Definition of Gross Domestic Product (GDP): A measure of the aggregate goods and services produced by an economy over a time period.
What is Gross Domestic Product (GDP)?
Gross Domestic Product is an economic key performance indicator (KPI). It provides a meaningful picture of the overall size of an economy, as measured by the value of goods and services it can produce.
The economic growth of a country is typically expressed as the percentage growth in its GDP year-to-date or against the comparative period last year. This latter measure removes the impact of seasonality from the comparison.
You’ll notice that the best economics books use terms GDP interchangeably with phrases such as ‘the size of the economy’. It’s a concise way to refer to the size and shape of an economy, so authors use it frequently.
How is GDP calculated?
In the UK, GDP is calculated by the Office for National Statistics, which compiles a GDP figure each quarter for the United Kingdom. In the US, it’s the Bureau of Economic Analysis which performs this analysis.
Data is collected via mandatory surveys which the ONS sends to a sample of businesses, asking for information about payroll, purchases and turnover.
There are several ways to measure GDP:
- The total value of goods & services produced
- The total value of income earned
- The total value spent
These are slightly different bases, as they effectively take the temperature of an economy at a slightly different point in the cycle of production and consumption.
However, you should end up with a roughly similar figure regardless of the method used, on the basis that a pound is spent on a pound of goods produced, which eventually is paid to employees and shareholders in the supply chain as a pound earned.
The Bank of England states that total spending is the most common metric to measure. The detailed breakdown of total spending is as follows:
Total spending = household spending + investment + government spending + net exports
Said another way, this formulae combines the spending of citizens, corporations, government and foreigners spending. This provides a complete picture of the economy.
What else you should know about Gross Domestic Product (GDP)
GDP is useful when comparing the relative size of countries. However, because it’s an aggregate statistic, this doesn’t provide much insight into the living standards of citizens unless we combine it with other statistics.
GDP per capita
GDP per capita is one of the most quoted subsets of GDP data. It is calculated as GDP divided by the population, and gives ‘GDP per person’.
This gives economists a useful way to compare the income per head between different nations.
For example, the GDP per capita of the US in 62,794.59 USD (2018), and the GDP per capita of Morocco is 3,237.88 USD (2018).
However, GDP per capita is not the same as the national average wage. It will always be higher than the average wage, due to taxation which siphons away a significant chunk of income before it can reach citizens.
Purchasing Price Parity
When GDP between countries, economists sometimes use GDP calculated with ‘Purchasing Price Parity’ which takes into account the cheaper living costs of some nations.
For example, someone earning a $20,000 salary in London, UK would struggle to afford basic accommodation & utilities. Whereas the same salary in Thailand would provide a very comfortable standard of living.
Therefore is it useful to compare GDP per capita dollar terms? Not always, particularly when looking at the experience of individual citizens.
When GDP is calculated with ‘purchasing power parity’ or PPP for short, the figures are adjusted to provide a boost to the GDP figures of countries where the same dollar goes further.
The result is a set of GDP figures which are more comparable in real terms. Countries with similar GDP per capita on a PPP basis are able to buy an equivalent amount of services.
How does the definition of Gross Domestic Product (GDP) relate to investing?
GDP growth is generally correlated with growth in the value of stock markets. As an economy grows, its companies become more efficient and produce a higher volume of goods and services. The companies become more valuable and therefore, their share prices rise.
That being said, expectations of future GDP growth are always factored into the pricing of the stock market. As any investing book or investing course will explain, the Efficient Market Hypothesis suggests that investors should not expect to generate a premium return by simply chasing high GDP rates.
Emerging markets, such as China have seen tremendous economic growth as measured by GDP, and this has been reflected in a positive trend in their stock market. However, the Shanghai Composite Index has not kept pace with the percentage change in GDP. In fact, at the time of writing, the index is still lower than its last peak in 2015, despite a continuous period of economic growth since.