GDP represents the sum total of a nation's output and income

• Gross domestic product is the total value of goods and services produced in a country over a period of time.
• There are various ways to calculate GDP and different types of GDP that look at different factors.
• GDP is used to track economic expansion or contraction but lacks some important nuance.

One of the most important economic indicators that helps us understand how an economy is doing is its GDP.

In the US, GDP is a key consideration in the government's tax-and-spending plans and the Federal Reserve's monetary policies. Here's how GDP works, how it's calculated, and the limitations of using GDP as a measurement for economic health.

What is GDP?

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

Understanding how GDP works 

GDP is used to monitor both the size and strength of an economy and is usually discussed in terms of the percentage of its growth or contraction over time.

For example, the US Bureau of Economic Analysis (BEA) reported that real GDP decreased at an annual rate of 0.6% in the second quarter of 2022. GDP for the US is measured in quarterly and annual intervals.

"It's typically used as a method of measuring a country's economic strength when compared to others," explains Jim Pendergast, senior vice president of altLINE, a division of The Southern Bank Company.

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

The BEA describes each of the main categories like this:

• Consumer spending: The goods and services you buy, such as groceries, clothes, cellphone service and health care
• Business spending: Money spent on everything from land, buildings, and equipment to unsold inventory; also includes consumer home purchases

• Government spending: The 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 into the US

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

On the surface, evaluating GDP numbers shows that the economy is either expanding or contracting. It doesn't track everything, though.

Some of the things not included in GDP are unpaid domestic labor such as childcare, activities that occur on the black market, the sale of used items, the sale of items not produced in the US, stock transactions, unemployment or Social Security payments, and volunteering. 

GDP is used by various entities in different ways. Federal and local government officials use it as part of the budgeting process. It's a key metric informing the Fed's decision making on monetary policy. Businesses use it when making strategic decisions about expansion. 

Investors can use GDP to assess the pulse of the economy and certain industries as well as review international markets. 

"It helps investors know which countries are most profitable. If a country is struggling financially, investors could lose a lot of money in the market," says Pendergast. "For example, when Greece experienced its significant economic downturn, many foreign investors lost money on the market. By analyzing trends in the GDP, investors can know where to put their money."

How is GDP calculated? 

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

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

Adding these together, you get GDP, which reflects the overall market value of all goods and services that are produced. This GDP calculation is typically referred to as the expenditure approach, but there are two other ways to calculate GDP as well. 

According to the IMF, the income approach takes the total sum of all the incomes that are created by production. Additionally, there is the production approach, which calculates any added value from the production process. This can include things such as food ingredients creating a meal, or designers' services included in a project that comes to life later on. 

The BEA releases GDP estimates and reports that you can review yourself. You can also turn to the IMF to see 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 evaluation of a country's economic production, excluding inflation and the cost of rising prices within the country," says Pendergast. 

Sometimes this can also be called "current-dollar GDP". Since nominal GDP doesn't account for inflation, you need to look at real GDP numbers which are adjusted for inflation over time to provide a more accurate picture. 

"Real GDP is the inflation-adjusted GDP with information of years past in terms of monetary value over time," explains Pendergast. 

There are other important GDP-based metrics that offer more insights and nuance. 

"GDP per capita measures the average assets of everyone within a country's population, which can include productivity and living standards," Pendergast notes. "GDP growth rate primarily focuses on the average change in economic growth over time based on new policies, inflation, and unemployment rates."

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

The PPP exchange rate reflects the rate that a particular country would need to convert its GDP currency to another country and hold the same 'purchasing power' to buy an equal amount of goods and services. 

Limitations of GDP 

GDP is used as a go-to economic benchmark on a global level. While it can provide markers for economic growth, it doesn't show you the big picture for everything and lacks some important nuance. 

"For the most part, GDP can give an accurate account of areas of improvement and decline, both of which are essential to rebuilding a population's economy," says Pendergast.

But it falls short in other aspects because evaluating output is just one way to look at the productivity of a particular country or economy. 

"GDP gives a poor evaluation of quality of life. Since a GDP report is broad, it's difficult to analyze how people are thriving within the country," explains Pendergast. "Different standards of living and unemployment in a variety of cities are extremely different, and such a broad view doesn't improve a country's ability to make small changes to fix big problems."

The bottom line

GDP is an economic metric that is used in a wide variety of contexts and has uses that are far-reaching on a national and global level. It's a good benchmark to use as an investor to assess the health of the economy and certain industries. What it doesn't do is take into account unpaid labor, quality of life, or happiness.