What is Gross Domestic Product (GDP)? The basics

GDP stands for Gross Domestic Product and is used to measure a country’s economy and wealth. There are many variants of GDP, each measure a different aspect of the economy.

What is GDP?

Gross Domestic Product is the market value of all finished goods and services produced within a country within a specific time frame (usually a year).

Why is it important to measure GDP?

GDP is important because it is used to measure a country’s economy and how much it is growing or shrinking. A growing GDP also indicates a healthy economy what usually means, wealthier inhabitants and less unemployment. During recessions, GDP’s tend to stagnate or even contract.

What is used in the calculation of GDP?

Only the finished goods and services produced in a specific country will add to its GDP. This also includes products that are exported to another country where it will be consumed or used.  Normally only goods and services that are sold in a market are counted in GDP. Because products without a market value can not be calculated at an accurate price.

Finished goods & services

Finished goods are those goods that are ready to be used or consumed and that will not be used as a part of another good.

Intermediate goods

Intermediate goods are goods that are not finished goods yet but that will be used in the production of finished goods. Some things, however, can change from category depending on who buys it. If for example, a factory buys potato’s to make chips, it’s considered an intermediate good. In this case, the bag of chips would be the finished good. If a consumer buys potatoes in the supermarket to make a meal at home, it’s considered a finished good and therefore calculated in the GDP.

Capital goods

Capital goods are used to make finished goods but are also considered finished goods. For example, a blender that’s used to make orange juice is also considered a finished product. The reason for this is that the blender will be used to make other goods instead of being part of a finished good.

The reason that goods and services are split up in categories is to avoid that the same good is counted twice in the calculation of GDP.

bernd-dittrich-eCc7FjMoR74-unsplashPhoto by Bernd Dittrich on Unsplash

How GDP is used to measure growth

To measure whether or not our economy is growing, and by how much, we need to compare today’s GDP to that of a previous point in time. However, When comparing current GDP to the GDP of the past, there is a problem. The GDP that we just described is the nominal GDP, calculated based on the product prices of today. If we want to get to the real GDP, we need to adjust it for inflation.

How can GDP grow?

GDP grows when a country produces more valuable products and services and in a higher quantity. This is often driven by an increase in demand for products and services.

Let’s take a closer look at the main drivers.

Demand

In times of low-interest rates, increased wages and confidence in the overall economy, the demand for products and services tends to increase. An increase in the demand side means that there is room to produce more, new and better products. This stimulates growth in the economy and therefore also GDP growth.

Productivity growth

Productivity growth of an economy can be stimulated by investments in new technology, think about farmers using big tractors instead of horses for example. Another way to stimulate productivity growth is by an increase in the working population due to immigration or a higher birth rate. Also, better education can result in productivity growth. Better education can lead to better technology and innovative solutions which drive productivity growth as well.

Nominal GDP to Real GDP

So before we can compare our current GDP to a GDP of the past, we need to adjust it for inflation.

In the conversion from nominal GDP to real GDP, we will, therefore, use the same product prices for all the periods.

The graph below shows the nominal GDP growth, thus a GDP that isn’t adjusted for the increase in product prices.

Us nominal GDP
Source: FRED

The graph above would make you believe the GDP has been growing by a staggering amount.

However, If you look at the graph below that is adjusted for inflation (= Real GDP), you can see that the growth was (good but) not as significant as the graph above would suggest.

us real gdp
Source: FRED

How does GDP measure wealth?

To measure the standard of living and by how much it has increased (or decreased), we use GDPPC or Gross Domestic Product Per Capita. This is calculated by adjusting the nominal GDP for inflation to get the real GDP and then dividing real GDP by the number of people living in that country.

GDP per capita = Real GDP/ Total number of Inhabitants

GDP per capita is often used to compare the standard of living between countries or with the past.

 

What GDP growth tells us

GDP growth tells us the rate at which our economy is growing. This rate is very important to measure the health of our economy. The ideal GDP growth has been determined to be between 2.5% and 3.5%.

What happens when GDP grows too fast?

When GDP grows too fast, the demand for goods grows faster than its production. Unemployment levels bottom out, therefore companies have to raise wages to keep their employees. These raises in wages further increase the demand for products which in turn forces companies to increase prices. These events eventually drive hyperinflation.

(hyperinflation = very high and accelerated inflation)

What happens when GDP grows to slow?

When GDP grows too slow, the supply of money becomes bigger than the supply of goods. Therefore prices start to rise and money becomes worth less. It’s also called inflation.

 
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