What is GDP?

Key Takeaways

• Gross domestic product (GDP) measures the value of all the final goods and services produced within a country during a specific time

• GDP provides a snapshot of a country's economy and is a crucial tool to guide policymakers, investors, and businesses in strategic decision-making

• There are three ways to calculate GDP. They are the expenditure approach, the production approach, and the income approach

Understanding GDP

Gross domestic product (GDP) measures the value of all the final goods and services produced within a country during a specific time.

In the U.S., the government releases an annualized GDP estimate for each fiscal quarter and the calendar year. 

GDP provides a snapshot of a country's economy and is a crucial tool to guide policymakers, investors, and businesses in strategic decision-making.

3 ways to calculate GDP

A country's GDP can be calculated using expenditure, production, or income. The three approaches arrive at the same result, but each views GDP from a different perspective.

• The Expenditure Approach

The expenditure approach, also known as the spending approach, looks at spending by different participants in the economy. It uses the following formula:

GDP = C + G + I + NX

where

C=consumption;

G=government spending;

I=investment; 

NX=net exports

All of these activities contribute to the GDP of a country.

Consumption refers to how much the residents of a country spend on final goods and services, including those produced abroad. Consumer spending is the most significant component of the U.S. GDP, accounting for more than two-thirds of the GDP. Consumer confidence, therefore, matters a lot to economic growth. 

Government spending represents government consumption expenditure and gross investment. Governments spend money on equipment, infrastructure, and payroll. Government spending may become more important relative to other components of a country's GDP when both consumer spending and business investment decline sharply. (This may occur in the wake of a recession.)

Investment refers to domestic investment or capital expenditures in the private sector. Businesses spend money on new capital goods or increasing inventories. Business investment is a critical component of GDP since it increases an economy's productivity and boosts employment.

• The Production Approach

Also known as the output approach, the production approach calculates the total value of economic output and deducts the cost of goods that are consumed in the process (i.e., the cost of material, supplies, and services used to produce final goods or services). 

• The Income Approach

The income approach calculates GDP by adding the income earned by all the factors of production in an economy.

Total income can be subdivided according to different classifications, so several formulae for GDP are available. A common one is:

GDP = compensation of employees + gross operating surplus + gross mixed income + taxes - subsidies on production and imports

Compensation of employees (COE) measures the total remuneration to employees for work they've done. It includes wages and salaries, employers' contributions to social security, and other similar programs.

Gross operating surplus (GOS), often called profits, is the surplus due to owners of incorporated businesses.

Gross mixed income (GMI) is the same measure as GOS, but it's for unincorporated businesses, which refer to most small family businesses.

Finally, adding taxes and subtracting subsidies on production and imports give us the result of GDP.