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Politics & Society

What Is GDP (Gross Domestic Product)?

Written by MasterClass

Dec 20, 2018 • 6 min read

When you hear an economist or news reporter talking about the “size” of an economy, they are most likely referring to Gross Domestic Product or GDP. GDP is one of the most important statistics in economics. Measuring GDP tells us an enormous amount about how a nation is doing. If GDP is rising, it signifies that incomes are rising, and consumers are purchasing more. All of this means a stronger economy.

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Written by MasterClass

Dec 20, 2018 • 6 min read

What Is GDP?

GDP measures the total value of all final goods and services produced within a country’s borders at a given time. GDP is one of the most widely used tools to measure a country’s economy, and it is calculated by countries themselves as well as occasionally by world organizations such as the World Bank, the International Monetary Fund, and the United Nations. In the United States, GDP is measured quarterly by the Bureau of Economic Analysis (BEA) at the United States Department of Commerce.

What Is the Formula for Calculating GDP?

There are three different ways that economists and statisticians can calculate GDP and they should all, theoretically, produce the same number:

1) Expenditures

This is the value of everything that is purchased within the country plus that country’s net exports to other countries.

2) Income

This is the income of all the individuals and businesses within the country. Also called national income.

3) Production

This is the value of everything that is produced within the country.

How to Calculate GDP Based on Expenditures

This is calculated using the formula GDP = consumption (C) + investment (I) + government spending (G) + (exports (X) - imports (M)).

The expenditure method is based on the idea that all final goods and services produced in an economy must be purchased by someone. Goods that remain unsold are accounted for as having been purchased by the producer.

Let’s break down each component of the calculation to better understand what GDP is and why the number is important to economists:

Consumption makes up the largest part of GDP calculation.

  • This is anything a household or individual would spend money on, like food, rent, toothpaste, etc. Note that purchasing property is not included in consumption.

Investment is typically defined as investment in new equipment or materials by a business.

  • For example, a business buys new computers for all of its employees. Households purchasing property is included in investments, since houses are purchased on loans (most households will not pay all cash for property up front). Investments, such as the purchasing of stocks, is not included in this definition of investment as that is considered savings.

Government spending is the sum of everything the government has purchased or spent money on.

  • This means any physical products the government has purchased, like fire trucks or aircraft carriers, investments the government has made, and salaries of government employees, like teachers. This does not include any payments or programs such as welfare or social security.

Exports are all goods that are produced within the country and sold to other countries. Imports are all the goods that are produced in other countries and sold to this country.

  • Imports must be subtracted from exports as otherwise foreign production would be counted as domestic supply.

How to Calculate GDP Based on Income

This is calculated using the formula:

GDP = Compensation of employees + gross operating surplus + gross mixed income + (taxes - subsidies on production and imports).

Compensation of employees is the total payments made to all employees or laborers.

  • This also includes any welfare payments such as social security.

Gross operating surplus is essentially the profit of incorporated businesses.

  • Most large businesses with many employees are incorporated.

Gross mixed income is the profit of unincorporated businesses.

  • Many small businesses are unincorporated.

Income is defined in various ways through the four factors of production:

  • Labor and laborers earn wages
  • Land earns income through rent
  • Capital earns interest
  • Entrepreneurs earn profit

For a more detailed discussion of the various forms of income, read about the Circular Flow Model.

How to Calculate GDP Based on Production

This approach takes into account the value added to the entire domestic output. The value added is calculated by taking the price at which a seller is selling a product and subtracting that from the price at which the seller purchased the product from the supplier.

Which Formula Should You Use to Calculate GDP?

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All three of the methods outlined above should arrive at the same GDP measurement, however there are often slight differences between them which are usually caused by discrepancies in the raw statistics used to calculate them.

The 4 Types of GDP

There are four different types of GDP and it is important to know the difference between them, as they each show different economic outlooks.

1) Real GDP

Real GDP is a calculation of GDP that is adjusted for inflation. The prices of goods and services are calculated at a constant price level, which is usually set by a predetermined base year or by using the price levels of the previous year. Real GDP is considered the most accurate portrayal of a country’s economy and economic growth rate.

2) Nominal GDP

Nominal GDP is calculated with inflation. The prices of goods and services are calculated at current price levels.

3) Actual GDP

Actual GDP is the measurement of a country’s economy at the current moment in time.

4) Potential GDP

Potential GDP is a calculation of a country’s economy under ideal conditions, like a steady currency, low inflation, and full employment.

The Uses of GDP

GDP is used by economists to determine the health of the economy and whether an economy is growing. GDP growth over consecutive quarters indicates the economy is expanding. If GDP growth and economic growth continue, this could signal to economists that there might be a risk of inflation and policymakers should raise interest rates to help abate those consequences of growth.

If the GDP growth is negative over two or more consecutive quarters, this is considered a recession. This indicates to economists and policy makers that measures to increase economic activity, like lowering the interest rate or printing more money, are necessary to maintain stability.

GDP data can also indicate how other countries or economic regions measure against each other. China has historically had the largest GDP in the world, which has only been interrupted in the past two centuries, first by the British Empire, then by the United States, and, briefly, by the European Union. The United States currently has the world’s largest GDP as of 2018, though China’s GDP is expected to surpass it by 2020.

The Drawbacks of Using GDP in Calculations

There are few drawbacks and criticisms of GDP.

GDP as a whole does not indicate standard of living.

Even though China has a large GDP, its standard of living is quite low and it is considered a “middle income” country. The United States, on the other hand, has one of the highest standards of living in the world, with high incomes and a large amount of consumer spending. The GDP can be divided by the total population of a country to determine standard of living, which is called GDP per capita.

GDP does not include any black market economies.

Though some countries, like the United States, do try to make estimates based on tax revenues. Black markets include any goods and services that are bought and sold but which are not reported because they are illegal. This includes drugs and drug dealing, illegal prostitution, and illegal labor.

GDP also does not include other forms of unreported labor.

Unreported labor includes child care or household maintenance like cooking or cleaning. This mean that, for example, the sector of the economy made up of men and women who choose to stay home to look after their children, while they work full time, are not included in national figures on the economy or labor.

GDP does not include environmental costs of economic output.

For example, the single use plastic cup that was produced and sold was included in the GDP but the long-term cost associated with its disposal and harm it causes the environment are not included.

GDP is a crucial measure of economies. However, while GDP can portray a country’s standard of living, it does not take into account a population’s overall wellbeing, health, and happiness. This is why economics is an important, yet imperfect, science.

Paul Krugman

Teaches Economics: Think like an economist

For Nobel Prize-winning economist Paul Krugman, economics is not a set of answers, it’s a way of understanding the world. In his MasterClass, Paul teaches you the economic principles that shape political and social issues—like access to health care, the tax debate, globalization, and political polarization. Heighten your ability to read between the lines and decipher the underlying economics at play.

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