Defining and Measuring GDP

Gross domestic product (GDP) is a measurement of a country's total economic output, or the market value of all the final goods and services produced within a country's borders in a specific time period. Market value is the price that end users pay for a good or service, rather than the cost of producing or providing the good or service. Final goods are goods produced for and consumed by the end user. GDP measures goods and services produced within a country’s borders without regard for the ownership of the factors of production. For example, the market value of automobiles manufactured by Toyota in the United States would be counted in the United States' GDP even though Toyota is a Japanese-owned company. GDP is a vital measure of the overall economic activity in a country.

Only newly produced goods—including those that increase inventories—are counted in GDP. Also, only goods that are produced and sold legally are included in GDP. A product will only be counted in GDP one time in its life. Sales from inventories of goods that were produced in previous years are excluded. Current transactions involving assets and property produced in previous periods are not counted in the current GDP, either. The value of any intermediate good or service, which is a good or service used in the production of other goods and services, are not included in GDP. This is because if intermediates were counted, they would be counted twice: the value would be counted both in processing and at final goods. Neither are secondhand sales (used cars, items sold in thrift stores), purely financial transactions such as buying and selling stocks and bonds, or exchanging one financial asset for another included. Transfer payments such as welfare, unemployment or social security payments, unreported legal activity such as tips a waitress doesn’t report, and “off the books” cash transactions are all excluded as well. Illegal business activities, such as illicit drug sales and prostitution, are not included in GDP. Additionally, U.S. corporations producing goods overseas, household work performed by a stay-at-home parent, and volunteer work are not considered in the calculation of GDP. These goods, services, and transactions are not included in GDP because they are difficult to track (as in the case of secondhand sales and illegal business activities) or do not accurately reflect the production levels of the economy (as in the case of transfer payments and asset exchanges).

GDP can be measured in different ways. GDP per capita is a measure of the total output of a country divided by the number of people in the country: $\text{GDP}\;\text{per}\;\text{Capita}=\text{GDP}/\text{Population}$ GDP per capita is an important indicator of economic performance and is a useful unit for making cross-county comparisons of average living standards and average economic well-being. China, for example, will have a higher GDP than the United Arab Emirates (UAE) because of the relative size of China’s economy, but because China has a larger population over which GDP is “spread,” China’s GDP per capita will be lower.

Nominal GDP is the total gross domestic product expressed in current year prices. It is calculated according to current price (price at the time of calculation when calculating GDP). Nominal GDP does not adjust for changes in market prices that occurred during the current year. For example, the United States's nominal GDP for 2017 is calculated by taking the quantities of all final goods and services produced in 2017 and multiplying them by their 2017 prices.

Real GDP is the total output of the economy adjusted for inflation. It is calculated according to the constant price (price set to a specific "constant" to adjust for inflation when calculating GDP). Real GDP measures the value of goods and services at base-year prices. For example, if 2010 were chosen as the base year, all values in the calculation of GDP would be expressed in 2010 dollars. So, real GDP for 2017 is calculated by taking the quantities of all goods and services produced in 2017 and multiplying them by their 2010 prices. GDP can be measured in either form, but only real GDP should be used when comparing changes between time periods or between countries as nominal GDP can become distorted by fluctuating changes in price levels.

The formula for calculating real GDP is nominal GDP divided by the GDP deflator: . The GDP deflator is a number that represents the current prices of various goods and services versus their past prices of a given year. It is a measure of the level of prices of all new domestically produced final goods and services. It is often used to measure inflation and to convert nominal GDP to real GDP. To calculate the GDP deflator, divide nominal GDP by real GDP and multiply the result by 100. The GDP deflator is always equal to 100 in the base year. Inflation is a sustained increase in the general price level of commonly bought goods and services. As inflation varies between countries over time, real GDP is preferred for GDP comparisons between nations. Real GDP is also useful to economists for evaluating the state of production and growth in a country. Nominal GDP growth may be produced by wage increases and price hikes. Real GDP strips out these considerations and allows analysts to concentrate instead on production growth. For instance, a manufactured automobile is counted as real GDP when it is shipped to a dealer and then added to that dealer's inventory. The profit the dealer makes when the car is sold is then also added to GDP. Real GDP is thus concerned primarily with production and inventory adjustment rather than sales. Furthermore, real GDP is a gauge of how swiftly a country's economy is growing. This aspect of the measure is isolated by comparing real GDP within a set period of time, such as quarter over quarter or year over year, and then calculating the rate of change.

It is important to understand both nominal and real GDP. Economists use real GDP to monitor the growth of output in the economy. As nominal GDP does not account for changes in price levels, real GDP is a better gauge of changes in the output level of an economy. However, nominal GDP can be useful when analyzing GDP along with other economic data that do not exclude or adjust for inflation. For example, debt is expressed in nominal terms.