Gross Domestic Product (GDP) is one of the most widely used measures of an economy’s output or production. It is defined as the total value of goods and services produced within a country’s borders in a specific time period—monthly, quarterly, or annually.
GDP is an accurate indicator of the size of an economy and the GDP growth rate is probably the single best indicator of economic growth, while GDP per capita has a close correlation with the trend in living standards over time.
As Nobel laureate Paul A. Samuelson and economist William Nordhaus put it:
While GDP and the rest of the national income accounts may seem to be arcane concepts, they are truly among the great inventions of the twentieth century.”
Key Takeaways
- GDP enables policymakers and central banks to judge whether the economy is contracting or expanding and promptly take necessary action.
- It also allows policymakers, economists, and businesses to analyze the impact of variables such as monetary and fiscal policy, economic shocks, and tax and spending plans.
- GDP can be calculated either through the expenditure, income, or value-added approach.
- GDP isn't always flawless and overlooks several important factors.
Why GDP is Important?
Samuelson and Nordhaus neatly sum up the importance of the national accounts and GDP in their seminal textbook “Economics.” They liken the ability of GDP to give an overall picture of the state of the economy to that of a satellite in space that can survey the weather across an entire continent.
GDP enables policymakers and central banks to judge whether the economy is contracting or expanding, whether it needs a boost or needs to be restrained, and if threats such as a recession or rampant inflation loom on the horizon.
The national income and product accounts (NIPA), which form the basis for measuring GDP, allow policymakers, economists, and businesses to analyze the impact of such variables as monetary and fiscal policy, economic shocks, such as a spike in the oil price, and tax and spending plans on specific subsets of an economy, as well as on the overall economy itself.
Along with better-informed policies and institutions, national accounts have contributed to a significant reduction in the severity of business cycles since the end of World War II.
GDP Calculation
GDP can be calculated either through the expenditure approach—the sum total of what everyone in an economy spent over a particular period—or the income approach—the total of what everyone earned. Both should produce the same result. A third method, the value-added approach, is used to calculate GDP by industry.
Expenditure-based GDP produces both real (inflation-adjusted) and nominal values, while the calculation of income-based GDP is only carried out in nominal values. The expenditure approach is the more common one and is obtained by summing up total consumption, government spending, investment, and net exports.
GDP = C + I + G + (X – M)
where:
- C = private consumption or consumer spending;
- I = business spending;
- G = government spending;
- X = value of exports
- M = the value of imports.
GDP fluctuates because of the business cycle. When the economy is booming, and GDP is rising, there comes a point when inflationary pressures build up rapidly as labor and productive capacity near full utilization. This leads the central bank to commence a cycle of tighter monetary policy to cool down the overheating economy and quell inflation.
As interest rates rise, companies and consumers cut back spending, and the economy slows down. Slowing demand leads companies to lay off employees, which further affects consumer confidence and demand. To break this vicious circle, the central bank eases monetary policy to stimulate economic growth and employment until the economy is booming once again. Rinse and repeat.
Consumer spending is the biggest component, accounting for more than two-thirds of the U.S. economy. Consumer confidence, therefore, has a very significant bearing on economic growth.A high confidence level indicates that consumers are willing to spend, while a low confidence level reflects uncertainty about the future and an unwillingness to spend.
Business investment is another critical component of GDP since it increases productive capacity and boosts employment. Government spending, too, assumes particular importance as a component of GDP when consumer spending and business investment both decline sharply, as, for instance, after a recession. Finally, a current account surplus also boosts a nation’s GDP, since (X – M) is positive, while a chronic deficit is a drag on GDP.
Drawbacks of GDP
Some criticisms of GDP as a measure of economic output are:
- It does not account for the underground economy: GDP relies on official data, so it does not take into account the extent of the underground economy, which can be significant in some nations.
