Gross Domestic Product (GDP) is defined as the market value of all final goods and services produced within an economy over a specific period, with nominal GDP reflecting current prices and real GDP adjusted for price changes. It is calculated through various expenditure streams: personal consumption, gross private domestic investment, government spending, and net exports, with only legal and formal market activities included. GDP serves as a key economic performance measure and is critical for assessing economic growth and living standards, represented by per capita GDP.

1. Gross Domestic Product
Erskine S. Walther, Ph.D.
GDP: Defined
GDP: The market value of all final goods and services
produced in an economy in a specific period of time.
Market Value: The measurement is in current prices, this
known as Nominal GDP or just GDP.
Final Goods and Services: Goods and services that have
reached their final usage. They are not used to produce another
good or service. Goods that are used in that way are
Intermediate Goods.
Intermediate Goods and Services are those that are used as
inputs into the production of other goods and services. There
are not directly counted in GDP as their value is included in the
value (price) of the final goods and services. Thus, counting
them directly would double count the same output. However, if
the intermediate good has not been sold, it is counted in GDP as
inventory.
GDP Defined: continued
Specific Period of Time: GDP can be computed for a month, a
quarter or a year. The most common measures are annually and
quarterly.
Formal, Legal Markets: Only goods and services that are traded

2. in formal, legal markets are counted in GDP.
Underground Economy: The underground economy is composed
of economic transactions involving activities that are not legal
activities in a given society. These are not included in GDP.
Illegal drugs and illegal gambling are common examples.
Informal Economy: These are legal activities that do no go
through formal markets. They are not included in GDP.
Income not reported for taxation purposes or work done for
barter are examples of informal economic activities.
Some authors include legal activities as part of the underground
economy definition.
GDP Defined: continued
Household Production: Productive activities done in and for the
household are not counted in GDP as there is no direct monetary
payment for such activities. (If you give children an allowance
for household chores that would be part of the informal
economy. If you clean your own home, that is household
production.)
Leisure Activities: Leisure activities that do not involve the
purchase of goods and services are not counted in GDP.
Spending an afternoon with family and friends that does not
involve buying goods or services would not be counted in GDP
as no economic transaction has occurred.
A vacation involving paid activities does count in GDP as goods
and services are purchased.
GDP: Purpose
The Purpose of GDP is to measure the total output of goods and
services in any economy during a specific period of time.

3. GDP is Value Neutral: It makes no judgments regarding
product quality or whether or not a good or service is “good”
for you. Those judgments are left to the consumer who is
assumed to be able to make intelligent decisions that reflect
their own personal tastes, preferences and values.
Changes in GDP measure economic growth.
Economic growth is the increase in the output of goods and
services in an economy over a specific period of time. This
must be done using Real GDP values.
GDP: Real vs. Nominal
Nominal GDP is GDP measured in current prices. This is
referred to simply as GDP.
Real GDP is Nominal GDP adjusted for price changes. To
compare across time, Real GDP is required otherwise price
changes will distort the values and lead to incorrect analysis.
GDP (Price) Deflator or just the GDP Deflator is the price index
used to adjust Nominal GDP for price changes. This adjustment
produces Real GDP values.
This is the broadest measure of price changes in the economy as
it includes everything that is included in GDP.
GDP: Computation
GDP is a measure of total output. However, the production of
output simultaneously involves the creation of income as the
input (resources) used in the production process must be paid.
That payment is income to the resource owners.
Thus, GDP can be computed as a Sum of Income created by the
production process. While this is a useful computation, it is

4. also a bit complicated.
GDP can also be computed as a Sum of Expenditures. This is a
more straight forward approach which also has several analysis
advantages.
Thus, the GDP measure tells us the National Income of the
country as well as the production activity and the amount of
spending in the economy.
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GDP: The Expenditure Streams: PCE
GDP is composed for four Expenditure Streams. The major
categories of spending.
Personal Consumption Expenditures (Consumption): This is the
spending of the household sector of the economy. It is also
referred to a Consumer Spending. In the developed world it is
the largest of the expenditure streams. In the US it has
normally been about 2/3’s of GDP. But in the last few years it
has increased to 70% to 72% of GDP. Thus, it is a very
important component of GDP, but it is relatively stable.
In addition to the household sector, the spending of private non-
profit organizations is counted under PCE.
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GDP: The Expenditure Streams: GPDI
Gross Private Domestic Investment is the spending of the
business sector. It is commonly known simply as Investment

5. Spending.
This is the most changeable of the spending streams.
It tends to be the leading factor in movements into recessions
and in movements out of recessions. Thus, it is closely
watched.
It is sensitive to interest rates and to expectations about the
future.
Business confidence is a widely used measure of expectations
about the future.
Investment spending is critical to long term economic growth.
It is a primary source of new technologies.
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GDP: The Expenditure Streams: GPGS
Government Purchases of Good and Services is the spending the
by government sector. It is commonly called Government
Spending.
It includes spending by all levels of government.
It includes all types of expenditures by all levels of
government. It counts everything from paper clips to welfare to
highways to national defense, etc.
Be sensitive to the context when you hear or read about
government spending. Many speakers/authors only mean
federal government spending when they use the term. But for
GDP purposes it includes all levels of government.
GDP: The Expenditure Streams: NX

