Gross domestic product, or GDP, measures a country’s economic growth. The converted value of all final goods and services produced within a given country over a given period, GDP can offer important insight into the structure, state and trajectory of an economy. As such, it is considered one of the single-most important metrics economists use to evaluate a country’s overall health.

Each quarter and every year, countries all over the world release GDP data detailing changes in production compared to the previous quarter or year. As a “domestic” measurement, GDP only counts goods produced within the borders of a country, eschewing foreign production from even domestic companies. 

There’s actually a separate measurement designed to calculate the production of all the citizens of a particular nation, called gross national product, or GNP. For example, if an American produced, say, cheese in France, the sale of the cheese would contribute to France’s GDP, but in U.S. GNP.

It’s worth noting that GDP doesn’t quite cover everything. Goods and services sold in a black market, for example, aren’t included in a country’s GDP. Neither are goods or services produced via unpaid labor, such as items made at home or by volunteers. As a result, some GDP calculations may notably underestimate a country’s true production. 

There are also two distinct GDP figures: Nominal and real GDP. Real GDP takes inflation into account by converting the nominal figure using a constant value of money from a past base year (called a GDP deflator). Economists generally prefer real GDP. So, most of the time you read about a country’s production, it’ll be an inflation-adjusted value.  

How Is GDP Calculated?

There are actually three well-known ways of computing GDP.

• Expenditure Approach: This calculates GDP by adding the value of all purchases of final goods. This means adding up all the purchases made by households, businesses and the government over a specified period. 
• Production Approach: The production approach sums “value-added” at each level of production, minus the value of intermediate inputs into the final product. Milk, for example, may be an intermediate input into the final production of cheese. 
• Income Approach: Lastly, this approach derives GDP by adding up all the incomes generated by the production of all goods in the economy. A cheesemaker’s contribution would consist of the wages paid to their employees, in addition to the company’s operating surplus, which is basically just sales minus costs. 

All three methods should theoretically yield the same result. However, the most famous GDP formula uses the expenditure approach:

GDP = Consumption + Government Spending + Investment + Net Exports. 

Consumption is typically the most important variable in the equation, making up more than two-thirds of U.S. GDP. Because of this, other metrics of consumer health — like consumer confidence and consumer spending — may weigh heavily on a country’s GDP.

Net exports subtracts total exports from total imports (Exports – Imports). This essentially filters out goods and services made in a different country but purchased domestically from goods made domestically but sold internationally. The balance of exports and imports a country has can determine whether net exports have an additive or subtractive effect on a country’s overall GDP. 

Limitations of GDP and GDP Per Capita

GDP is an admittedly imperfect metric. Just because a country has a high GDP doesn’t necessarily mean it has high standards of living, and vice versa.

Italy, for example, experienced tremendous economic growth under infamous dictator Benito Mussolini. However, the people of the country were none the better for it due to the harsh policies put in place to bolster production. A similar phenomenon can be seen in the former Soviet Union over the same period.

Many economists have come to prefer GDP per capita as a means of evaluating a country’s general prosperity. GDP per capita, as its name suggests, divides a country’s GDP over its population, showing the country’s output per person.

Should a country’s population expand faster than its GDP, it’s GDP per capita will actually come out negative over a given period. It’s traditionally believed that if a country’s economy is expanding faster than its population, it’s living conditions will likely improve. As such, the metric serves to provide some context to an otherwise relatively abstract production figure.

Still, while GDP per capita is generally considered a superior metric compared to GDP alone, it’s also flawed. Because population and production growth rates vary so much country to country, comparing GDP per capita between countries doesn’t always offer much insight into the living conditions of a country.

It’s also highly manipulable. Should a virus, for example, result in the deaths of many people, GDP per capita may come out notably high — even despite potentially horrible living conditions.

Understanding the Data

In the U.S., the Bureau of Economic Analysis (BEA) releases two quarterly GDP reports. It publishes an advance GDP report four weeks following the end of the quarter and a final data release about three months after quarter-end. Typically, the advanced report isn’t too far off from the final release, but there are exceptions.

The data is comprehensive, offering insight into the country’s overall economic growth, and major drivers within the economy. Because of this, businesses and industries place a lot of value on GDP as an indicator of wider macroeconomic trends.

Famously, two consecutive quarters of contracting GDP is considered a “technical recession” signal, hinting at an economic downturn to come. However, this is also imperfect, having shown false positives over the years.

With GDP of over $27 trillion in the fourth quarter of 2023, the U.S. remains the single-largest economy in the world, overshadowing China’s $17.41 trillion (after conversion from yuan). The U.S. has also enjoyed strong production growth, recording 3.4% annual real GDP growth in its fourth quarter. Though, this is admittedly less than China’s 9% GDP growth average since 1978.

Interestingly, the countries with the highest GDP per capita tend to be on the smaller side, comparatively. Luxembourg consistently ranks at the top of the GDP per capita list, coming in at $135,605 for 2023, just overshadowing the likes Ireland at $112,248 and Switzerland at $102,866. On a per capita basis, the U.S. actually ranks seventh in GDP.

On the date of publication, Shrey Dua did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.