What is the definition of Gross Domestic Product (GDP)?

Well, the 2.9% growth rate measures the country’s GDP. What does GDP stand for? It stands for gross domestic product, one of the country's broadest measurements of overall economic activity. And it's one of the best tools to measure how our economy — and all economies — are doing.

In this article, we'll define GDP, break down "What is the definition of gross domestic product GDP and "What does the GDP mean?" and why it's significant, how it differs from other economic indicators and what it says about the business cycle and inflation. By the end of the article, you'll have a much more thorough grasp of GDP and its role in economics.

Components of GDP 

What is gross domestic product? The GDP meaning is a broad measure of overall economic activity. It includes all consumption (both public and private), government outlays, investments, private inventories, paid-in construction costs and the foreign balance of trade (exports-imports). 

Gross domestic product is sometimes confused with the gross national product (GNP). However, GNP excludes domestic production by foreigners. So what does GDP measure? 

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Consumption 

Consumption is spending by households on durable goods, non-durable goods and services. It's an important economic growth driver, accounting for about two-thirds of total GDP components. Consumption is the largest component of GDP and includes everything from food and clothing to rent, healthcare, recreation, travel and entertainment expenses. It's consumption when you buy groceries at the supermarket, get a haircut at a salon or purchase a new car. 

Household consumption spending provides income to businesses, which in turn boosts their profits and helps create jobs. Consumer spending can be affected by changes in taxes or government regulations. When consumer confidence is high, households are likely to spend more, boosting economic growth.

Investment

"Investment" refers to new investments in capital assets such as stocks, bonds, real estate or equipment for businesses and households. Residential construction is also considered an investment since it increases housing stock and provides more living space.

Investment plays a vital role in economic growth since it helps create jobs, meaning consumers have more to spend. Investment can also improve productivity and efficiency if businesses invest in new technology or equipment that allows their employees to work faster or better than before.

Inward foreign direct investment (FDI) also factors in since it provides capital from abroad. A nation's exports also contribute to GDP since they are final goods sold to other countries.

Government spending

Government spending includes government purchases of goods (such as defense spending) and services (including education). Government spending includes defense spending, public education, infrastructure development and social welfare programs. Of course, government spending also includes transfer payments such as unemployment benefits or welfare assistance. Still, transfers don't add to GDP since they do not purchase goods or services.

Government spending can have both a direct and indirect impact on GDP. It directly adds to total production output and creates jobs, leading to increased consumer spending and thus indirectly boosting GDP growth. When government expenditures increase, businesses are more likely to expand their operations and create jobs. And government expenditure often stimulates private investment by providing additional capital for businesses to reinvest or expand.

Net exports 

Net exports, also known as the balance of trade, refer to the difference between a country's total exports and total imports. Net exports equal exports minus imports and can either be positive or negative.

Net exports factor heavily into the GDP. If net exports are positive, the home country is exporting more than it's importing, which boosts GDP growth since all exported goods and services add to total output. On the other hand, if net exports are negative, the home country imports more than it exports, reducing total output since imported goods and services subtract from GDP. Therefore, higher export levels may lead to increased economic growth.

You can see the relationship between exports, imports and GDP through changes in exchange rates, which will affect both imports and exports. When a nation's currency appreciates (strengthens), its imports become cheaper for local customers, resulting in greater demand for them and increased GDP from these purchases. Conversely, when a currency depreciates (weakens), its exports become cheaper for foreign customers, increasing demand for them and increasing GDP from these purchases.

Methods of calculating GDP

How is GDP calculated? There are three different ways to learn how to calculate GDP. When you calculate the GDP equation correctly, they should all lead to roughly the same result.

Expenditure approach

The expenditure approach, or GDP based on spending, is considered the most common. This approach accounts for both consumer spending and government spending. It also considers the goods and services made in a country and exported overseas (net exports) as well as the goods and services purchased in this country but brought in from overseas (net imports). One way to look at the expenditure approach is that it measures the sum of all the materials and services used to develop a finished product for sale.

The GDP formula using the expenditure approach is:

GDP = C + G + I + NX

C: Consumer spending

G: Government spending

I: Sum of a country’s investments (including capital expenditures)

NX = Total net exports (net exports – net imports)

Income approach 

This approach looks at the income side of the economy. The theory is that everything that makes up national income can be used as implied productivity and expenditure. 

So, if consumer income is increasing, it should lead to increased spending. If a business owner makes profits, they can apply that to their business or invest in something else. It also takes into account the interest earned from investments. The income approach will also consider offsetting factors to business income, such as property taxes, sales tax and depreciation.

Production (value-added) approach 

This approach estimates the total value of economic output and deducts the costs of intermediate goods consumed in the process. It is different from the expenditure approach because it's not looking forward to project economic activity but is looking backward at the economic activity.