- It is geographically limited in a globally open economy: Gross National Product (GNP), which measures the output from the citizens and companies of a particular nation regardless of their location, is viewed as a better measure of output than GDP in some cases. For instance, GDP does not take into account profits earned in a nation by overseas companies that are remitted back to foreign investors. This can overstate a country's actual economic output. For example, Ireland had a GDP of $210.3 billion and a GNP of $164.6 billion in 2012, the difference of $45.7 billion (or 21.7% of GDP) largely being due to profit repatriation by foreign companies based in Ireland.
- It emphasizes economic output without considering economic well-being: GDP growth alone cannot measure a nation's development or its citizens' well-being. For example, a nation may be experiencing rapid GDP growth, but this may impose a significant cost to society in terms of environmental impact and an increase in income disparity.
Global GDP Trends
Discussions about GDP growth invariably turn to the torrid pace of growth recorded by China since the late 1970s and India from the 1990s, following revitalizing economic reforms.
Smaller nations such as the Asian Tigers—Hong Kong, Singapore, South Korea, and Taiwan—had already achieved rapid economic growth from the 1960s onward by becoming export dynamos and focusing on their competitive strengths. But China and India succeeded despite their massive populations, with an average 10% GDP growth rate in China since 1978, and a slower growth pace in India enabling hundreds of millions to escape the clutches of poverty.
While the emerging market and developing nations have been growing at a faster pace than the developed world since the 1990s, the divergence in growth rates has begun to narrow since the end of the Great Recession in early 2009.
For instance, in 2011 developing countries collectively recorded GDP growth of 6.2%, while developed nations only grew by 1.7%. By 2019, that gap tightened, with developing countries' collective GDP shrinking to 3.7%, while developed nations' GDP stayed steady at 1.7%.
Future GDP Shifts
The Organization for Economic Cooperation and Development (OECD), in a report released in March 2020, addressed the potential impact of COVID-19 on the global economy. Understandably, the prognostications were grim as they noted that:
output contractions in China are being felt around the world, reflecting the key and rising role China has in global supply chains, travel and commodity markets. Subsequent outbreaks in other economies are having similar effects
The report goes on to state:
annual GDP growth is projected to drop to 2.4% in 2020 as a whole, from an already weak 2.9% in 2019, with growth possibly even being negative in the first quarter of 2020
Effective mitigation is expected to see the global economy recover to 3.75% by 2021. However, a longer-lasting coronavirus outbreak and spread, especially throughout the Asia-Pacific region, Europe and North America could see global GDP:
drop to 1.5% in 2020, half the rate projected prior to the virus outbreak.
Assuming that the world survives COVID-19 and normal activity resumes then, thanks to their sheer size, China and India appear to be inexorably on track to become the world’s biggest economies in time. The largest and best-run companies in these countries will be among the biggest beneficiaries of long-term economic expansion.
An investor wishing to participate in these growth prospects can easily do so through exchange-traded funds (ETFs), such as the iShares China Large-Cap ETF (FXI), which tracks the performance of 26 of the largest Chinese companies, or the India Fund (IFN), a closed-end fund that was introduced in February 1994 and holds some of the subcontinent’s best-known companies.
Using GDP Data
Most nations release GDP data every month and quarter. In the U.S., the Bureau of Economic Analysis (BEA) publishes an advance release of quarterly GDP four weeks after the quarter ends, and a final release three months after the quarter ends. The BEA releases are exhaustive and contain a wealth of detail, enabling economists and investors to obtain information and insights on various aspects of the economy.
The advance GDP data has the most impact on the markets as it is the first snapshot of how well the economy is performing. Subsequent releases have limited market impact, unless there is a significant variance from the advance GDP figure, since a substantial amount of time has already elapsed between the quarter-end and these releases.
The market impact can be severe if the actual numbers differ considerably from expectations. For example, the experienced a sizable decline on Nov. 7, 2013, following reports that U.S. GDP had increased at a 2.8% annualized rate in Q3, compared with economists' estimates of 2%. The data fueled speculation that the stronger economy could lead the Federal Reserve (Fed) to scale back its massive stimulus program that was in effect at the time.
