As the most commonly tracked economic indicator, GDP says a great deal about a nation’s economy and is closely watched by economists, investors, and policymakers. In fact, the release of the latest GDP report can move markets and is a key indicator of whether governments should boost spending or slow down to avoid overheating and inflation.
GDP is calculated as the sum of a country’s consumption, investment, government spending and net exports. Consumption includes purchases of durable and nondurable goods such as food, clothing and gasoline. Investment is money that businesses spend to expand their operations, such as buying new machinery. Government spending includes salaries for public servants and military expenditures. Additions to private inventories and paid-in construction costs are also included in GDP. GDP is measured in current dollars, but to make international comparisons, it is converted into real terms using the purchasing power parity exchange rate.
One of the big limitations of GDP is that it only measures market activity and excludes activities that take place outside the marketplace, such as household production, bartering, black-market transactions and unremunerated volunteer work. This can distort the measurement of a nation’s economic health. In addition, GDP fails to consider phenomena that impact citizens’ well-being such as traffic jams or environmental damage.
The methodology of calculating GDP has been refined over the years to overcome its limitations. Inflation is accounted for by adding the price index to nominal GDP. It is also adjusted to make up for differences in cost of living across countries by using the purchasing power parity exchange rate.