When evaluating how productive a country or nation is on the macro scale, few numbers are more important to understand than GDP, or gross domestic product.

With just a glance, this number can give you a sense of a state economy’s size and, when compared to past data, whether it’s growing or shrinking. As such, it’s a crucial tool for investors, business leaders, and policymakers to understand—both domestically and internationally.

If you’re interested in business, economics, or international affairs, it’s vital to understand GDP. Below is a look at what GDP is, how it’s calculated, and why it’s so important.

What Is GDP?

GDP stands for gross domestic product, which represents the total monetary value, or market value, of finished goods and services produced within a country during a period, typically one year or quarter. In this sense, it’s a measurement of domestic production and can be used to measure a country’s economic health.

Nominal GDP vs. Real GDP

GDP is typically spoken of in two main forms, depending on how it’s calculated: nominal GDP and real GDP.

Nominal GDP accounts for current market prices without factoring in deflation or inflation, meaning it tracks general changes in an economy’s value over time. Real GDP factors in inflation and accounts for the overall rise in price levels, so it’s more accurate for calculating a country’s economic health.

This article will primarily focus on real GDP because it offers more value and insight.

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GDP Equation

GDP can be expressed as an equation that sums up all of its components: a nation’s level of consumption, investment, government spending on goods and services, and the difference in profit between exports and imports.

GDP = Consumption + Investment + Government Spending on Goods and Services + (Exports – Imports), which looks like this: Y = C + I + G + (X-M)

Components of GDP

1. Consumption (C)

Consumption represents the sum of goods and services purchased by citizens—such as retail items or rent—and it grows as more is consumed. It’s the largest component of GDP. Typically, professionals view a steadily increasing consumption as a sign of a healthy economy because it signifies consumer confidence in spending versus uncertainty in the future and lack of spending.

2. Investment (I)

Investment refers to any domestic investment, or capital expenditures, in new assets that will provide future benefits. To invest in business activity, companies spend money on purchasing equipment, inventory, and building new establishments. The difference between consumption and investment is the period over which the purchased good or service provides benefits to its purchaser.

Investment is important because higher levels of it increase productive capacity and boost employment rates.

3. Government (G)

Government represents the money (consumption expenditure and gross investment) spent by the government on goods and services, such as education, transportation, military, or infrastructure. This spending is funded by taxes and companies or borrowed. To run at a surplus instead of a deficit, the government needs to collect more money than it spends.

Government spending becomes even more important to consider in the wake of a recession when consumer spending and business investment dramatically decline.

4. Exports - Imports (X-M)

The exports – imports piece of the equation refers to the exports of goods and services produced within the domestic economy and sold abroad, minus the imports purchased by domestic consumers. This includes all expenditures by companies geographically located within the country.

If the country’s export (X) is greater than the value of its imports (M), the net value is positive, and the country has a trade surplus. Likewise, if M is greater than X, the country is running a trade deficit.

Keep in mind that GDP ratios aren’t directly comparable between the United States and other countries, but the equation, metrics, and information used to calculate GDP are similar across the globe.

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The Importance of GDP

Everyone—investors, politicians, and citizens—is impacted by the strength of global and local economies, and GDP is a critical measurement of an economy’s size, performance, and general health.

GDP is calculated on an annual, as well as quarterly, basis in the United States. The Bureau of Economic Analysis (BEA) calculates GDP using data collected from retailer, manufacturer, builder, and trade flow reports and surveys.

Any of the entities mentioned above can use GDP to measure the country’s health by comparing the current GDP against past numbers. If the number is growing, then the economy has become more productive. If the number is shrinking, then the economy has become less productive. This comparison can be especially insightful when conducted over a long period, as it allows for long-term trends to emerge.

The metric can be used in several ways, making it an invaluable tool:

  • An organization or firm looking to expand into new markets might use GDP to evaluate which markets would prove healthiest.
  • An investor interested in emerging markets might use GDP to understand which countries are growing at the fastest rates and, therefore, might provide the greatest return on investment (ROI).
  • A politician or policymaker might use GDP to understand how policies have impacted the economy.

GDP is just one financial metric you should seek to understand, but it’s undoubtedly an important one. Few numbers contain so much valuable information.

If you’re an aspiring business leader, entrepreneur, investor, or policymaker, gaining a firm understanding of how GDP works and what each component measures will be a crucial step in your professional development.

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Tim Stobierski

About the Author

Tim Stobierski is a marketing specialist and contributing writer for Harvard Business School Online.