6. Net Exports is Exports – Imports. This is sometimes referred to
as “the rest of the world”. It is the international component of
GDP.
Exports are goods produced domestically, but sold
internationally.
Imports are goods produced internationally (in a foreign
country), but sold domestically.
Exports bring money into the economy and produce domestic
jobs and income.
Imports send money out of the economy and produce jobs and
income in other countries. (That may, in turn, increase the
market for exports.).
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GDP: Sum of Expenditures: Equation
GDP computed as a Sum of Expenditures can be summarized in
the following equation:
GDP = C + I + G + NX
This can also be written as: Y = C + I + G + NX where Y is
GDP or National Income, we’ll treat these different expressions
as interchangeable.
Where:
C = Consumption
I = Investment
G = Government
NX = Net Exports

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GDP: Per Capita GDP: Standard of Living
Per Capita GDP is GDP/Population
Per Capita GDP is normal measure of Standard of Living.
This is an average and tells us the amount of output that the
economy produces per person.
It does not mean that each individual in the society receives that
amount of output. It is not a measure of Income Distribution,
just of what is potentially available to each individual.
Therefore, it is not a measure of Quality of Life (however that
is defined).
But it does tell us about the potential that an economy has to
provide for it’s members. A higher GDP means a greater
potential that people have more opportunities, more goods and
services available to them and that the public sector can offer
more services as it has a larger tax base.
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GDP: Composition
What is demanded is what is produced.
Thus, the specific goods and services that make up GDP are a
reflection of those goods and services demanded by the
expenditure streams.
In a market based economy, consumers are the primary
determiners of what is demanded and; therefore, of what is
produced. Consumer income determines how what is produced
is distributed across the economy.
In a command economy, the government determines what is
produced and how it is distributed across the economy.
Mixed economies have a market based element and a

8. government based element. Developed economies are normally
mixed economies. The relative mix of free market and
government decision making varies widely across the developed
world and more so in the developing world.
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GDP: International Comparisons
When comparing the GDPs of different nations an adjustment
must be made for the use of different currencies in order to put
the values into the same currency, normally US Dollars.
Exchange Rate Method – this approach uses the current
exchange rate to convert the GDP into US Dollars.
While this method is the easiest to calculate, it’s accuracy is
diminished by the variability of exchange rates during any given
year and the reality that exchange rates do not always reflect the
domestic purchasing power of a currency.
Purchasing Power Parity (PPP) – this approach adjusts exchange
rates for differences in the domestic purchasing power of
different currencies. The core concept is that it should take the
same amount of purchasing power (opportunity cost) to buy
good X regardless of the country of purchase or the currency
used.
This is the preferred method for calculating and comparing
GDPs internationally. GDPs calculated in this way will be
noted as GDP (PPP).
GDP (PPP) values will be expressed in a common currency,
normally US Dollars.

9. 15
GDP: International Comparisons: continued
Other factors that influence the ability to compare GDP values
across countries include:
Accuracy of GDP data collection – This is not a problem with
developed world countries as they have sophisticated data
collection systems. However, it is a factor with developing
country values. In the developing world, data collection
methods are not as well developed and the informal economy
can be a significant part of total economic activity.
There is nothing that can be done about this difficulty and for
our purposes it can be ignored even in cases with the numbers
may be significant.
Different legal structures – Since GDP only includes legal
activities and only legal activities are counted in GDP, national
law differences can impact GDP values.
Activities that are illegal in the US, for example, may well be
legal in other countries.
The differences this would create are usually too small to be of
significance, thus, they be safely ignored.
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GDP: Summary of Key Points
GDP is the market value of all final goods and services
produced in an economy during a specific time period.
Nominal GDP is GDP in current prices.
Real GDP is Nominal GDP adjusted for price changes and must
be used for any cross-temporal comparisons.
The adjustment is made using the GDP Price Deflator – which is

10. the broadest measure of price changes in use.
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GDP: Summary of Key Points: continued
GDP is composed of four spending streams of which
Consumption is the largest, but Investment is the most variable.
GDP includes only economic activity that is legal and occurs in
formal markets.
GDP makes no value judgments about the non-monetary worth
of what is produced.
Per Capita GDP is the measure of Standard of Living.
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GDP: Summary of Key Points: continued
Purchasing Power Parity is the preferred method for calculating
foreign GDP values for conversion into US Dollars for
international comparisons.
GDP is the most widely used overall measure of economic
performance and is essential for measuring economic growth.
Per Capita GDP is the normal measure of a nation’s Standard of
Living.

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