Gross Domestic Product

What It Means

Gross domestic product (GDP) is a figure that represents the total value of all goods and services produced in a country in a given time period. More simply, it is a measure of the total size of an economy. In the United States, government economists calculate GDP every quarter (in the financial world, each year is commonly broken down, for purposes of analysis, into four three-month periods called quarters), as well as yearly. GDP is generally considered one of the most important measurements of a country’s economic health. Therefore, it is used by government officials as an aid in creating policies, by business leaders in making business decisions, and by economists to improve their understanding of the economy.

In order to avoid counting certain goods (those that are part of other goods) multiple times, GDP measures only what are known as final products, or products that are sold to consumers on the open market. For instance, the plastic used to make a laptop computer might be made in the United States and sold in the United States to a computer manufacturer, but economists use only the sale of the computer itself when they calculate GDP. If they included the sale of the plastic to the manufacturer as well as the sale of the computer to the consumer, they would be counting the value of the plastic twice.

When Did It Begin

GDP represents both a refinement of and an alternative to a similar measure of economic health called gross national product (GNP). GNP also measures the total value of goods and services produced in a country during a given period of time, but GNP is calculated using a different approach to the U.S. business activity of foreign citizens and to the foreign business activity of U.S. citizens. The statistics yielded by both calculations are typically very similar in countries with developed economies.

The concept of GNP was developed in the 1930s by a Ukrainian-born U.S. economist named Simon Kuznets (1901–85; Kuznets won the Nobel Prize in 1971, in part for work related to the concept of GNP). The U.S. government, reeling from the effects of the Great Depression, was in search of a way of measuring the country’s economic problems. Kuznets’s idea of calculating the value of only final products provided a sorely needed way of measuring economic health and growth accurately, and it became a standard economic indicator (a statistic that reflects the health of the economy) in countries around the world. In the early 1990s the U.S. government began using GDP rather than GNP in its assessments of economic health, though GNP is still widely applied as well.

More Detailed Information

GDP is generally arrived at by using a formula that adds together the monetary value of products in four different economic categories: consumer spending, investment, government spending, and net exports. Household purchases fall into the category of consumer spending; purchases made by businesses come under the category of investment; government spending refers to purchases made by the government; and purchases of American-made products by citizens of other countries (minus U.S. purchases of imports, which are excluded from the calculation of GDP) make up net exports. Because these four categories include all of the major kinds of purchases of U.S. goods and services, GDP can be thought of as a measure of the total national income.

When the GDP is rising, a national economy is growing. In the United States GDP increases of 3 to 5 percent each year are considered optimal. These figures indicate that the economy is growing at a healthy, sustainable rate (a rate that can be kept up). GDP increases of 2 percent and below are considered sluggish. A recession (a time of economic decline less severe than a depression) is generally defined by the shrinking of the GDP for two straight quarters.

Government officials depend on GDP to judge the rate at which the economy is growing; they use it to determine the future course of economic and other policies. For instance, a U.S. president or Congress might use sluggish GDP figures as a reason to lower taxes, a strategy that is believed to promote economic growth; or a nation’s central bank (an agency of the government responsible for overseeing the money supply) might see rapid increases in GDP as a reason to restrain economic growth by raising key interest rates (the fees borrowers pay to institutions that loan money).

Similarly, business executives in a variety of private industries look to GDP as a way of predicting economic activity in the future. An executive trying to decide whether or not to invest in new factories, for example, might be more likely to do so if the rate of overall economic growth (as measured by GDP) is strong. Financial professionals and investors, likewise, might pay close attention to GDP numbers (along with other economic data) when determining whether to buy stocks and bonds at any given moment.

Economists, meanwhile, rely on GDP figures in improving their theories about how economies develop and behave. A record of GDP growth and declines during the past three decades in the United States, for instance, might provide crucial insights into how the national economy has evolved from one based primarily on manufacturing to one increasingly dependent on service industries (forms of business activity dealing with human services rather than physical goods).