Total Market Cap to GDP
One interesting metric that investors can use to get some sense of the valuation of an equity market is the ratio of total stock market capitalization to GDP, expressed as a percentage. The closest equivalent to this in terms of stock valuation is the market cap to total sales (or revenues), which in per-share terms is the well-known price-to-sales ratio.
Just as stocks in different sectors trade at widely divergent price-to-sales ratios, different nations trade at stock-market-cap-to-GDP ratios that are literally all over the map. For example, the U.S. had a stock-market-cap-to-GDP ratio of 172% as of Q4 2019, while China had a ratio of just over 139% and India a ratio of 75%.
However, the utility of this ratio lies in comparing it to historical norms for a particular nation. As an example, the U.S. had a stock-market-cap-to-GDP ratio of 136% at the end of 2015, which then surged to 172% by the end of 2019. Given the rise in the U.S. stock market by the end of 2019—and with the benefit of hindsight—these readings might be viewed as zones of undervaluation and overvaluation.
The Bottom Line
In terms of its ability to convey information about the economy in one number, few data points can match the GDP and its growth rate.
FAQs
GDP is important because it gives information about the size of the economy and how an economy is performing. The growth rate of real GDP is often used as an indicator of the general health of the economy. In broad terms, an increase in real GDP is interpreted as a sign that the economy is doing well.
What is the importance of GDP quizlet? ›
- Gross Domestic Product (GDP) measures the total value of final goods and services produced within a given country's borders. It is the most popular method of measuring an economy's output and is therefore considered a measure of the size of an economy.
What is the most important part of GDP? ›
Consumption represents the sum of goods and services purchased by citizens—such as retail items or rent—and it grows as more is consumed. It's the largest component of GDP.
What is GDP and why is it important what are the limitations of GDP? ›
GDP is a useful indicator of a nation's economic performance, and it is the most commonly used measure of well-being. However, it has some important limitations, including: The exclusion of non-market transactions. The failure to account for or represent the degree of income inequality in society.
What is an example of a GDP? ›
If, for example, Country B produced in one year 5 bananas each worth $1 and 5 backrubs each worth $6, then the GDP would be $35. If in the next year the price of bananas jumps to $2 and the quantities produced remain the same, then the GDP of Country B would be $40.
What is the meaning of GDP growth? ›
Definition: The annual average rate of change of the gross domestic product (GDP) at market prices based on constant local currency, for a given national economy, during a specified period of time.
What is more important than GDP? ›
Essentially, GDP focuses too much on total wealth while ignoring other important humanly and environment aspects. The HDI is a prime alternative to the GDP system, factoring in life expectancy, education length and quality, and standards of living.
What is the conclusion of the GDP? ›
CONCLUSION. Gross Domestic Product, the total market value of all final goods and services produced in a country in a given year, equal to total consumer, investment and government spending, plus the value of exports, minus the value of imports.
What is GDP and what are the important terms in the definition quizlet? ›
Gross Domestic Product is the dollar value of all final goods and services produced within a country's border in a given year. It has 4 categories: consumer goods and services, business goods and services, government goods and services, and import goods and services.
What is the GDP quizlet? ›
What is gross domestic product? Final market value of the total output of all goods and services produced within a country's geographic boundaries during a year's time.
The calculation of a country's GDP encompasses all private and public consumption, government outlays, investments, additions to private inventories, paid-in construction costs, and the foreign balance of trade. Exports are added to the value and imports are subtracted.
What's in GDP quizlet? ›
GDP includes tangible goods such as shoes, burgers and beer. GDP also includes services such as haircuts, car repair, and dry cleaning. What does within a country mean in GDP? GDP includes only goods and services produced inside a country's borders no matter who owns the factory.
What are the benefits of a high GDP? ›
High economic growth leads to increased profitability for firms, enabling more spending on research and development. This can lead to technological breakthroughs, such as improved medicine and greener technology. Also, sustained economic growth increases confidence and encourages firms to take risks and innovate.
