Gross Domestic Product: An

Economy’s All
When it is growing, especially if inflation is not a problem, workers and businesses are generally
better off than when it is not
Tim Callen

MANY PROFESSIONS commonly use acronyms. To doctors, the wear and tear on the machinery, buildings, and so on (the
accountants, and baseball players, the letters MRI (magnetic so-called capital stock) that are used in producing the output.
resonance imaging), GAAP (generally accepted accounting If this depletion of the capital stock, called depreciation, is
principles), and ERA (earned run average), respectively, need no subtracted from GDP, we get net domestic product.
explanation. To someone unfamiliar with these fields, however, Theoretically, GDP can be viewed in three different ways.
without an explanation these acronyms are a stumbling block • The production approach sums the “value added” at each
to a better understanding of the subject at hand.. stage of production, where value added is defined as total sales
Economics is no different. Economists use many acronyms. minus the value of intermediate inputs into the production
One of the most common is GDP, which stands for gross domes- process. For example, flour would be an intermediate input and
tic product. It is often cited in newspapers, on the television bread the final product, or an architect’s services would be an
news, and in reports by governments, central banks, and the intermediate input and the building the final product.
business community. It has become widely used as a reference • The expenditure approach adds up the value of purchases
point for the health of national and global economies. When made by final users—for example, the consumption of food,
GDP is growing, especially if inflation is not a problem, workers televisions, and medical services by households; the investments
and businesses are generally better off than when it is not. in machinery by companies; and the purchases of goods and
services by the government and foreigners.
Measuring GDP • The income approach sums the incomes generated by pro-
GDP measures the monetary value of final goods and services— duction—for example, the compensation paid to employees,
that is, those that are bought by the final user—produced in rent paid to land, interest paid on capital and profit paid to the
a country in a given period of time (say a quarter or a year). It company owners.
counts all the output generated within the borders of a country. GDP in a country is usually calculated by the national statisti-
GDP is composed of goods and services produced for sale in the cal agency, which compiles the information from a large number
market and also includes some nonmarket production, such as of sources. In making the calculations, however, most countries
defense or education services provided by the government. An follow established international standards. The international
alternative concept, gross national product, or GNP, counts all standard for measuring GDP is contained in the System of
the output of the residents of a country. So if a German-owned National Accounts, 1993, compiled by the International Mon-
company has a factory in the United States, the output of this etary Fund, the European Commission, the Organisation for
factory would be included in US GDP, but in German GNP. Economic Co-operation and Development, the United Nations,
Not all productive activity is included in GDP. For example, and the World Bank.
unpaid work (such as that performed in the home or by vol-
unteers) and black-market activities are not included because Real GDP
they are difficult to measure and value accurately. That means, One thing people want to know about an economy is whether
for example, that a baker who produces a loaf of bread for a its total output of goods and services is growing or shrinking.
customer would contribute to GDP, but would not contribute But because GDP is collected at current, or nominal, prices, one
to GDP if he baked the same loaf for his family. cannot compare two periods without making adjustments for
Moreover, “gross” domestic product takes no account of inflation. To determine “real” GDP, its nominal value must be

14 FINANCE & DEVELOPMENT | Back to Basics

adjusted to take into account price changes to allow us to see that of another to purchase the same amount of goods and ser-
whether the value of output has gone up because more is being vices in each country. There is a large gap between market and
produced or simply because prices have increased. A statistical PPP-based exchange rates in emerging market and developing
tool called the price deflator is used to adjust GDP from nominal countries. This is because nontraded goods and services tend
to constant prices. to be cheaper in low-income than in high-income countries—
GDP is important because it gives information about the size for example, a haircut in New York is more expensive than in
of the economy and how an economy is performing. The growth Bishkek—even when the cost of making tradable goods, such
rate of real GDP is often used as an indicator of the general as machinery, across two countries is the same. For advanced
health of the economy. In broad terms, an increase in real GDP countries, market and PPP exchange rates tend to be much closer.
is interpreted as a sign that the economy is doing well. When real These differences mean that emerging market and developing
GDP is growing strongly, employment is likely to be increasing countries have a higher estimated dollar GDP when the PPP
as companies hire more workers for their factories and people exchange rate is used.
have more money in their pockets. But real GDP growth does The IMF publishes an array of GDP data on its website (www.
move in cycles over time. Economies are sometimes in periods of imf.org). International institutions such as the IMF also calcu-
boom, and sometimes periods of slow growth or even recession late global and regional measures of real GDP growth. These
(with the latter sometimes defined as two consecutive quarters give an idea of how quickly or slowly the world economy or the
in which output declines). In the United States, for example, economies in a particular region of the world are growing. The
there were ten recessions of varying length and severity between aggregates are constructed as weighted averages of the GDP
1950 and 2017 (see chart). The National Bureau of Economic in individual countries, with weights reflecting each country’s
Research makes the call on the dates of US business cycles. share of GDP in the group (with PPP exchange rates used to
determine the appropriate weights). So, for example, the IMF’s
Comparing GDPs of two countries World Economic Outlook reported that global real GDP grew
GDP is measured in the currency of the country in question. by –0.15 percent in 2009, at the height of the global financial
That requires adjustment when trying to compare the value of crisis and has been growing at an average rate of 3.4 percent
output in two countries using different currencies. The usual since 2012 to date.
method is to convert the value of GDP of each country into
b2b, corrected 2/3/2014
US dollars and then compare them. Conversion to dollars can What GDP does not reveal
be done either using market exchange rates—those that prevail It is also important to understand what GDP cannot tell us. GDP
in the foreign exchange market—or purchasing-power-parity is not a measure of the overall standard of living or well-being
(PPP) exchange rates. The PPP exchange rate is the rate at which of a country. Although changes in the output of goods and
the currency of one country would have to be converted into services per person (GDP per capita) are often used as a measure
of whether the average citizen in a country is better or worse
off, it does not capture things that may be deemed important to
Growth and gaps general well-being. So, for example, increased output may come
Since 1950, US economic output measured by gross domestic at the cost of environmental damage or other external costs,
product adjusted for inflation, has mainly been growing, except
such as noise. Or it might involve the reduction of leisure time
for ten recessions of varying length and severity.
(real GDP annual change, percent)
or the depletion of nonrenewable natural resources. The qual-
15 ity of life may also depend on the distribution of GDP among
12
the residents of a country, not just the overall level. To try to
account for such factors, the United Nations computes a Human
9
Development Index, which ranks countries not only based on
6 GDP per capita, but on other factors, such as life expectancy,
3 literacy, and school enrollment. Other attempts have been made
0 to account for some of the shortcomings of GDP, such as the
Genuine Progress Indicator and the Gross National Happiness
–3
Index, but these too have their critics.
–6
1950 60 70 80 90 2000 10
TIM CALLEN is a division chief in the IMF’s Middle East and Central Asia
Source: National Bureau of Economic Research (NBER).
Note: Light-shaded areas indicate recessions—periods when output declines. Department. SARWAT JAHAN, a senior economist in the IMF’s Asia and Pacific
Recessions are dated by the NBER, a private organization. Department, updated this article.

Economics Concepts Explained | FINANCE & DEVELOPMENT 15