Economists note nominal GDP quarterly because these figures closely reflect economic activity. Real GDP accounts for inflation, so it’s better for analyzing economic performance over the long term than nominal GDP.

Economists consider a steadily growing real GDP ideal, as it shows a country's economy is growing but not at such a pace that would require changes in monetary policy. If GDP rises too rapidly, policymakers might fear rising inflation and pressure on employment. Rapidly expanding economies also tend to collapse, leading to great economic pain, which policymakers may try to avert by raising interest rates.

However, if GDP begins to shrink, policymakers become concerned about a recession. To avert this, they may lower interest rates and introduce stimulus packages to increase consumer spending. Economists consider two consecutive quarterly GDP decreases as a recession.

Despite its retrospective nature, investors use GDP growth rates to predict economic activity and stock market movements. U.S. stock markets typically swing heavily immediately after a quarterly GDP report, mainly due to possible policy changes. For instance, if GDP is expanding too rapidly, investors will anticipate an increase in interest rates, which is bad for corporate borrowing, and stocks will fall.

What are the flaws in GDP?

GDP is one of the most reliable measures of economic activity, but as with any measure of economic activity, GDP has flaws.

Timing

GDP is retrospective, as the data points are difficult to aggregate and collate. The earliest snapshot of a quarterly GDP is a month behind the actual economy, and it will be three months behind before it provides the full view. The growth rate reported in the final GDP calculation often varies greatly from the estimate given one month after the end of the quarter. This leaves policymakers and investors guessing about economic trends.

The informal sector

GDP relies on reported numbers, so it does not consider informal employment, underground market activity or unpaid volunteer work. In many developing countries, these activities play a large part in the economy. Even in a country as large as the U.S., undocumented workers receive their wages in cash that goes unreported, vendors sell or barter goods at flea markets and a relative may provide free childcare while the parents work.

Foreign companies’ income

GDP measures output by foreign companies but does not record where their income goes. For instance, Ireland offers low corporate taxes to attract companies to establish their headquarters. In 2021, Ireland's GDP was $498.5 billion, whereas its gross national income was $372.1 billion. The typical Irish citizen may not live as well as the country's GDP suggests.

Wasteful spending

Finally, wasteful or nonprofitable spending contributes to GDP, even when that spending could negatively impact the population’s quality of life. Governments’ could push through massive spending on unneeded infrastructure ’or projects that benefit a select few, boosting the country's GDP and creating an appearance of economic growth. However, the country's citizens see no benefit or have to pay higher taxes to finance the spending.

Key takeaways

• GDP records the value of all finished products and services a country produces during a specific period.
• Real GDP factors out inflation, while nominal GDP does not.
• GDP is retrospective, as figures usually appear 30 to 90 days after the end of a quarter or fiscal year.
• Economists calculate GDP using either the expenditures, production or income method.
• GDP growth, be it positive or negative, is a primary tool for policymakers when deciding on monetary policy.
• GDP adjustments, such as per-capita GDP and PPP, allow for meaningful comparisons between economies.