The Gross Domestic Product of a country is the sum of all consumption, government spending, investment and net exports within a certain time frame - typically one year. Essentially, it serves to put a number on the economic output of a nation. The formula to calculate it is as follows:
GDP = C + G + I + X
Where:
C = Private consumer spending. This component simply refers to the amount of money that people spend on everyday goods and services. Consumption usually makes up the bulk of a country’s GDP. Barring non-typical economies, such as nations with tiny populations or those with huge export markets, consumer spending will normally make up between half and three-quarters of GDP.
G = Government spending and investment. This is the sum of all state expenditure, including government operation costs, salaries and public infrastructure and maintenance. This component can vary from almost nothing to at most a quarter of the total GDP, only pushed beyond this fraction in the event of heavy government intervention, such as during economic depression or war.
I = Private investment. This part mostly refers to business expenditure and investment, such as machinery and equipment purchases, commercial and industrial buildings, as well as changes to stock inventories. It also includes private residential buildings and other private sector developments. Normally, this category also tops out at around a quarter of the total GDP. Although much smaller than consumer spending, it remains an important contributor to GDP because it is intertwined with job creation.
X = Net exports. This takes into account total imports and exports. This component is positive if the country has a trade surplus, negative if it has a trade deficit. It also indicates how reliant a given country is on foreign trade. Nations with large export markets, such as those with natural resources, typically have a larger part of their GDP comprised by this factor. On the other hand, poorer countries are often dependent on foreign imports, sometimes leading to huge trade deficits, dragging their GDP lower.
The reason GDP is such a headline-gripping term is because it is the primary metric by which countries traditionally measure growth. The current formulation dates back to 1934 and has remained the default method for measuring the size of a country’s economy ever since. Not only is it useful for comparing the economic output of different nations, it also serves to define whether a country’s economy is growing or shrinking.
As a rule of thumb, a recession is defined as two consecutive quarters of negative growth. The term “depression” is less tangible, but is generally defined as a much longer period of negative growth, or a more sudden period of extreme economic contraction. Either way, both definitions are dependent on GDP.
GDP is defined as a monetary value. In the US it is calculated in Dollars, in the UK in Pounds, in China in RMB, etc. When comparing growth between quarters of the same year, it is customary to use nominal GDP, which means the figures have not been adjusted for inflation. However, when comparing growth over longer timeframes, adjusting for inflation becomes crucial. After all, if GDP increased by 5% year-on-year but prices inflated 10% during that same time frame, then the actual growth was negative. This inflation-adjusted figure is known as real GDP and is a far more pertinent economic gauge.
Another closely associated metric is GDP per capita, which is simply the GDP of a nation divided by its population. If GDP represents the yearly economic output of an entire country, then GDP per capita represents the value that can be attributed to each citizen. This can serve as a benchmark for the overall prosperity or quality of life of a country’s people, albeit a very crude one.
There are two main problems with GDP per capita. The first is simply that it is an average. Averages do not model human behaviour very well. Human groups are heavily influenced by outliers, creating significant gaps between the average and the mean. A nation with a high GDP does not necessarily have a wealthy citizenry. The second problem with GDP per capita is that it does not take into account the cost of living in different countries. Economists will often bring in Purchasing Power Parity (PPP) to reconcile the differences in prices across a basket of goods, thereby making GDP comparisons more meaningful.
Criticisms of GDP have been around since the inception of the metric itself. In fact, the man behind the current formulation, Simon Kuznets, warned of its limited application, claiming it was not a measure of welfare. GDP serves as a measurement of growth. Nothing more; nothing less. It does not vouch for the type or quality of that growth, nor does it attempt to. For economists, the limitations of GDP are well understood. For all the attention afforded to GDP figures in the media, they are in fact most useful to the government, as an indicator that helps to steer economic policy.
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