GDP 101: An Introduction
You’ve probably heard about the GDP in the news in general and in financial news specifically, especially during the economic turmoil of the past decade and the Great Recession. After reading this article, you’ll have a general understanding of what this often-used, often-misunderstood, and often-misused measure of the macroeconomy is.
GDP stands for Gross Domestic Product.
Gross = Total
Domestic = Within the borders of a particular country
Product= What is produced (which can be measured in various ways and is often hard to measure)
So, GDP, or the Gross Domestic Product, is the dollar value of the goods and services produced within a country’s borders during a particular period of time, that time period being one year for the obvious reasons of convenience and comparability.
Calculating the GDP is very difficult, but for our purposes, we shouldn’t complicate things. To calculate the Gross Domestic Product, we just need to add up the dollar value of all of the goods and services produced within a country’s borders during the period of one year. That total value represents “what was produced” in the year, and knowing “what was produced” helps us have a better understanding of how the economy is doing.
That total value of goods and services produced within a country’s borders within a year, the GDP, can be compared with the GDP of previous years. Comparing the GDP with previous years allows us to see how things are changing and if they are improving or getting worse. Was last year better than the year before? Better than 10 years ago? We can compare GDP measures for each year to find out.
Let’s dig a little deeper now that we know what the Gross Domestic Product attempts to measure. We know GDP is the total value of all the goods and services produced within a country’s borders, but economists have broken down the Gross Domestic Product into four components that generally make up the entire economy. These components are Consumption (C), Investment (I), Government (G), and Net Exports (X – M).
- Consumption (C): Consumption is the largest part of GDP, and it consists of private expenditures by individuals and households on goods and services. Consumption doesn’t include residential housing purchases, however.
- Investment (I): Investment is the purchase of various means of production (eg. equipment, software, computers, etc.) by businesses, and it also includes the purchase of housing by private individuals. Investment, as used to calculate the GDP, shouldn’t be confused with financial investing (eg. buying stocks), which is considered saving.
- Government (G): Government spending includes the total of government expenditures on final goods and services (eg. roads, schools, public servants, military). Transfer payments such as social security, food stamps, unemployment benefits, and other forms of welfare are not part of this portion of the GDP.
- Net Exports (X – M): Net exports are Exports (X) minus Imports (M). Exports (X) are what is produced within the borders of a country for other nations. Imports (M) are subtracted from Exports (X) because if we didn’t subtract Imports (M) we would count foreign production as domestic.
So, GDP = C + I + G + (X – M)
Now you have a relatively basic understanding of what the Gross Domestic Product (GDP) is. Although it has flaws and is just one of many measures of the economy, the relative simplicity and the all-encompassing nature of this measure make it useful and attractive.