There are a number of terms you’ll see in the business section of every newspaper, one of them being “GDP” aka gross domestic product. But despite its recurrence, most people only know GDP as a measure of the economy’s health, which is sort of true but it’s a little simplistic.
What is GDP?
The gross domestic product is the market value of all the finished goods and services produced in a country. Think of the economy as a giant supermarket with millions of goods and services being produced. The GDP of that supermarket would be the selling price of those goods and services.
The figure, reported on a quarterly basis by the Bureau of Economic Analysis is generally expressed as a dollar amount. While quarterly growth rates are a periodic measure of how the economy is faring, annual GDP figures are the benchmark for the overall size of the economy.
There are however, different kinds of GDP (as if the original one isn’t specific enough):
Nominal GDP: includes current prices in its calculation. In other words, it doesn't factor inflation which can inflate the growth figure. All goods and services counted in nominal GDP are valued at the prices that are actually sold for in that year.
Real GDP: nominal GDP’s doppelgänger, adjusting for inflation by holding prices constant from year to year which removes the impact of inflation or deflation.
GDP purchasing power parity (PPP): looks at a country’s GDP to see how it stacks up in “international dollars” by adjusting for differences in prices and costs of living in order allowing for cross-country comparisons of real output, real income, and living standards.
GDP per capita: measures the GDP while adjusting for population which helps indicate average productivity or average living standards. GDP per capita can be stated in nominal, real, or PPP terms.
How do you calculate it?
GDP can be determined in three ways, all of which should, theoretically give the same result.
The Expenditure Approach:
This method calculates spending by the different groups that participate in the economy by using the formula:
C + I + G + NX = GDP
C = consumption (what and how much private individuals spend)
G = government spending (need I say more?)
I = investment
NX = net exports (subtracts total exports from total imports)
The Production Approach:
The opposite of the expenditure approach; instead of measuring the inputs that contribute to economic activity (spending, investment, etc), the production approach looks at the value of economic output and deducts the cost of finished goods that are consumed.
The Income Approach:
A middle ground between the production and expenditure approach. The income approach calculates the income earned by factors of production (resources needed to create stuff), including wages, the rent earned by land, return on investments, and profits.
Technically, adding all this up gives us gross domestic income (GDI). In order to convert that to GDP, economists must subtract taxes and subsidies to go from factor cost to market price and they have to add depreciation (cost of a physical asset over its life expectancy) to go from net domestic product to GDP.
Why do economists use GDP?
People use GDP because it is a representation of the total market value of all goods and services produced by an economy over a specific time period. The question is, is this an accurate measurement of economic health?
Economists criticize the GDP metric on 2 counts: firstly, GDP ignores business-to-business activity. By focusing only on the final goods and services being sold to consumers, the importance of consumption relative to production is being overstated, which can lead to very misleading conclusions. For example, the US GDP dropped around 3-4% during the 2008 financial crisis, whereas the gross output (which accounts for business-to-business activity) plummeted more than 25%.
The second issue with GDP is that it considers all final private and government spending as societal benefits, even if those things are useless. People often point to the big spike in the US’s GDP during WW2. But this wasn’t because war is inherently better for an economy; rather it’s because the US government inflated the “G” part (from the C+I+G+NX equation) thus inflating the GDP. Private consumption actually shrank during the war and life for the average citizen was plagued with rationing and a deterioration in well-being - something GDP didn’t account for.
Conclusion
From when it was first introduced in the 1600s to when it truly went global in 1993, GDP is the most widely used economic metric with it being reported in dozens of economic journals every year.
There does, however, seem to be a growing distrust of GDP, with people turning to alternative measurements such as the OECD Better Life Index, arguing standard macroeconomic statistics like GDP don’t give a true account of people's current well-being. The world of economics is always undergoing intellectual conflict, so we can’t say as to whether or not this shift in indicators is a necessary step or simply a naive jump.