• Gross domestic product is the total value of goods and services produced in a country over a period of time.
• There are different ways of calculating GDP and different types of GDP that take different factors into account.
• GDP is used to track economic expansion or contraction, but lacks important nuances.
• Visit Insider’s Investment Reference Library for more stories.

Gross domestic product (GDP) is a measure of the total value of goods and services produced in a country during a given period. The amount that GDP periodically increases or decreases is an important metric that investors use to assess the health of the economy and of certain industries.

GDP is also a key consideration in government tax and spending plans and Federal Reserve monetary policies. Read on to find out how GDP works, how it’s calculated, and the limitations of using GDP as a measure of economic health.

Understanding how GDP works

GDP is used to monitor both the size and strength of an economy and is generally discussed in terms of the percentage of its growth or contraction over time. For example, the United States Bureau of Economic Analysis (BEA) reported this

Real GDP

grew at an annual rate of 2.1% in the third quarter of 2021. The GDP of the United States is measured at quarterly and annual intervals.

“It’s typically used as a method of measuring the economic strength of one country relative to others,” says Jim Pendergast, senior vice president of altLINE, a division of the Southern Bank Company.

The size and reach of the US economy of over $ 22 trillion makes calculating GDP a complex task. Finding the total dollar value of goods and services produced in a year involves collecting data in four main categories: consumer spending, government spending, business (or investment) spending, and net exports.

The BE A describes each of the main categories like this:

• Consumer spending: Goods and services you buy, such as groceries, clothing, cell phone service, and healthcare
• Business expenses: Money spent on everything from land, buildings and equipment to unsold inventory; also includes home purchases by consumers

• Government spending: Money spent on goods and services, including schools, roads and national defense

• Net exports: The value of exports to other countries minus the value of imports to the United States

The International Monetary Fund (IMF) notes that while GDP is valuable because it gives information about the size and performance of an economy, it is also important to understand what GDP does not. This includes the general standard of living or the well-being of countries where increased production may come at the expense of the environment or reduced leisure time.

At first glance, an assessment of the GDP figures shows that the economy is either expanding or contracting. It doesn’t follow everything, however.

Some of the things not included in GDP are unpaid domestic work like babysitting, black market activities, selling second-hand items, selling items not produced in the United States. United, stock market transactions, unemployment or social security payments, and volunteer work.

GDP is used by various entities in different ways. Federal and local officials use it as part of the budgeting process. This is a key measure that informs the Fed’s decision-making on monetary policy. Companies use it to make strategic decisions about expansion.

Investors can use GDP to gauge the pulse of the economy and specific industries as well as to examine international markets.

“This helps investors know which countries are the most profitable. If a country is in financial difficulty, investors could lose a lot of money in the market,” Pendergast said. “For example, when Greece experienced its major economic downturn, many foreign investors lost money in the market. By analyzing trends in GDP, investors can know where to put their money.

How is GDP calculated?

According to BE A, GDP is calculated as the sum of the four main categories:

Consumer spending + business spending + government spending + net exports = GDP

By adding these items together, you get the GDP, which reflects the aggregate market value of all goods and services produced. This calculation of GDP is generally referred to as the spending approach, but there are also two other ways to calculate GDP.

According to IMF, the income approach takes the total sum of all income created by production. In addition, there is the manufacturing approach, which calculates any added value of the production process. This can include things like food ingredients creating a meal or designer services included in a project that comes to life later.

The BEA publishes GDP estimates and reports that you can review yourself. You can also turn to the IMF to view global GDP data in its World Economic Outlook or Global Financial Stability Reports.

What are the types of GDP?

There are also various types of GDP that are measured in different ways, each serving a different purpose.

“Nominal GDP is an assessment of a country’s economic output, excluding inflation and the cost of rising prices in the country,” Pendergast explains.

Sometimes this can also be referred to as “GDP in current dollars”. Since nominal GDP does not take inflation into account, you need to look at real GDP numbers that are adjusted for inflation over time to provide a more accurate picture.

“Real GDP is GDP corrected for inflation with information about past years in terms of monetary value over time,” Pendergast explains.

There are other important measures based on GDP that offer more information and nuance.

“GDP per capita measures the average assets of each within a country’s population, which can include productivity and standard of living,” notes Pendergast. “The GDP growth rate focuses primarily on the average change in economic growth over time as a function of new policies, inflation and unemployment rates.”

There is also a way to compare GDP between countries. Each country reports GDP data in its own currency, so to assess GDP between different countries, a purchasing power parity (PPP) exchange rate is used to convert GDP to US dollars.

The PPP exchange rate reflects the rate that a particular country would need to convert the currency of its GDP in another country and have the same “purchasing power” to purchase an equal amount of goods and services.

GDP limits

GDP is used as an economic benchmark at the global level. While it may provide markers of economic growth, it doesn’t give you the big picture and lacks important nuances.

“For the most part, GDP can give an accurate account of areas of improvement and decline, both of which are critical to rebuilding a population’s economy,” Pendergast explains.

But it is insufficient in other respects, because valuing output is only one way of looking at the productivity of a particular country or economy.

“The GDP gives a poor assessment of the quality of life. Since a GDP report is broad, it is difficult to analyze how people are prospering in the country, ”Pendergast explains. “Different standards of living and unemployment in different cities are vastly different, and such a broad view does not improve a country’s ability to make small changes to solve big problems.”

The financial report

GDP is an economic measure that is used in a wide variety of contexts and has far-reaching uses at the national and global levels. It is a good benchmark to use as an investor to assess the health of the economy and of certain industries. What it doesn’t do is factor in unpaid work, quality of life, or happiness.

To do your own research on GDP, you can consult reports published by the BEA and look at the IMF data.