Gross Domestic Product (GDP): Definition, Types and Alternatives

The gross domestic product (GDP) is the total market value of all finished goods and services produced in the country within a defined period. “Finished goods” are products not yet distributed to consumers, one cog in the supply chain. How GDP shrinks or grows over time is a good indication of an economy's health.

A strong and growing GDP typically means an upward trend for the economy that bolsters confidence among entrepreneurs, businesses, and workers.

The process of understanding GDP involves understanding its four components:

• Personal consumption
• Business investments
• Government spending
• Net exports

Several organizations provide GDP data. These include the World Bank, the International Money Fund (IMF) and the Organization for Economic Cooperation and Development. However, in the U.S., the foremost authority for GDP data is the Bureau of Economic Analysis.

GDP is one factor most economists look at when determining an economy's well-being. An increasing GDP points to a growing economy, while a decreasing GDP indicates a shrinking one.

GDP data provides a wealth of information. It may show how fast or slow economic growth is based on how much it changes over time. From a global perspective, GDP allows you to compare how well the U.S. economy compares to that of other countries. You can also use it to see which industries are getting stronger or weaker.

Although it's primarily a macroeconomic concept, GDP can significantly affect finances at a consumer or business level. For example, businesses in weaker sectors can develop strategies to pivot. Consumers can also take advantage of a strong economy and invest their money. It's typically a good time to do so because it'll allow you to earn more.

The Bureau of Economic Analysis produces a set of accounts referred to as NIPAs (National Income Product Accounts). These allow economists to see the different kinds of transactions that comprise the economy. These include the buying and selling of goods and services. However, hiring labor, paying taxes, property rentals and investments also play their parts.

Among the NIPAs come several economic indicators, GDP being the most well-known.

Source: Bureau of Economic Analysis

Trying to see the NIPA in its entirety can be overwhelming and may only lead to more confusion. The diagram above represents a simplified economy comprising only individuals and businesses.

No business can produce a product or provide a service without labor. However, it happens with the help of individuals. People purchase these products and services, which allows businesses to generate income.

Businesses then use their income to compensate individuals for their work (labor) and produce more goods and services. When you calculate the total market value of these finished goods and services, you get the GDP.

When calculating the GDP, the BEA considers four essential elements — personal consumption, business investments, government spending and net exports. MoneyGeek details each of these components in the section below.

GDP numbers date back to the 1940s. Seeing how it has changed over 70 years can give you a better appreciation of how much the U.S. economy has grown.

Source: FRED Economic Data

Using 1947 as a jump-off point and working our way to 2021, you'll notice that the general trend of the U.S. GDP has increased continuously through the years.

Of course, it's unrealistic to say each year resulted in GDP growth — but there were only three years where it was lower than the previous year (1949, 2009 and 2020). You can attribute the continuous growth of GDP to several factors, such as technological advancements, more laborers, increased work hours and the acquisition of capital stock.

GDP hasn’t always been the most-used economic indicator. Gross national product (GNP) used to be the accepted measure. It represents the total value of goods and services produced by U.S. citizens, regardless of where they are in the world.

In 1937, Simon Kuznets proposed GDP — a number that summed up a country's economic strengths. The GDP was standardized and became the accepted tool for measuring the economy by the Bretton Woods Conference of 1944.

However, it was only in 1991 that the U.S. formally shifted from using GNP to GDP to measure economic health.

There are multiple ways of reporting GDP. Each provides slightly different information because it focuses on specific parts of the U.S. economy.

MoneyGeek gives an overview of the types of GDP reporting to help you examine its fundamental differences.

Nominal GDP is the total market value of all finished goods and services produced domestically over a specific period. What sets it apart from other GDP reporting is it does not account for price changes from inflation or the effects of deflation.

It's the best figure to use if you want to compare the GDP to other economic factors that don't get adjusted for inflation. An example of this is debt.

When the nominal GDP increases, it doesn’t automatically mean more economic activity. It typically points to higher prices or increased goods production.

Like nominal GDP, real GDP measures the market value of all services and goods produced by a country over a defined period. However, the amount is adjusted to factor in changes due to inflation. That's why it's also known as the constant dollar, price or inflation-corrected GDP.

Real GDP gives an accurate picture of how much change in production occurred between two periods. An increase means the country's economy is doing well. If it decreases, the Federal Reserve (“the Fed”) may lower the federal funds rate to encourage consumer borrowing and stimulate the economy.

If you want to know how fast an economy is growing or shrinking, the best GDP reporting to use is the GDP growth rate. It compares the economic output of two periods. That can be month-over-month, quarter-over-quarter or year-over-year.

A high growth rate indicates an overstimulated economy, which may result in high inflation. The Fed may increase interest rates in an attempt to control it. In contrast, a negative growth rate usually means we're in an economic recession. Interest rates may decrease to stimulate the economy and encourage consumers to spend.

