What is GDP and Why is it Important for the Economy?

GDP is one of the key economic indicators that measures all economic activity in a state. GDP has a special place in the minds of people who follow politics even a little. Surely, you know that the US has the largest GDP in the world, and China is catching up with America on this indicator. But what else can you tell?

Let’s examine a GDP indicator and discover why it’s important, how it’s measured, and what types of GDP exist.

What is GDP and Why is it Important?

Gross Domestic Product (GDP) is the value of all goods produced and services provided within the borders of one country for a certain period of time (most often a year). Thanks to GDP, we have an idea of a country’s level of economic activity.

For example, according to the World Bank, the US Gross Domestic Product in 2023 was $27.72 trillion, which is $1.71 trillion more than in 2022. That means that over the course of the year, the U.S. produced nearly $2 trillion more in goods and services.

Of course, the numbers can be argued about. We’ll talk a little later about how the GDP figure can be adjusted for inflation and population.

Interestingly, the modern concept of Gross Domestic Product was first coined only in the middle of the 20th century. In 1934, American economist Simon Kuznets developed the concept, and in 1944, following the Bretton Woods Conference, the parameter was adopted as the main indicator of economic activity in the country.

How Is GDP Calculated?

There are several methods for calculating GDP. Note that we are talking about GDP calculation, not GDP types (like GDP per capita).

So, you should know three methods: expenditure-based approach, production-based approach, and income-based approach. In an ideal situation, all three methods of calculation will give the same result. If they don’t, then there’s a mistake somewhere. Let’s break them down.

Expenditure-based approach

The expenditure approach allows to calculation of GDP volumes of a state using expenditures of different economically active groups—businesses, households, and the state. The expenditure approach is often used in the United States to estimate GDP. For this method, it is enough to use the formula:

GDP = C+I+G+NX

Where:

• C (Consumption): Consumer spending on goods and services.
• I (Investment): Business investment in capital goods.
• G (Government Spending): Government spending on public goods and services
• NX (Net Exports): Exports minus imports.

Let’s talk in more detail about each of the parameters.

Consumer Spending includes all spending by individual households. We are talking about food, clothing, appliances, health care, education, and so on.

Business investment involves spending on upgrading equipment or buying new equipment, building housing or manufacturing facilities, and buying materials.

Government spending includes all the money the government spends on building roads, opening schools, producing tanks, and so on.

Net exports are simpler: if the government sells more goods abroad than it buys, then it has a trade surplus; if the opposite is true, then the balance is negative, and there is a trade deficit.

All of the above expenditures are calculated and entered into a formula to estimate the Gross Domestic Product.

Production-based approach

The production approach estimates GDP by simply adding the value of all final goods and services produced minus the cost of materials consumed in the production process.

In other words, if JustMarkets decides to produce stools and sell them for $100 each, but pays $40 for materials, then $60 per stool will be added to the GDP calculation.

Some clarification:

• If JustMarkets did not produce the stool themselves, then the labor payment for the worker is also included in the GDP calculations.
• If JustMarkets produced 100 stools but sold only 80 of them, the remaining 20 are counted as inventory replenishment and still go into GDP.
• The sawmill that provided the materials for the stools also increased GDP by investing labor in it. The designer who will later decorate the stool from JustMarkets will also contribute by adding value.

Income-based approach

The income-based approach calculates GDP by summing up all earnings generated in the production of goods and services. This includes wages paid to workers, business profits, rental income, and interest earned on capital. Essentially, it reflects how an economy’s total output is distributed as income among its participants.

This method also accounts for indirect taxes, such as sales taxes, which affect the final cost of goods and services, as well as depreciation, which represents the gradual wear and tear of capital assets over time. Unlike the expenditure approach, which measures GDP through spending, or the production approach, which focuses on value-added, the income approach provides insight into how economic output translates into earnings for individuals, businesses, and the government.

A simplified example of GDP calculation

GDP calculations have an international standard of measurement. It is contained in the so-called System of National Accounts, which is used by the IMF, OECD, UN, World Bank, and the European Commission. For example, in the USA, the Bureau of Economic Analysis takes this standard and painstakingly calculates the final amount. Let’s imagine that we work for the BEA or a similar organization and want to quickly calculate GDP using the expenditure-based approach.

Let’s assume that our economy in a certain year consists of the following indicators:

1. Consumer spending (C): $5 trillion.
2. Investment (I): $2 trillion.
3. Government spending (G): $3 trillion.
4. Exports (X): $1.5 trillion.
5. Imports (M): $1 trillion.

Using the expenditure approach:

GDP=C+I+G+(X-M)
GDP=5+2+3+(1.5-1)
GDP=5+2+3+0.5
GDP=$10.5T

This means that a country’s total economic output, measured by GDP, is $10.5 trillion for the period.

To better understand how GDP has evolved over time, let’s look at the historical trend of U.S. GDP. The chart below highlights major economic shifts, including recessions, financial crises, and periods of rapid growth.

What Are the Different Types of GDP?

There are several different types of GDP used in economic analysis. Let us briefly analyze the main ones.

