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GDP stands for "gross domestic product." It is a measure of the values of all goods and services produced by a country in a year, minus net income from foreign sources. It is one of the most fundamental aspects of macroeconomics.
What is GDP?
GDP can be determined by using one of three calculations, all of which (should) yield the same results.
- The first, and most direct, approach is the expenditure approach, which defines GDP as the total annual expenditures incurred by a state. This assumes that everything produced gets consumed, so the total production of a country must equal the total expenses of a country. This approach does not include in its calculations goods that are produced but not sold. So, the sweater your grandmother made for you is not included as part of GDP, unless she sold it to you and reported the profits to the government.
- The second is the production approach, which counts the market value of all final goods and services produced annually. The expenditure approach is the total amount bought, and the production approach is the total amount produced. These can differ because a widget produced in one year may not be sold until the next.
- The third is the income approach, which is the annual total of incomes of all of a state's individuals. While the expenditure approach assumes that everything produced in a year will be bought in that year, the income approach assumes that every dollar paid to employees will be invested or spent in some way (this includes depositing money into a bank). This leaves out money that an individual may have simply put under their mattress (metaphorically speaking).
- GDP = Consumption + Government spending + Investment(capital, not financial; includes net change in inventory) + Xn(net export)
- GDP = C + G + I + X
Why does it matter?
One major use of GDP is as a measure of a state's total economic power. For example, the total GDP of the US is roughly 15 trillion dollars, Bhutan's total GDP is 4.284 billion dollars, and Bermuda's is 4.5 billion dollars. Thus, the total economic power of the US is about 3,342% that of Bermuda's, and a similar amount to that of Bhutan's.
The other major use of GDP is in changes in GDP, broadly called economic growth. This includes growth (when the economy grows over one or more quarter by more then 1% of the total GDP), stagnation (when the economy does not shrink or grow by more than 1% in either direction), recession (when the economy shrinks moderately, tracked by diminished GDP over two consecutive quarters), and depression (when people can no longer buy all the stuff their country is able to produce over a long period of time, or when this decline is severe).
The third major use of GDP is in the figures that are derived from it. For example, a major economic measure is GDP per capita, simply GDP divided by the total resident population, and is used largely as a (theoretical) measure of standard of living. An example of this is that the US has a GDP per Capita of $48,100, Bhutan's GDP per capita is $6,000, and Bermuda's GDP per capita is $69,900. It is important to note that Bermuda has a total GDP similar to that of Bhutan, but has a GDP per capita more similar to that of the US.
There are additionally a few dozen other measures which are built off of GDP which are largely measures of economic efficiency, and include things like GDP per employee, GDP per barrel of oil, GDP per hour worked, and so on.
GDP, GNP, or GSP?
GNP is a related, but different concept, which is gross national product. GNP is different because it is the market value of all products and services produced in one year by labour and property supplied by the residents of a country. So, Hyundai plants in the US are not counted towards the GNP of the US, but are included in the GNP of South Korea, and are counted towards the GDP of the US, but not South Korea. Total GDP and total GNP tend to be similar, but are never the same. A third related measure is GSP, or gross state product. GSP is (essentially) the GDP of a subnational unit, defined here as a 'state', even if it isn't a state. So, Washington D.C. (essentially a city) has its own GSP, just like South Carolina, and British Columbia.
Limits and Criticisms
While GDP and its derivatives are extremely useful in economics and politics, it is still extremely limited in a number of ways, and has a fair share of criticism, both legitimate and not.
It is inaccurate (and fairly dishonest) to use changes in GDP as a marker of total economic health, even though this tends to be what happens. There are a few reasons for this: GDP is a limited number (it only talks about one thing); it is heavily dependent on population (for example, a country that has a growing GDP but a faster growing population is still in depression); is somewhat dependent on government spending; and is heavily influenced by government trade policies. Additionally, while GDP is the way economists define depression, recession, stagnation, and growth, equally important factors that need to be considered when trying to figure out the health of an economy include sovereign debt, public debt, private debt, wealth inequality, employment rate (itself having multiple definitions), and inflation (also having multiple definitions) at the very least. So, while talk of GDP and changes in GDP in the political arena are common, to talk of only one is extremely dishonest. Nominal GDP also does not take inflation into consideration — while an economy can appear to grow modestly, it may be shrinking when inflation is accounted for.