This GDP reporting considers two elements: a country's GDP for a specific period and its population. At its core, per-capita GDP estimates each person's value of output. Economists use it to have a better understanding of domestic output.

If a nation's per-capita GDP continues to increase, but its population remains the same it may indicate the presence of technological advances. It allows for more production without requiring additional labor.

It's also possible for a country with a small population to have a high per-capita GDP. It typically means they have large quantities of unique resources.

Unlike other GDP reporting in our list, the GDP purchasing power parity (GDP PPP) doesn't measure GDP directly. However, it helps economists understand how the costs of living and living standards vary between nations.

It considers the exchange rates between currencies, allowing economists to compare the economic output of two countries. It explores how much the same product will cost in different currencies, assuming it’s the same price.

Along with knowing what GDP is, it's equally as important to understand how economists calculate it. There are two approaches to its calculation — by expenditure and by income.

It's crucial to note that each bases the calculation on different areas. MoneyGeek explores both methods.

Between the two, the expenditure approach is more widely-known and commonly used. This method involves looking at how much the participating sectors spent and contributed to the economy. It involves the four components of GDP.

Let's break the formula down into its components. To get the GDP, you must first obtain the values for the following within a specific period:

C = Consumption (whether durable or non-durable)
G = Government spending (whether at a federal, state or local level)
I = Investments (whether fixed investments or changes in private inventories)
NX = Net exports (total exports less total imports)

To get the GDP, add the values for the above categories. The resulting figure is the GDP for the defined period.

The other way to calculate GDP is by using the income approach. As its name implies, it involves computing the total revenue generated by all finished goods produced and services provided within a given period. It also looks at four factors, called the factors of production, to determine the GDP.

Let's take a closer look at the formula above and break it down. Instead of using the four components of GDP, it derives its final figure from the following:

TNI = Total national income, which includes all revenue from the four factors of production. These are as follows:

• Income from labor
• The rent earned from land
• The profits of corporations
• The interest earned by capital

ST = Sales tax, those the government imposes on the sale of goods and services
D = Depreciation, the cost assigned to an asset over its lifespan
NFFI = Net foreign factor income, which is the difference between these two figures:

• The total revenue from U.S. citizens and companies earned from locations outside the country
• The total revenue from foreign companies and citizens generated within U.S. borders

Add the figures for the above categories to generate the GDP.

Although the GDP is the globally-accepted tool for measuring economic activity, it still doesn't give a complete picture. Because its calculation only considers specific segments, some areas are left out. Unfortunately, these also provide information crucial to understanding economic health.

The two approaches to calculating GDP may consider different factors, but they have one thing in common: official data.

The informal economy, better known as the “Black Market,” is not included in official data. The underground economy involves many unrecorded and illegal transactions, such as the trade of drugs and weapons.

The strength of informal markets varies between countries. For some, it contributes significantly to their social and economic mobility. However, it's relatively challenging to measure because of its nature, making their GDP an inaccurate measure of their economic output.

The exclusion of the informal economy is one of the biggest criticisms about the GDP as a measure of a country’s economic well-being.

Economies today face many challenges that in past decades weren't as much of a concern. Examples of these are climate change, rapidly depleting resources and health crises from pollution — all of which contribute to the overall health of a nation's economy.

While GDP measures financial and production capital, it doesn't cover others, such as human, social and natural capital. Over the years, there have been numerous instances wherein nations sacrificed human and environmental well-being in the name of economic progress.

As they say, nothing is free — and continuous economic growth is no exception. Often, it's the environment that bears the brunt of things. Environmental damage is a potential byproduct when countries focus on enhancing production output.

While more progressive nations have regulations against this, most developing countries don't. As a result, not all corporations pay fines for increasing pollution, and their economies are less concerned with environmental concerns.

The GDP may not be the most accurate measure of sustainable economic growth since it doesn't consider environmental damage and depletion of natural resources.

Many factors may contribute to economic activity that is not economic factors in and of themselves. Severe weather conditions and their effects are examples. It might create an artificial growth rate in GDP due to the specific sectors increasing production to fulfill a temporary demand.

The COVID-19 pandemic is another excellent example. The need for vaccines, PPEs and medical equipment boosted productivity in specific sectors. Manufacturing companies also started producing different goods (even if these weren't their primary product) to fulfill the present demand.

GDP is the total market value of all goods and services produced within U.S. borders for a defined period. In this case, it applies to U.S. companies.

However, the situation is slightly different when it comes to organizations outside of the U.S. GDP does not consider profits that these companies remit back to foreign investors (money that exits the economy). It may make a nation's economic output look better than it is.

GDP — and, by extension, per-capita GDP — may paint an inaccurate picture of how much individuals earn in the real world. For example, let's say that a small country with a population of 1,000 has a total income of $500 million. Applying the concept of GDP per capita, you can say that each individual earns $500,000.