1. Nominal GDP: Nominal GDP measures the total value of goods and services produced in a country using current market prices, without adjusting for inflation. The methods of calculating nominal GDP were discussed in the previous section.
2. Real GDP: Real GDP is adjusted for inflation by using constant prices from a selected base year, allowing for a more accurate comparison of economic output over time. The supermarket price in 2025 would likely be higher due to inflation, but in the real GDP calculation, it is adjusted back to 2019 levels to make comparisons meaningful.
3. GDP per capita: This is a measure of GDP per person in a country. To calculate it, we take real, nominal or PPP GDP and divide it by the number of people in the country. GDP per capita provides an estimate of economic output per person, helping to compare the standard of living across different countries. However, GDP per capita can be misleading if income distribution is highly uneven.
4. Purchasing Power Parity (PPP) GDP: PPP GDP adjusts for differences in the cost of living between countries by considering how much a common basket of goods and services would cost in each nation. For example, if a Big Mac costs $6 in the U.S. and $3 in Poland, the PPP adjustment would standardize the price to allow for better cross-country economic comparisons.
5. GDP growth rate: this is a comparison of the change in a country’s economic output over a year (or a quarter) to estimate the growth rate of the economy. It is a key indicator used by policymakers to assess economic performance and guide policy decisions.

As you can see, GDP can be calculated in many ways. In some cases, GDP figures can be framed or interpreted in ways that do not fully reflect the real economic situation.

GDP is a widely used economic indicator, but it has limitations, such as not accounting for income inequality, environmental factors, or informal economic activity. We will explore these and other limitations in the following section.

What Are the Limitations of GDP?

GDP is a key indicator of economic activity, but it does not always reflect the true picture of society’s well-being. One major shortcoming is that GDP only takes into account market transactions and does not include the informal sector, the shadow economy, and work that is not directly paid for. For example, if a person takes care of a child at home or does volunteer work, his or her contribution to society is significant, but it is not included in GDP calculations.

Another important flaw is that GDP does not measure how evenly economic benefits are distributed among the population. A country may have high GDP growth, but if most of the income is concentrated in the hands of a small group of people, it does not mean that the living standards of the majority of citizens have improved.

In addition, GDP does not distinguish between beneficial economic activity and that which may have long-term negative consequences. For example, responding to natural disasters, over-extraction of natural resources, or large-scale military spending increases GDP but does not necessarily improve the quality of life or the sustainability of the economy.

Also, GDP does not take into account the impact of the economy on the environment. If a country is actively developing industry, cutting down forests or polluting water bodies, this may contribute to GDP growth in the short term. However, long-term environmental impacts such as climate change or depletion of natural resources are not reflected in this indicator.

Finally, GDP ignores many aspects of human well-being, such as levels of education, health, and overall quality of life. This is why many economists believe that for a comprehensive assessment of economic development, additional indicators, such as the Human Development Index (HDI) or the Gini coefficient, which measures the level of inequality, are necessary.

How is GDP used?

GDP is one of the main benchmarks for governments, businesses and investors to assess the current state of the economy and forecast the future. Governments use GDP to inform economic policy: if the economy is growing too fast, central banks may raise interest rates to curb inflation, and if growth is slowing down, they may lower them to stimulate demand.

Investors look at GDP to understand the economy’s state. High growth rates mean good business prospects, which makes stock markets attractive. If GDP is falling, however, investors may flee to more stable assets, fearing a recession.

For businesses, GDP is a metric that can be used to forecast demand and make decisions about hiring, investment, and scale. During an economic upturn, companies expand production and hire new employees. In periods of recession, on the other hand, companies may cut costs and staffing levels to survive the downturn.

Thus, GDP is an important tool that influences real economic processes.

GDP Around the World

GDP growth differs depending on the structure of the economy, the level of development, and global factors. In terms of the absolute size of GDP, the leaders in the world are the United States and China. However, depending on the method of calculation, their positions may change: by nominal GDP, the US remains in the first place, and by purchasing power parity (PPP), China remains in the first place.

The chart below compares the Chinese economy by nominal GDP per capita and PPP per capita, illustrating how rankings change based on the calculation method:

Fast-growing developing countries such as India and Vietnam are experiencing high GDP growth due to investment, industrialization, and rising consumer demand. For example, India has been steadily increasing its GDP by 6-7 percent per year in recent years, fuelled by the development of the service sector and the inflow of foreign investment. 

At the same time, in developed countries such as Japan or Germany, growth rates are slowing down due to aging populations and market saturation.

World events also play an important role. For example, the COVID-19 pandemic in 2020 caused a sharp drop in GDP worldwide but was followed by a recovery in growth fuelled by support measures from governments and central banks. Geopolitical instability, trade wars, and inflation can also significantly impact economic dynamics, altering GDP forecasts for even the most stable countries.

The Future of GDP

Despite its importance, GDP is no longer considered the only universal indicator of economic well-being. With digital transformation, the rise of the informal economy, and environmental challenges, there are growing calls to supplement it with alternative metrics.

The Human Development Index (HDI) or Gross National Happiness (GNH) can provide a more complete picture of quality of life, taking into account not only output but also social and environmental factors.

The rapid development of the digital economy is also challenging traditional methods of calculating GDP. Online services, cryptocurrency transactions and remote working create economic value that is not always accurately reflected in statistics. This is pushing economists to find new ways to measure the modern economy.

In addition, more and more countries are considering the concept of ‘green GDP,’ which takes into account the impact of production on the environment. China and some European states are already experimenting with such models, trying to balance economic growth with sustainable development.

In the future, the GDP approach may evolve to include additional parameters reflecting the real state of the economy, living standards, and the impact of technology. The only question is which indicators will become part of this new economic reality.