Still, while government officials and other analysts may point to a high GDP as evidence a society’s economic vitality, it can sometimes be misleading to equate this particular measure of economic size with a country’s or region’ overall economic well-being or standard of living. Consider, for example, the economic consequences of one of the biggest environment disasters in U.S. history. In 1989 the Exxon Valdez oil tanker ran aground in Alaska, dumping more than 11 million gallons of crude oil into its pristine Prince William Sound. The spill generated so much spending for cleanup-up efforts (Exxon claimed to have spend more than $2.1 billion on the project during the next few years), media coverage, and law suits that it led directly to a rise in Alaska’s GDP. This rise masked the lasting environmental damage to Price William Sound and the crippling of the region’s fishing industry, one of its main sources of income. This example points out that while the GDP is a valuable measure of the size of an economy, it does not a describe what is in the economy, nor does it necessarily reflect the quality of life the economy provides. Another limitation of the GDP is that it does not include certain types of economic exchange—for example, the black market (such as drugs, prostitution, and illegal weapons), bartering (goods and services that are traded, not bought or sold), and work done without pay, such as volunteering at the local humane society or even helping a friend move. Conversely, it does not measure positive aspects of a society that have no easily assigned monetary value, such as healthy children, clean water, ecological diversity, and close-knit neighborhoods.

Recent Trends

GDP is likely to remain one of the chief tools economists and government officials use for evaluating economic health both in a given country and in relations between countries. One particularly useful way of comparing the economic health of different nations is by calculating per capita GDP: the measure of income produced by a national economy per citizen (the dollar figure divided by the number of citizens). The reason that the per capita figure is more meaningful than total GDP in some cases is that two countries may have the same GDP, but one of the countries may have a far higher population. In this case per capita GDP differs greatly. For instance, imagine two economies, both with a GDP of $100, but one has 2 citizens and the other has 10 citizens. The first economy would have a per capita GDP of $50, and the second would have a per capita GDP of $10.

Per capita GDP tends to correspond to many other statistics about a country, such as access to medical care, the infant mortality rate (the percentage of infants that die), and life expectancy (the number of years the average person lives). In the United States in 2005, per capita GDP stood at almost $42,000. Per capita GDP in most western European countries was somewhat lower but still comparable. For example, France and Germany both had a per capita GDP of roughly $30,000. The split between such developed economies and developing economies, like those of China and India, is extreme. China and India have larger total GDPs than France or Germany, but in 2005 China’s per capita GDP was just under $7,000, and India’s was around $3,000. Meanwhile, the per capita GDP of Afghanistan was well below $1,000.

GROSS DOMESTIC PRODUCT (GDP)

Led by the auto industry, the United States economy grew rapidly in the 1920s, generating more jobs, more income, and more free time that the American consumer had in order to spend. As long as people were employed, paying for goods and services, there was really no need to measure how the economy was doing. However, in the 1930s, the American economy went bust and a frustrated Congress asked if there was any way to measure the depth of the Great Depression.

On January 4, 1934, economist Simon Kuznets (1901–1985), professor at the University of Pennsylvania, sent to the Senate a report entitled "National Income: 1929–1932," the first accounting of U.S. productivity, essentially the gross national product (GNP). More than 4,500 copies of this report were sold in just eight months. The basic concept that Kuznet had was to limit this accounting measurement to the marketplace, and thus to the amount that consumers paid for goods and services. Until 1992, the term GNP was used to refer to the total dollar value of all finished goods and services produced for consumption in society during a particular period of time (usually one year). In 1992 the Commerce Department began to compute gross domestic product (GDP) instead of GNP. The differences between the two are slight and involve how to count earning of assets owned by foreigners. GNP counts the earnings in the homeland of the owner of the asset, while GDP counts the earnings of a manufacturer in the country in which the assets exists. For the United States, there is virtually no difference between the two measures.