However, that's an oversimplification of what happens in the real world. The chances of everyone earning the same amount are slim, if not non-existent. According to the Khan Academy, if there are about 10% of households earning 80% of the country’s income, it’s an indication that income inequality exists. The remaining amount is shared among the other households (90% in this example), often unequally, which means they earn significantly lower than the declared per-capita GDP.

Unfortunately, GDP does not take into account income disparity. So, a nation may have an attractive per-capita GDP, but you may still find a portion of the population living below the poverty line.

Although GDP helps economists see how one country's economy compares to another, it's not always an apples-to-apples comparison. Despite what numbers say, it's crucial to understand the disparity regarding the cost of living between nations. It helps you develop an accurate understanding of their economic health.

Raw GDP and per-capita GDP don't consider this. Unfortunately, they're what economists typically use to measure economic progress. GDP PPP attempts to address this, but it doesn't measure GDP directly.

A lot of factors you consider when calculating GDP focus on spending (whether by consumers or the government) and production. So, if a manufacturing plant produces more finished goods, it improves the country's GDP — even if these eventually become non-moving stock (which may turn into waste in the future).

The same logic applies to government spending. Federal spending may result in infrastructures and programs, but it doesn't consider whether these become profitable or successful.

Holistic economic health considers various elements of the economy. A single measurement tool, such as GDP, isn't enough to cover every sector.

Other measurement tools can compensate for what GDP lacks. MoneyGeek highlights several of these tools in the section below.

As its name implies, the Human Development Index (HDI) focuses on measuring achievements in the various stages of human development. It has three main dimensions:

• Health and long life - measured by life expectancy
• Knowledge - measured by educational attainment
• Standard of living - measured by gross national income per capita

While GDP focuses on financial and capital growth, HDI pays more attention to human capital and the factors that affect a person's overall well-being.

It can be a basis to question policies or regulations that focus too much on increasing production and ends up sacrificing the quality of individuals' lives. However, it's crucial to note that the HDI only includes some aspects of human development. Some areas, such as empowerment, poverty and inequality, still need to be covered.

Until 1991, the U.S. used GNP as its primary measure of economic activity. Although GDP is now the accepted tool, it fails to consider some factors that GNP does.

Both GNP and GDP measure a country's economic output. The difference lies in what it includes in its computation. While GDP focuses on the value of goods and services produced within its borders, GNP does not have the same limitation.

GNP measures the economic output from a nation's residents and businesses, no matter where they generate it. For example, the gig economy has been gaining traction in the way of the global pandemic. Some companies have a global workforce. However, since these workers live outside their country's borders, GDP wouldn't reflect it, but GNP would.

GNP may be a better basis than GDP if you want to see how business overseas or remote workers contribute to a nation's economic activity.

GDP primarily uses production and income to measure economic growth but fails to incorporate other aspects that may impact a nation's well-being.

Genuine progress indicator (GPI) approaches things more holistically. It still considers economic factors when measuring a country's health, such as personal expenditure, underemployment and consumer durables services. However, this aspect only comprises a third of the GPI's factors.

GPI also includes fields like volunteer work and higher education, which points to social factors. These aren't part of the GDP because they're difficult to measure. GPI assigns a value to them because they still impact the economy. The third factor focuses on the environment, such as climate change and ozone depletion.

To date, some states have implemented a GPI to measure their prosperity. One example is Maryland, which uses it as part of its Maryland Quality of Life Initiative.

GDP, the most widely-accepted measure of economic progress, measures income, not wealth. It focuses on the value of goods and services a country produces within a specific amount of time.

In contrast, the Inclusive Wealth Index (IWI), as its name implies, measures wealth. While GDP centers on the total market value of capital assets, IWI considers social value. The capital stocks it includes in its measurement are also different:

• Manufactured or physical capital are physical assets people produce, such as cars, structures and roadways.
• Human capital refers to the population's level of skill and knowledge. Investments in this area include education, health initiatives and training.
• Natural capital may include ecosystems covering the land, forests, rivers and oceans, among other things.

There may be better gauges than GDP for holistic human progress, social inclusivity and sustainability. IWI's strength is that it assigns values to areas and assets that GDP does not.

Comprehending economic health goes beyond knowing the definition of GDP, but it's an excellent place to start. MoneyGeek provided answers to some frequently asked questions below.

The GDP is only one macroeconomic concept. It’s one look at how an individual's finances are impacted. MoneyGeek provides several online resources to help deepen your understanding of the U.S. economy.

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• Opportunity Cost: Not everyone is familiar with the concept of Opportunity Cost, but it may help you make better financial decisions.
• Economic Recessions: History, Causes and Characteristics: Everyone worries when the country is in recession. How do you spot a recession? MoneyGeek provides extensive information regarding its history and causes.
• Economic Depression: History, Characteristics and Impact: We may have experienced many recessions, but did you know that there has only been one economic depression in the U.S.? You can read more about it in this MoneyGeek article.