Gross domestic product (GDP) is an official financial measure of the total goods and services produced by a country’s citizens within its borders during a particular time period. All sectors or industries are party to GDP: manufacturing, agriculture, construction, energy, government and service sector. Calculated annually and also quarterly at times, GDP helps find out a country’s economic health. It’s compared with every preceding period to determine economic growth. For instance, if the annual 2012 GDP numbers went up by 2 percent compared to 2011 GDP figures, it means the economy grew by 2 percent over the period. When GDP exhibits growth, it means the state’s unemployment levels are low and people are having more money to spend. During an economic crisis, GDP goes down.
GDP was first used as an official economic measure in 1937, after being devised by a Russian economist called Simon Kuznets as an aftermath to the Great Depression. Prior to GDP, gross national product (GNP) was the official measurement system. GNP’s scope is similar to GDP; however, it doesn’t consider location of the citizens. In other words, if a British citizen produces goods and services outside the United Kingdom, the value of his production would be counted towards Britain’s GNP. With GDP, however, the British citizen should have effected production within UK borders for consideration. After the 1944 Bretton Woods conference, GDP became standard across the world.
GDP calculation mechanism is standard across countries, which almost accurately helps compare the economic value of different countries. Basically GDP can be calculated either by accounting a country’s total income (income approach) or total expenditures (expenditure method). The income approach accounts compensation of all employees, incorporated and non-incorporated institutions’ gross profits, and taxes minus subsidies. A more common method, the expenditure method considers total investment, consumption, net exports and government spending. There’s another method called product approach that takes into account all goods and services’ market value. All the three measures more or less arrive at the same number.
GDP numbers are usually calculated by a country’s national statistical agencies – these institutes compile data from several different sources. Since GDP numbers are calculated quarterly or annually, GDP is never up-to-date or real-time.
Nominal and Real GDP
When people talk about GDP, they’re technically referring to nominal GDP, which doesn’t factor in inflation. For a more accurate number, real GDP numbers should be used which adjust for inflation. When comparing annual GDP numbers with the previous year, real GDP helps determine the actual economic growth, if any.
As aforementioned, GDP helps measure a country’s economic status, and these GDP numbers can be compared with other country’s figures to determine comparative performance. However, since GDP is measured in a particular country’s currency, adjustments are needed when comparing the output values in different currencies. Typically, a specific currency is taken as standard and GDP is converted into that currency for a more accurate comparison. When a country’s inflation numbers are high, its nominal GDP may see an increase. However, there won’t be similar growth patterns in terms of real GDP. When comparing GDPs of different countries, real GDP is considered since different countries don’t have the same inflation rate.
Using GDP to measure a country’s economic health is riddled with certain pitfalls. First, GDP doesn’t consider unofficial production numbers, which includes the black market and other unaccounted business transactions, such as unpaid work or work done by volunteers, or at home. For example, if a pizza vendor makes a pizza and sells it to a consumer, the revenue generated gets accounted. However, if he provides that same pizza to his family member(s), there is no sales and the cost of making that pizza won’t be reported to the government. Similarly, the correct value of transport infrastructure, education and healthcare is usually unknown.
Also, GDP only accounts a country’s economic progress. Social factors such as happiness and health aren’t considered. Increased production could at times come at the expense of external costs such as environmental damage. The higher output may also be at the cost of nonrenewable natural resource depletion, or reduced leisure time for employees or increased working hours. For instance, the GDP of United Kingdom would be higher than France, if UK employees work longer than their French counterparts. Other metrics such as energy consumption, per capita GDP, education levels, pollution, innovation, etc. must also be accounted to determine the true economic state of a country.