What are the strengths of GDP? ›
GDP enables policymakers and central banks to judge whether the economy is contracting or expanding and promptly take necessary action. It also allows policymakers, economists, and businesses to analyze the impact of variables such as monetary and fiscal policy, economic shocks, and tax and spending plans.
How does GDP affect the standard of living? ›
However, economists often make adjustments to GDP, such as using real GDP, or use alternative methods for determining the standard of living. Generally, rising global income translates to a higher standard of living, while diminishing global income causes the standard of living to decline.
What does GDP mean in the US? ›
What is Gross Domestic Product? A comprehensive measure of U.S. economic activity. GDP measures the value of the final goods and services produced in the United States (without double counting the intermediate goods and services used up to produce them).
What are the 3 types of GDP? ›
GDP can be measured in three different ways: the value added approach, the income approach (how much is earned as income on resources used to make stuff), and the expenditures approach (how much is spent on stuff).
What GDP does the US have? ›
The United States has the largest gross domestic product in the world as of 2022, with China, Japan, Germany, and India rounding out the top five. The GDP of the United States has almost quadrupled since 1990, when it was about 5.9 trillion U.S. dollars, to about 25.46 trillion U.S. dollars in 2022.
Is GDP growth good or bad? ›
Most economists, politicians and businesses like to see GDP rising steadily because rising GDP usually means people spend more, more jobs are created, more tax is paid and workers get better pay rises. If GDP is falling, then the economy is shrinking - bad news for businesses and workers.
What happens if GDP is too high? ›
However, too much GDP growth is also dangerous, as it will most likely come with an increase in inflation, which erodes stock market gains by making our money (and future corporate profits) less valuable.
Economists traditionally use gross domestic product (GDP) to measure economic progress. If GDP is rising, the economy is in solid shape, and the nation is moving forward. On the other hand, if gross domestic product is falling, the economy might be in trouble, and the nation is losing ground.
How can GDP be improved? ›
Infrastructure spending is designed to create construction jobs and increase productivity by enabling businesses to operate more efficiently.
- Tax Cuts and Tax Rebates.
- Stimulating the Economy With Deregulation.
- Using Infrastructure to Spur Economic Growth.
Economic growth, measured popularly via GDP, is a complementary indicator to development, but not an adequate indicator when considered on its own. The challenge of modern capitalism is to balance its role as an efficient and effective mode of production with its tendency to concentrate income, wealth and, thus, power.
Is GDP the worth of a country? ›
It's called GDP, or 'gross domestic product' - the total value of everything a country produces and sells. It's a measurement of cold hard cash and doesn't distinguish between food, medicine and even weapons.
What was the original purpose of GDP? ›
According to this perspective, GDP was invented by Keynesian economists in response to war mobilization needs during World War II and was operationalized during the postwar period to manage growth.
What is the solution for GDP? ›
GDP = consumption + investment + government spending + net exports.
Why did GDP rise? ›
The increase in real GDP in 2022 primarily reflected increases in consumer spending, exports, private inventory investment, and nonresidential fixed investment that were partly offset by decreases in residential fixed investment and federal government spending.
What are the four important aspects of the definition of GDP? ›
There are four main components of GDP, or parts of GDP. The four components of gross domestic product include the consumption of goods and services, government spending, business investment, and net exports.
What are the most important terms of economy? ›
Four key economic concepts—scarcity, supply and demand, costs and benefits, and incentives—can help explain many decisions that humans make.
What is the largest and most important component of GDP in the United States? ›
Consumption expenditure by households is the largest component of GDP, accounting for more than two-thirds of the GDP in any year. This tells us that consumers' spending decisions are a major driver of the economy.
GDP can be measured either by the sum of what is purchased in the economy using the expenditures approach or by income earned on what is produced using the income approach.