Real GDP vs. nominal GDP 

One of the limitations of GDP is that it doesn't adjust for inflation or deflation. Therefore, if GDP increases, it can be unclear whether the growth is due to expanded production or because prices are increasing (inflation). To compensate for this, economists created a new measurement called real GDP. It's contrasted with nominal GDP, a measure of a country’s economic output that doesn't consider inflation or deflation.

Nominal GDP 

The nominal GDP definition is calculated by taking all the goods and services produced in an economy and multiplying them by their current market prices. This figure represents the total value of all final products and services produced in that economy in a given period.

However, because nominal GDP doesn't consider the effects of inflation or deflation, it can distort the true picture of economic growth. For example, if prices increase due to inflation, nominal GDP may look like it's growing while real GDP may stagnate or even decrease. 

Real GDP 

Meanwhile, real GDP uses a GDP price deflator (or implicit price deflator). The implicit price deflator measures the price difference between the current and base years. For example, if prices rose 4% since the base year, the deflator would be 1.04.

Real GDP = Nominal GDP/1.04

GDP per capita and its implications

Because the population and costs of living impact are different around the world, when comparing the GDP of one country to another, economists use refined data to get a truer picture. One of the most common is GDP per capita, which divides a nation’s GDP by its population. This figure provides a more accurate reflection of the economic well-being of a country than simply looking at the total GDP since it takes into account differences in population size.

For example, if two countries have the same GDP, but one has a larger population, then that country will have a lower GDP per capita because it needs to divide its total output among more people. The GDP per capita formula is often cited when economists assess the quality of life (standard of living) between two countries. However, it also has limitations, such as not considering income distribution. For example, if one country has an extremely unequal income distribution and a lot of people living in poverty, then its level of economic development could still appear high when looking only at the overall GDP. However, income equality will not be reflected in the GDP per capita figure.

Limitations of GDP as an economic indicator

One of the primary limitations of GDP is that it doesn't capture all economic activities. It only considers those in the formal market, meaning activities taxed and/or regulated by the government, leaving out a significant portion of the economy that operates in the informal sector or underground economy. 

Activities such as subsistence farming, bartering and domestic labor — often performed by women — go uncounted and unvalued.

GDP also fails to reflect the overall quality of life or well-being since it doesn't consider health, education, climate change or income inequality factors. As a result, due to its narrow focus on production and consumption, GDP has been criticized for not accurately measuring all aspects of a nation's economic performance.

Alternative indicators like the Human Development Index (HDI) have proposed to measure better a country's well-being and progress toward development goals. HDI considers measures such as education levels and life expectancy in addition to GDP per capita to provide a more rounded picture.

The role of GDP in economic policy and decision-making 

Governments can use the global GDP figures for many purposes, including to set monetary policy, which includes the pace and amount of interest rate adjustments, and it can offer guidance on the inflation rate.

Government and policy 

Governments can use the GDP figures to set things like monetary policy, which includes the pace and amount of interest rate adjustments, and it can offer guidance on the rate of inflation. GDP also informs fiscal policy, meaning how much money the government spends and collects in taxes.

GDP data can help assess how well existing policies work and determine what policies should be implemented to stimulate or slow growth. Tax cuts or changes in spending levels can be evaluated based on their effect on GDP.

Most international organizations use GDP figures to assess a country’s creditworthiness and eligibility for financial assistance or loans for development projects or emergency relief efforts.

International comparisons 

GDP compares a country’s performance against its peers and understands which countries are making strides economically or areas where they may need to focus more resources.

For example, countries may enter into free trade agreements, such as the North American Free Trade Agreement or the proposed Transatlantic Trade and Investment Partnership, to increase production and exports by reducing tariffs and other impediments to trade. These agreements provide opportunities for smaller countries to benefit from increased access to larger markets, especially developed countries with higher demand for imports. GDP figures can monitor the effects of these agreements on production levels and export values.

Similarly, other trading blocs like the European Union use GDP data when assessing whether or not a country meets certain criteria for membership, such as economic stability and market access.

International organizations like the International Monetary Fund (IMF), World Bank and Organization for Economic Cooperation and Development rely heavily on GDP figures when assessing a nation’s current economic situation and prospects for growth and determining types of loans or assistance packages that might help it achieve stability or growth.

Governments often look at per capita GDP when determining how much foreign aid they should provide to improve living standards or reduce poverty levels in a given country.

GDP: A valuable snapshot of the economy 

GDP is one of the most closely observed economic indicators for a reason. Although just a snapshot of a country’s economic performance, it can provide businesses and investors with confirmation of what they are viewing or point to a reversal.

While imperfect, GDP is one of the best tools to measure the current state of our nation's employment rate, consumer confidence and trade balance. It can compare one country's performance to another, evaluate the effects of certain policies and provide valuable insight into an economy's short-term performance and long-term growth prospects.