How to calculate GDP?
GDP is short for Gross Domestic Product and is defined as a monetary measure of all goods and services produced in a period of time. The period of times measured are typically annually or quarterly. GDP is used to compare and determine performance in one’s economy to that of another country or region. You will hear a lot about GDP growth and comparisons of USA’s GDP to other countries.
GDP is one of the economic indicator’s economists will use when considering the current/historical health of one’s economy. An economic indicator is a statistic about an economic activity. Think unemployment, wage or salary increases or decreases, the stock market, interest rates, CPI (Consumer Price Index), etc. These indicators allow us to measure performance and predict future performance for an economy. GDP is considered to be the most important when valuing an economy and its state. It is a tool that companies can use as a guide to understand and plan future business activities.
Let’s take a look and compare countries and their GDP. In first place, the United States has a Nominal GDP of $19.39 trillion. Second place, China with a Nominal GDP of $12.01 trillion. Third place, Japan with a Nominal GDP of $4.87 trillion. And then we will go down the list to give more perspective… Switzerland ranks 20th with a nominal GDP of $678.57 billion. I hope that gives you an idea of the actual dollar value each country produces in goods and services annually.
Now you might be wondering how GDP is calculated and how someone can determine or put a number to a country’s GDP. There are actually a few different ways to calculate GDP. Two ways we will look at are the Income Approach and the Expenditure Method.
- Income Approach = adding up everyone’s earnings in the country
- Expenditure Method = adding up everyone’s spending in the country
The Income Approach and Expenditure Method will give you the closest amount of monetary value of all final goods and services produced in an economy. The difference is they both have different starting points. Income Approach would begin with income earned from selling goods and services. Expenditure would begin with the money individuals spend on purchases of goods and services.
The Formula for the income approach would be:
Total National Income + Sales Tax + Depreciation + Net Foreign Factor Income
Total National Income = Wages + Rent + Interests + Profits
The Formula for the expenditure method would be: (the more popular approach)
Consumption + Investments + Government + (Exports – Imports)
Consumption = consumer spending
Investments = business spending
Government = government spending
Exports = made in USA, sold abroad
Imports = Made outside USA, sold in USA
Regarding exports and imports, there are two terms you want to be aware of.
- Current Account Surplus = more exports than
- Good for growth
- Current Account Deficit = more imports than exports
Let’s look at consumption, investments, and government spending that is mentioned in the expenditure method.
Consumption is the largest piece of the equation and represents more than 2/3 of the GDP amount. This is tied directly to the term “consumer confidence.” You heard this a lot through 2018, consumer confidence is high. This can be because of low unemployment and wages were growing which resulted in consumer spending and the optimism that consumers had towards the overall state of the economy.
Next, Investments. This talks about business spending and the ability to produce more goods and services. As business spending increases so does the growth potential.
Government spending is an important one. When the government spends money on things like improving infrastructure. Well imagine how the country would improve infrastructure. This will put people to work to do this, this will fulfill orders and give businesses money. When the government puts money into the economy it has a circular effect. It creates jobs in order to fulfill whatever the government is spending money on.