There are three basic components that determine the U.S. GDP:

1. Consumption, the amount that consumers pay for goods (durable and nondurable).
2. Investment, the amount of money spent on new production facilities, that is, plants and facilities.
3. Services, the amount that consumers pay for the services they use.

Several things that were not included in GNP but were subsequently included in the GDP are:

• Work that is provided in an economy by nonmarket transactions such as homemakers and military personnel. These factors were too difficult for Kuznets and his team to measure.
• Illegal activities such as gambling and drug trafficing. These factors are also difficult to estimate but Kuznets excluded them from GNP because he deemed them a "disservice" to the economy.
• Goods and services that are bartered. These were excluded because they cannot be measured.
• Sale of intermediate goods (raw materials).
• Sale of used goods (used cars, furniture, etc.).
• Purely financial transactions such as sale of stocks and bonds.
• Imports (goods made outside the United States).

The GDP is the ultimate benchmark that measures the expansion and contraction of the U.S. multitrillion dollar national economy. It covers everything that is produced and sold in the marketplace. Bankers, investment brokers, and government officials use the GDP to determine such things as interest rates, investment opportunities, and tax rates. The GDP is not the only measure of output, however, as economists use the GDP because it is the most comprehensive of output measures. This measure is important because it helps societies understand both inflation and employment.

In the flow of payments in the economy, where does one measure? Consider, for example, an automobile. The mining operator receives income from the sale of iron ore, the mill owner receives income from the sale of finished steel, and the automobile manufacturer receives income from the sale of the finished car. In order to avoid the inaccuracy of counting the same money three times, Kuznets decided to use only final sales. Thus the amount paid to the dealer for the car is the only amount used in calculating GDP. The labor cost of the workers at all three locations is added to GDP. In essence, the price of the automobile includes the cost of the materials purchased from suppliers. The value added to manufacture the automobile can be found by deducting the cost of one product from the total cost of the automobile.

The more goods and services a country produces, the healthier that country's economy becomes. There is a major flaw in measuring economic success, however, in that when GDP (production) increases, negative externalities

(air and water pollution) also increase. The environment becomes degraded and negatively affects the quality of life. The GDP measures goods and services traded, but the negative externalities are not included in this counting. However, these negative externalities increase the GDP. For example, when the automobile industry wants to produce more cars, the smoke that is emitted from the smokestacks includes carcinogens that may make people in the area sick. A person who gets sick from the emitted smoke may go to the doctor. The doctor may prescribe medication. The cost of the visit to the doctor and the cost of the medication are added to the total value of the GDP.

Table 1 contains output and price statistics for a simple economy that produces only three goods. In the first year, the value of output, or GDP, is $1,000; in the second year, the GDP is $1,120. These numbers are obtained by multiplying quantities by prices and then summing the resulting values. They give us current dollar or nominal GDP, that is, the value of output measured in prices that existed when the output was produced.

The GDP has risen 12 percent from the first year to the second, but this increase is only partially due to additional output ($1,120 − $1,000 = $120). Part of the increase is due to changes in prices. To get a measure that contains only the increase in output, we can multiply the outputs of the second year by the prices of the first year. When we add up these values, they total $1,025. This number implies that if only the quantities of output had changed and not the prices, GDP would have increased only from $1,000 to $1,025, a rise of only 2.5 percent. This $1,025 is real GDP.

see also Macroeconomics/Microeconomics

bibliography

Eggert, James (1997). What is Economics? (4th ed.). Mountain View, CA: Mayfield Publishing Company.

Mansfield, Edwin, and Behravesh, Nariman (2005). Economics U$A (7th ed.). New York: W.W. Norton & Co.

Mings, Turley, and Marlin, Matthew (2000). Study of Economics: Principles, Concepts, & Applications (6th ed.). Guilford, CT: Dushkin/McGraw-Hill.