There are five significant criticisms of GDP as a primary economic measure. The first is that GDP is a poor measure on the grounds that it does not take into account the damage industry does to the environment. GDP does not account for environmental damage because it is normally be long term damage that does not affect the economy as the environmental damage is happening. The second, and somewhat related, criticism is that GDP includes in its calculations economic waste as if it were growth. For example, if a person (A) paid another person (B) to punch themselves in the face, and this transaction was reported to the government, this would be counted towards GDP, but nothing of any real economic value was produced. As a matter of fact, sometimes downright negative events may have a positive effect on GDP. Imagine an oil spill: Someone has to clean it up, so they get paid, which in turn grows GDP. So in essence a company ignoring environmental regulations is doubly "good" for GDP; first when they ignore the regulations and make their profits and second when somebody has to come and clean up.
A third criticism of GDP (or, more accurately, its derivatives) is that it is not an accurate measure of economic efficiency. For example, as already mentioned, the GDP per capita of the US is $48,100. However, this is not the average income of the US, which is actually $41,673.83. While these numbers are similar, and greatly above the global average, they are not the same, and GDP per capita is often sold as a measure of standard of living. A related critique is found in the fact that GDP does not include the informal sector, which is any economic activity not officially recorded. This includes illegal activity, paying illegal immigrants (or anyone else paid under the table), or anyone who works in their home and does not report the income to the government. This is extremely pronounced in the global south where little economic activity is reported to the government. The problem is exacerbated by the weak role of the state in many of these societies; in other countries a bus driver is paid a salary to her bank account and the customers mostly pay long term tickets through regular bank transfers, in the global south, a bus driver collects the money cash and is neither inclined nor encouraged to ever record the exact amount of money he collects every day. Add in rampant tax evasion, even in countries like Greece, and you know why some GDP figures have to be taken cum grano salis.
Another criticism is that GDP measures the wrong kind of stuff. While the US (as mentioned above) have the highest GDP per person in Purchase Power Parities of all countries of nontrivial size and population, this means jack shit to the person making minimum wage who has to pay down the mortgage and try to keep the car from breaking down. In part as a response to this criticism of the GDP, the "Human Development Index" (HDI) was developed that tries to measure factors such as education. While the HDI of a country strongly correlates with its GDP per capita, it is noteworthy that countries with a strong welfare state such as the Nordic countries score higher on the HDI scale than countries with a more laissez fare approach like the US. Of course this criticism is valid, and one single number should never be the only thing people look at, but the HDI has obvious problems of its own and is thus not a cure-all either.
A final criticism is often heard from libertarians, but their criticisms are largely applicable outside of their economic school. Their position is, essentially, that because GDP is so heavily influenced by monetary policy (which they hold as always being bad when there is any central bank manipulation) or government activity (again, always bad), the measure as a whole is useless in economics. Add in the usual liberatarian paranoia, we get that the use of GDP is in justifying government and central bank action. To quote economist Frank Shostak (an Austrian thinker):
“”The GDP framework cannot tell us whether final goods and services that were produced during a particular period of time are a reflection of real wealth expansion, or a reflection of capital consumption.
For instance, if a government embarks on the building of a pyramid, which adds absolutely nothing to the well-being of individuals, the GDP framework will regard this as economic growth. In reality, however, the building of the pyramid will divert real funding from wealth-generating activities, thereby stifling the production of wealth.
So what are we to make out of the periodical pronouncements that the economy, as depicted by real GDP, grew by a particular percentage? All we can say is that this percentage has nothing to do with real economic growth and that it most likely mirrors the pace of monetary pumping.We can thus conclude that the GDP framework is an empty abstraction devoid of any link to the real world. Notwithstanding this, the GDP framework is in big demand by governments and central bank officials since it provides justification for their interference with businesses. It also provides an illusory frame of reference to assess the performance of government officials.