Gross Domestic Product (GDP) is an economic measure of a nation's total income and output for a given time period (usually a year). Economists use GDP to measure the relative wealth and prosperity of different nations, as well as to measure the overall growth or decline of a nation's economy.
The most common way to measure GDP is the expenditure approach. With the expenditure approach, GDP is the sum of the following elements:
- Total domestic consumption: This is the total amount spent on domestically produced final goods and services. Final goods are items that will not be resold or used in production within the next year — milk, cars, bow ties, and so on.
- Total domestic investment expenditures: This measurement includes not only investments in stocks and bonds, but also investments in equipment — such as bulldozers, computer servers, and commercial buildings — that will be useful over a long period of time. It also includes inventory goods — final goods waiting to be sold that a company still has on hand.
- Government expenditures: This includes everything from paying military salaries to building roads and maintaining monuments, but does not include welfare and social security payments.
- Net exports: Net exports is the total of goods and services produced domestically and sold to foreigners minus goods and services produced by foreigners but sold domestically (imports).
Using GDP as a measure of a nation's economy makes sense because it's essentially a measure of how much buying power a nation has over a given time period. GDP is also used as an indicator of a nation's overall standard of living because, generally, a nation's standard of living increases as GDP increases.
But there are a number of shortcomings to using GDP. Here are just a few:
- GDP doesn't count unpaid volunteer work: GDP doesn't take into account work that people do for free, from an afternoon spent picking up litter on the roadside to the millions of man-hours spent on free and open source software (such as Linux). In fact, volunteer work can actually lower GDP when volunteers do work that might otherwise have gone to a paid employee or contractor.
- Disasters can raise GDP: Wars require soldiers, oil spills require cleanup, and natural disasters require health workers, builders, and all manner of helping hands. Rebuilding after a disaster or war can greatly increase economic activity and boost GDP.
- GDP doesn't account for quality of goods: Consumers may buy cheap, low-quality, short-lived products repeatedly instead of buying more expensive, longer-lasting goods. Over time, consumers could spend more replacing cheap goods than they would have if they had bought higher-quality goods in the first place, and GDP would grow as a result of waste and inefficiency.
Although economists are constantly working on other ways to measure an economy, GDP is still the best indicator of a nation's overall economic health, in spite of its shortcomings.