Wilson, J. Holton, and Clark, J. R. (1996). Economics. Cincinnati, OH: South Western Educational Pub.

Gregory P. Valentine

Gross Domestic Product

BIBLIOGRAPHY

As a measure of the aggregate level of economic activity, gross domestic product (GDP) is the main indicator used to monitor the state of an economy. GDP growth, commonly referred to as economic growth, is thus of great interest to policymakers for the conduct of fiscal and monetary policy. It is also widely used to measure productivity of an economy.

GDP is defined as the value-added of all goods and services produced in a given period of time within a country. The measurement of GDP can be approached from three angles: value added by industry, final expenditures, and factor incomes.

• Value added created by industry (output less inputs purchased from other producers);
• Expenditures by consumers, businesses on investment goods, government on goods and services, and foreigners for exports (minus expenditures by domestic residents on imports); and
• Incomes generated in production, operating surplus generated by business and compensation of employees.

GDP is usually expressed in terms of current prices in national currency units, or in real terms (real GDP) after removing the effects of price change to reflect the volume of production in the economy. For international comparisons, GDP is also expressed in a common currency such as U.S. dollars using purchasing power parity exchange rates.

Up to the 1980s, the term gross national product (GNP) was more commonly used than GDP. The former, more correctly called gross national income (GNI), includes incomes of residents of a country earned abroad and excludes incomes from domestic production sent abroad. In contrast, GDP includes only domestically produced incomes. GNI in combination with GDP are often expressed in per capita terms and used as measures of living standards of the nation.

National income accounting (the methodologies to measure GNI and GDP) originated in the 1930s and 1940s with the work of Simon Kuznets in the United States and Richard Stone in the United Kingdom. A detailed history of national accounting is found in Andre Vanoli’s work A History of National Accounting (2005). Since the 1950s, the United Nations, working with other international organizations such as the International Monetary Fund, World Bank, and Organization for Economic Cooperation and Development, has coordinated the development of international standards for the national accounts. The current international standard was last issued in 1993. These standards evolve over time with the world economies, and a new edition of the standard will be released in 2008. The International Association for Research in Income and Wealth was founded in 1947 for the advancement of knowledge related to national accounting. The publications of this Association, including the journal Review of Income and Wealth, document the evolution of the field.

GDP is not a measure of economic welfare. It does not incorporate into its official estimates environmental degradation and resources depletion, nor the value of leisure. Neither does it take into account the influence on income inequality and economic insecurity on well-being.

BIBLIOGRAPHY

United Nations. 1993. System of National Accounts. http://unstats.un.org/unsd/sna1993/toctop.asp.

Vanoli, Andre. 2005. A History of National Accounting. Amsterdam: IOS Press.

Andrew Sharpe

GROSS DOMESTIC PRODUCT

Gross Domestic Product, or GDP, represents the total output of goods and services produced by a nation. In the United States for example, GDP includes all the corn and wheat grown by farmers, all the movies filmed in Hollywood, all the automobiles built in Detroit, all the meals served in restaurants, all the money spent on school books; in other words, every item produced for sale in the United States is represented by the GDP. Obviously millions of products and services go into the GDP of a modern industrial economy. Government economists keep track of output and release a measure of the GDP four times a year. These figures try to capture the amount that the economy is growing or shrinking. For example the government may report that the economy grew three percent in a given year. When the GDP figure is rising, the nation is in a positive economic upswing. In such times, more workers are being hired, and paychecks are getting bigger. But when the GDP begins to shrink, it means the nation is entering a recession. More people lose their jobs, and families have to tighten their belts. In general GDP growth in the range of three to five percent a year in the United States is considered healthy; growth of one or two percent a year is considered slow; and any decline in GDP is considered cause for alarm.

See also: Gross National Product

gross do·mes·tic prod·uct (abbr.: GDP) • n. the total value of goods produced and services provided in a country during one year. Compare with gross national product.