Gross Domestic Product is the principal measuring rod for an economy's output.

Gross Domestic Product (GDP) is the total market value of goods and services produced within a country during some period, usually one year.

 

            Our Gross Domestic Product includes the value of all goods produced inside the United States, without regard for where the producing individuals or organizations are headquartered. Thus, incomes of all foreign individuals who work in the United States and all profits from the U.S. operations of foreign-owned corporations are included in U.S. GDP.[1] The remainder of this chapter focuses on GDP, how it is measured, and shortcomings in measurement.

GDP as an Economic Indicator

Measuring GDP is a first step in tracking economic activity over time. Gauging the level of economic activity entails deflating GDP to adjust for inflation. Official estimates of GDP are reported in nominal (dollar) amounts. Thus, these data series must be deflated (divided by [the GDP deflator/100]) to make them truly comparable across time. This yields estimates of real GDP that indicate the effectiveness of government policies. Forecasts of GDP also help government decision makers time corrective policies. Good business managers consider macroeconomic forecasts when developing their plans for production, employment, and investments in new plant and equipment.

GDP and Economic Well-Being

            Real Gross Domestic Production also provides a crude gauge of national well-being. Income and employment are tied to aggregate output, so individual incomes and spending tend to swing with macroeconomic activity. Dividing real GDP by population yields a rough measure of the average well-being of individuals. Per capita real GDP indicates how well off average Americans are now relative to earlier times or to typical people in other countries, and helps us compare growth rates among countries.

 

            Usage of real GDP to measure productionsometimes conflicts with GDP as measure of economic well-being. Trade-offs between measuring production and measuring well-being are invariably resolved in favor of accurate measurement of production. This is why we include such things as inventory accumulation and exports in estimated GDP. Some numbers included in GDP to measure economic total production distort attempts to gauge welfare. For example, in 1997, the U.S. spent about 5 percent of its GDP on national defense. Did this make us better off than citizens of countries that avoided such massive defense spending? Typical European countries spent less than 2 percent of their GDPs on defense in 1997. As you will see in a moment, other complications also confound international comparisons of per capita GDP.

Measuring GDP

            Gross Domestic Product is measured in two basic ways: (a) the expenditure approach and (b) the income approach. Figure 1 illustrates these approaches with a version of the circular flow model introduced in Chapter 2. This shows that everything bought (expenditures) is sold by someone who receives income from the sale.

Figure 1

            Ideally, both methods would yield identical numbers because spending on output flows as income to resource owners. Unfortunately, most of the data available are recorded for accounting purposes, so the figures used to calculate GDP are only roughly suited for economic analysis. Figure 2 displays the proportional makeup of GDP by major types of income and expenditures.

Figure 2

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