Who defined GDP? ›
The first basic concept of GDP was invented at the end of the 18th century. The modern concept was developed by the American economist Simon Kuznets in 1934 and adopted as the main measure of a country's economy at the Bretton Woods conference in 1944.
What does high GDP mean? ›
Rising GDP means the economy is growing, and the resources available to people in the country – goods and services, wages and profits – are increasing.
How does GDP affect rates? ›
An increase in real gross domestic product (i.e., economic growth), ceteris paribus, will cause an increase in average interest rates in an economy.
What are the three ways of measuring GDP? ›
Gross domestic product (GDP) measures total domestic economic activity and can be measured in three different ways: the output approach, the expenditure approach and the income approach.
Who comes up with GDP? ›
BEA estimates the nation's GDP for each year and each quarter. But new GDP statistics are released every month.
Which of the following include GDP? ›
Components of the GDP:
GDP consists of four main components, which include investment spending, government spending, consumption, and export spending.
What happens if the GDP is low? ›
Negative growth is a decline in a company's sales or earnings, or a decrease in an economy's GDP during any quarter. Declining wage growth and a contraction of the money supply are characteristics of negative growth, and economists view negative growth as a sign of a possible recession or depression.
What does GDP not tell us? ›
The pattern of economic growth is not indicated by GDP. It does not reflect how each person is doing in the economy. GDP does not account for the factors that influence one's standard of living. The level of environmental cleanliness is not measured by GDP.
How does economic growth reduce poverty? ›
If economic growth raises the income of everyone in a society in an equal proportion, then the distribution of income will not change. However, if the growth occurs without a reduction in poverty, income distribution could become unequal.
literacy rate, natural resources, physical capital, and standard of living. explain how changes in a particular factor will influence the GDP of a country. analyze economic data and identify to which type of resource the data refers.
How does GDP affect inflation? ›
If 'potential GDP' is growing rapidly, actual output can also continue to grow rapidly without intensifying pressures on resources.” Translation: if growth is higher, inflation is lower.
Why GDP is not a good measure of well-being? ›
GDP is an indicator of a society's standard of living, but it is only a rough indicator because it does not directly account for leisure, environmental quality, levels of health and education, activities conducted outside the market, changes in inequality of income, increases in variety, increases in technology, or the ...
What is the difference between GDP and income? ›
National Income is the sum of all incomes earned by the factors of production in a country's economy. GDP is the total value of all goods and services produced within a country's borders in a specific period, usually a year.
Why is economic growth important to a country? ›
Economic growth increases state capacity and the supply of public goods. When economies grow, states can tax that revenue and gain the capacity and resources needed to provide the public goods and services that their citizens need, like healthcare, education, social protection and basic public services.
How does a country increase its GDP? ›
Broadly speaking, there are two main sources of economic growth: growth in the size of the workforce and growth in the productivity (output per hour worked) of that workforce. Either can increase the overall size of the economy but only strong productivity growth can increase per capita GDP and income.
What is the GDP of the United States today? ›
US Real GDP is at a current level of 20.25T, up from 20.18T last quarter and up from 19.92T one year ago. This is a change of 0.32% from last quarter and 1.62% from one year ago.
Does a rising GDP benefit everyone? ›
If a country's population increases, that will push GDP up, because with more people, more money will be spent. But individuals within that country might not be getting richer. They may be getting poorer on average, even while GDP goes up.
What does GDP not tell us about the economy? ›
The level of environmental purity, disease rates, level of inequality is not measured by GDP. It doesn't track if life expectancy or infant mortality rates have risen or fallen, how each person is doing in the economy, and how many individuals in a country can read or write.
What is the relationship between GDP and inflation? ›
Over time, the growth in GDP causes inflation—inflation, if left unchecked, runs the risk of morphing into hyperinflation. Most economists today agree that a small amount of inflation, about 1% to 2% a year, is more beneficial than detrimental to the economy.
GDP is the signature piece of BEA's National Income and Product Accounts, which measure the value and makeup of the nation's output, the types of income generated, and how that income is used.
