What is Gross Domestic Product (GDP)?
Gross Domestic Product (GDP) is the monetary value, in local currency, of all final economic goods and services produced in a country during a specific period of time. It is the broadest financial measurement of a nation’s total economic activity. The total goods and services bought by consumers encompasses all private expenditures, government spending, investments, and exports but excludes imports that take place within a designated country. Below are three different approaches to the GDP formula.
What is the GDP formula?
There are three methods or formulas by which GDP can be determined:
#1 Expenditure Approach
The most commonly used GDP formula, which is based on the money spent by various groups that participate in the economy.
GDP = C + G + I + NX
C = consumption or all private consumer spending within a country’s economy, including, durable goods (items with a lifespan greater than three years), non-durable goods (food & clothing), and services.
G = total government expenditures, including, salaries of government employees, road construction/repair, public schools, and military machines.
I = sum of a country’s investments spent on capital equipment, inventories, and housing.
NX = net exports or a country’s total exports less total imports.
#2 Income Approach
This GDP formula takes the total income generated by the goods and services produced.
GDP = Total National Income + Sales Taxes + Depreciation + Net Foreign Factor Income
Total National Income – the sum of all wages, rent, interest, and profits.
Sales Taxes – consumer tax imposed by the government on the sales of goods and services.
Depreciation – cost allocated to a tangible asset over its useful life.
Net Foreign Factor Income – the difference between the total income that a country’s citizens and companies generate in foreign countries, versus the total income foreign citizens and companies generate in that country.
#3 Production or Value-Added Approach
The sum of the value added to a product during the production process. To determine the value added between businesses, the price at which the product is sold by the seller is deducted from the price it was bought for from the supplier.
What are the Types of GDP?
GPD can be measured in several different ways. The most common methods include:
- Nominal GDP – the total value of all goods and services produced at current market prices. This includes all the changes in market prices during the current year due to inflation or deflation.
- Real GDP – the sum of all goods and services produced at constant prices. The prices used in determining the Gross Domestic Product are based on a certain base year or the previous year. This provides a more accurate account of economic growth, as it is already an inflation-adjusted measurement, meaning the effects of inflation are taken out.
- Actual GDP – real-time measurement of all outputs at any interval or any given time. It demonstrates the existing state of business of the economy.
- Potential GDP – ideal economic condition with 100% employment across all sectors, steady currency, and stable product prices.
Why is GDP Important to Economists and Investors?
Gross Domestic Product represents the economic production and growth of a nation and is one of the primary indicators used to determine the overall well-being of a country’s economy and standard of living. One way to determine how well a country’s economy is flourishing is by its GDP growth rate. This rate reflects the increase or decrease in the percentage of economic output in monthly, quarterly, or yearly periods.
Gross Domestic Product enables economic policymakers to assess whether the economy is weakening or progressing if it needs improvements or restrictions, and if threats of recession or inflation are imminent. From these assessments, government implementing agencies can determine if expansionary, monetary policies are needed to address economic issues.
Investors place important on GDP growth rates to decide how the economy is changing so that they can make adjustments to their asset allocation. However, when there is an economic slump, businesses experience low profits, which means lower stock prices and consumers tend to cut spending. Investors are also on the lookout for potential investments, locally and abroad, basing their judgment on countries’ growth rate comparisons.
What are Some Drawbacks of GDP?
Gross Domestic Product does not reflect the black market, which may be a large part of the economy in certain countries. The black market, or the underground economy, includes illegal economic activities, such as the sale of drugs, prostitution, and some lawful transactions that don’t comply with tax obligations. In these cases, GDP is not an accurate measure of some components that play a large role in the economic state of a country.
Income generated in a country by an overseas company that is transferred back to foreign investors is not taken into account. This overstates a country’s economic output.
Sources of GDP Information
For US GDP information, the Bureau of Economic Analysis in the U.S. Department of Commerce is the best direct source. You can view the bureau’s latest releases here: https://www.bea.gov/gdpnewsrelease.htm
We hope this has been a helpful guide to the GDP formula.
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep learning about important economic concepts, see the additional free resources below: