What is “GDP” and why is it such an important economic indicator?
Plus, how it's calculated, its limitations and who's at the top of the GDP league.
Hey everyone 👋🏼
I hope you had a great summer, whatever you’ve been up to! I’m back in action following a wonderful trip away celebrating a good friend’s wedding. If you’ve not experienced one, then I highly recommend going to a Greek wedding if the opportunity presents itself.
But it’s September and back to business it is and this week I want to delve into an economic fundamental…
GDP (Gross Domestic Product).
If you follow the news at all, hardly a day goes by without a story about how the GDP of certain countries is doing.
But as always, economics has the capacity to bore people to death sleep, so there’s a lot of folks who don’t really know what GDP is, why it’s used to measure a country’s economic health and what it might mean for them, personally.
So let's take a look under the hood of GDP.
Today I’ll cover:
What exactly is GDP 💸
How is it calculated
1 minute 📹 explainer (if you’re in a rush!)
GDP in statistics, by country 📊
The trouble with GDP ⛔️
Why GDP matters and how it’s role in marking recessions
(Quickly) Explained…
GDP stands for Gross Domestic Product. In a nutshell, it's the total value of everything produced in a country over a given period of time (usually a year).
In an ideal world, this value would be perfectly visible. We could see a car coming off the assembly line and a score would appear above it, telling us exactly how valuable that car is. In practice, we can't see an abstract idea of value, so we use prices instead. If someone paid $25,000 for a car, that's how valuable it was. Calculating GDP is just a very careful process of adding up all the purchases in an economy, taking care to avoid double counting (the car factory bought tyres to put on the car, but the end customer also bought those tyres, so we shouldn't count both purchases).
The higher a country's GDP, the more "stuff" it makes. Big countries will make more stuff than small countries, just by design.
If you divide all this stuff by the number of people, you get "GDP per capita".
On the (incorrect) assumption that all the stuff we make is actually divided equally among all citizens, each person can expect to get goods worth the GDP per capita*. That's why it's generally better for GDP per capita to be high and growing than low and shrinking.
Because we can't see value perfectly, this technique of calculating GDP means that a lot of activities of questionable value are included in GDP, and a lot of activities that contribute real value are not. If you crashed your car and then bought a replacement, that contributes to GDP. But if you grew your own vegetables and cooked a meal at home, that does not contribute to GDP because you never made any purchases that we can observe. On the other hand, if you bought a meal in a restaurant, that contributes to GDP.
*In reality, people have to pay for the things they get.
Calculating GDP 🤓
There are three main ways to calculate GDP:
Production approach: this adds up the value of all the goods and services produced within the country. It counts everything made, from cars to computers to haircuts.
Income approach: this adds up all the income earned by people and businesses in the country. This includes wages, profits, and taxes minus subsidies.
Expenditure approach: this adds up all the money spent on goods and services within the country. It includes consumer spending, business investments, government spending, and net exports (exports minus imports).
No matter which approach is used, the idea is to capture all the economic activity happening in a country during a certain period of time, usually a year. The GDP number gives an idea of how well the economy is doing and how much it's growing.
But the most common out of these various approaches is the expenditure, which is the sum of all spending on goods and services. The key components of the equation:
“C” is consumption, essentially how much households spend on goods and services.
“I” is investment, essentially any transactions made by businesses.
“G” is government spending on public goods.
And then the total values of exports and imports, respectively. Only the final value of a product is counted since components factor into the GDP of other countries, you would get weird overlap otherwise.
📹 GDP Explained…in 1 minute
🗺️ GDP by country…
Total GDP
OK, so first up is a glance at the top 20 countries making the most GDP. Remember, this alone is not a good measure of how wealthy people in those countries might be e.g. India’s GDP is growing by close to 10% YoY, which overall is great news, but when you divide that by the total population (1.4 billion) then GDP per capita is not looking great vs a lot of other countries.
Top 20 - Total GDP (in billion US dollars):
Top 20 - Total GDP per capita (in billion US dollars):
🚨The problem with GDP…
Alas, nothing is perfect. And GDP is no exception.
As much as economists like to use GDP as a measure of output, or even as a measure of a country’s economic well being, GDP has some limitations when trying to answer those questions. GDP leaves out some production in an economy, such as the carrots your mom might grow in the backyard, or other non-marketed goods.
Even though GDP is frequently used to capture the wellbeing of a society, it was never intended to do that, and as a result it leaves out important aspects of well-being like pollution or even happiness.
Other challenges with GDP
GDP is confused by the internet. if I buy my own cheap airline ticket, check myself in online and choose my own aisle seat, my convenience has gone up. But GDP has gone down. I am my own travel agent, a job that would once have been done by a fully paid GDP-producing employee. Wikipedia provides all human knowledge for free. In terms of GDP, it is worth nothing.
GDP deals in aggregates; GDP per capita in averages. in an age where a huge cause of social dislocation is inequality, GDP has nothing to say about distribution. Averages are misleading. Medians are better than means. A rise in average GDP could actually be retrograde, if it leaves 99% of people resentful at how the 1% is making good.
From GDP’s perspective, bigger is always better. In the real world, that is not always so. When the financial sector got bigger and bigger, it ended in financial crisis. When the US health service gets bigger and bigger, it means costs are out of control.
In general, GDP measures only cash transactions. so things like volunteer work, housework or looking after an ageing relative count for nothing in the context of GDP.
Why GDP matters when talking about the economy 🤔
GDP helps policymakers, investors and businesses make decisions by understanding an economy’s health.
It can also be used to compare different countries and regions.
When GDP is growing, workers and businesses are generally better off than when it is not.
When GDP is shrinking, employment often declines.
So, how is GDP linked to recessions?
An economic recession is when a country experiences two quarters (6 months) of negative real gross domestic product (GDP) growth.
But what do economists mean by "real"?
Real GDP, just means that it is the value of GDP corrected for any nominal price changes, e.g. if a country produces $1 billion in goods and services and then the next period it sells $1.1 billion, but prices increased 10%, the change in real GDP is 0% even though the nominal change is 10%.
In the U.S., the Bureau of Economic Analysis produces the estimate of GDP, so they in effect determine if the U.S. is in recession or not. Each country has its own measure of GDP and determines if it is in a recession or not. A global recession would be when total GDP of the world falls.
That’s all for today!
If you found this helpful and enjoyed the post, I’d be super grateful if you could hit the ❤️ below - thank you!
Jason
DISCLAIMER: None of this is financial advice. Concepts of Finance newsletter is strictly for educational purposes.