What Is GDP? Definition of Gross Domestic Product

The Key to Understanding What a Country Is Good at Producing

GDP
GDP per capita measures the country's standard of living. Photo: Blend Images - John Lund/Marc Romanelli

Definition: Gross Domestic Product (GDP) is the best way to measure a country's economy. It includes everything produced by all the people and companies that are in the country. 

How to Calculate Gross Domestic Product:

The components of GDP are:

Personal Consumption Expenditures plus Business Investment plus Government Spending plus (Exports minus Imports).

Now that you know what the components are, it's easy to calculate a country's Gross Domestic Product using this standard formula: C + I + G + (X-M).

Types

There are many different ways to measure a country's Gross Domestic Product. It's important to know all the different types, and how they are used.

Nominal:  In 2015, U.S. GDP was $18.037 trillion. This is known as nominal GDP, which is the raw measurement that leaves price increases in the estimate. The Bureau of Economic Analysis (BEA)  measures nominal GDP quarterly. It revises the quarterly estimate each month as it receives updated data.

Real: To compare economic output from one year to another, you must take out the effects of inflation.  To do this, the BEA calculates real GDP. It does this by using a price deflator, which tells you how much prices have changed since a base year. The BEA multiplies the deflator by the nominal GDP. The BEA makes these three important distinctions.

  1. Income from U.S. companies and people from outside the country are not included. That removes the impact of exchange rates and trade policies.
  1. The effects of inflation are taken out.
  2. Only the final product is counted. For example, say a U.S. footwear manufacturer uses laces also made in the United States. Only the value of the shoe gets counted. The shoelace does not.

Real GDP is lower than nominal. In 2015, it was $16.397 trillion. The BEA provides it using 2009 as the base year in Table 1.1.6.

Growth Rate: The GDP growth rate is the percent increase in the economy's output from quarter to quarter. It tells you exactly how fast a country's economy is growing. Most countries use real GDP to remove the effect of inflation.

In the U.S., the BEA calculates the growth rate. For the most recent quarterly report, see Current GDP Statistics. Read U.S. GDP Growth to see the forecast of this important economic indicator. You can also compare it to the business cycle phase for each year since 1929.

GDP per Capita: This is the best way to compare Gross Domestic Product between countries. That's because some countries have an enormous economic output because they have so many people. To get a more accurate picture, it's helpful to use GDP per capita. This divides Gross Domestic Product by the number of residents, and measures the country's standard of living.

You've probably already guessed that the best way to compare Gross Domestic Product by year and to other countries is with real GDP per capita.

This takes out the effect of inflation, exchange rates and differences in population.

What It Tells You About the Economy

Nominal Gross Domestic Product measures the absolute output of any country. Real GDP allows you to compare countries. The U.S. recently lost its position as the world's largest economy. In comparing the economy of two different countries, you've got to take out the effects of inflation and exchange rates. The best way to do this is to use purchasing power parity.

The growth rate measures if the economy is growing more quickly or more slowly than the quarter before. If it produces less than the quarter before, it contracts and the growth rate is negative. This signals a recession. If it stays negative long enough, the recession turns into a depression. As bad as a recession is, you also don't want the growth rate to be too high. Then you'll get inflation. The ideal growth rate is between 2-3%.

How It Affects You

Investors look at the growth rate to see if the economy is changing rapidly so they can adjust their asset allocation. In addition, investors compare country growth rates to decide where the best opportunities are. Most investors like to purchase shares of companies that are in rapidly growing companies.

The Federal Reserve uses the growth rate to decide whether to implement expansionary monetary policy to ward off recession or contractionary monetary policy to prevent inflation. For more, see The Federal Funds Rate and How It Works.

Let's say the growth rate is speeding up, and the Fed raises interest rates to stem inflation. In this case, you would want to lock in a fixed-rate mortgage.​ You know that an adjustable-rate mortgage will start charging higher rates next year.

If growth slows down, or is negative, then you should dust off your resume. Slow economic growth usually leads to layoffs and unemployment, but it can take several months. Declining growth means business revenues are down. It can take awhile before executives can put together a layoff list and package. If you follow Current GDP statistics, you can be better prepared.

You could also use the Gross Domestic Product report from the BEA to look at which sectors of the economy are growing and which are declining. This would help you determine whether you should invest in, say, a tech-specific mutual fund vs a fund that focuses on agribusiness. It can also help you find training in sectors that are growing. Even during the 2008 financial crisis, health care related industries continued to add jobs. 

Difference From GNP

To get everything produced by a country's citizens, no matter where they are in the world, you should look at Gross National Product (GNP). The World Bank has replaced it with Gross National Income (GNI) which is immaterially different.

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