Governments have used many indicators to help citizens and policymakers understand the state of their national economies for decades: unemployment, home sales, inflation, and industrial output are all key pieces of the economic pie.

However, one indicator, gross domestic product, or GDP, has long stood above all others, serving as a single all-purpose measure of economic strength for nations, regions, or even individual towns when enough data is available. But despite its importance in economic discussions, many people still don't quite understand how GDP is calculated, or even what it really means in the context of complex modern economies.

If you're looking to learn more about GDP, you've come to the right place.

What is GDP?

The simplest explanation of gross domestic product is that it represents the total value of a country's (or region's) economic output. 

Factorygdp

Source: John Goldsmith via Geograph.

GDP, like many other economic innovations, was developed during the Great Depression to give American policymakers a more complete picture of the decimated economy they were then struggling mightily to repair. What we now call GDP was first compiled by economist Simon Kuznets in 1934, and he would later win a Nobel Prize for his efforts.

Kuznets' first reports focused on one of the two calculations -- the sum of national income -- now commonly used to keep track of GDP. As the economy mobilized for World War II and incomes fell under stringent government controls, it became necessary to focus on the nation's total production instead. The GDP report for the United States, released every month by the Bureau of Economic Analysis (BEA), is titled "National Income and Product Accounts" to reflect the importance of these two calculations.

By the end of World War II, Kuznets' GDP calculations had become the primary economic indicator for developed nations around the world, and it remains so today, with a few caveats that we'll examine later.

How is GDP calculated?

The United States publishes monthly GDP reports. These are headlined by the GDP growth rate, which shows us how much the economy has grown from one quarter to the next. These reports also annualize each quarter's GDP, which takes the periodic results of income or production and estimates what they would be worth over the course a full year.

GDP is also seasonally adjusted, which accounts for the impact of known recurring seasonal influences on the economy. For example, American consumers buy more toys and gadgets in November and December as Christmas approaches, and many workers have schedules that leave them with ample time off in the summer months. These influences would make summertime GDP figures look consistently weaker than winter GDP if they weren't properly accounted for, which would make it harder to accurately assess the progress of the economy.

GDP is primarily reported in real terms, which simply means that it's been adjusted to account for the effects of inflation -- without this adjustment, we'd be looking at nominal GDP, which doesn't accurately reflect the growth of the economy over time. Click here to read more about inflation and its impact on the economy (and on your pocketbook)

The BEA calculates GDP as both the sum of production and the sum of incomes. Each of these calculations is made up of many sub-categories, which breaks the massive data-gathering required to calculate GDP into more manageable parts. These sub-categories also help citizens and policymakers better understand the relative importance of the many different parts of the economy. Let's take a look at the sum-of-incomes approach first.

Gdpcalcincomes
Source: U.S. Bureau of Economic Analysis. Data from year-end 2013.
Note: depreciation is defined as "consumption of fixed capital." 

This was what the United States' income-based GDP pie looked like at the end of 2013. Often called simply gross domestic income, or GDI, these four core income-based elements of the economy should give us the same result as the sum of all domestic production when we add them up.

Worker pay is simply the sum of all income earned by anyone whose income can be tracked by the government.

Corporate operating profit is the money businesses keep after accounting for the costs of their sales, but before accounting for taxes and other costs, like research and development or marketing.

When businesses pay sales and property taxes, they show up on this chart as the tax income of state and local governments, and federal taxes on imported goods and services are also counted. Since taxes on worker incomes are not deducted from either worker pay or corporate operating profits under the sum-of-incomes approach, including them as part of this figure would be double-counting and would unfairly inflate final GDP.

Depreciation is part of the balance sheet of any business with long-lived physical assets, but the BEA actually counts something called "consumption of fixed capital" instead. While very similar to depreciation, consumption of fixed capital values assets at their current market values rather than their original cost, and it may also account for installation and maintenance costs.

What's the difference between GDI and GDP?

Gross domestic income and GDP are supposed to equal each other, but early reports may contain discrepancies until more complete data can be gathered. The BEA believes that the sum-of-production approach utilizes more timely data, so monthly GDP reports focus on production figures. This should come as no surprise when you remember that the P in GDP stands for product. As with GDI, there are four major elements in the sum-of-production calculation:

Gdpcalcproduction
Source: U.S. Bureau of Economic Analysis.  Data from year-end 2013.

Household spending accounts for the lion's share of production-side GDP. Household spending, whether it's on a car (a durable good), a six-pack of beer (a non-durable good), or a haircut (a service), is called personal consumption expenditures in BEA reports.

Business investment, which the BEA records as gross private domestic investment, counts spending on long-lived capital goods like machinery and factories, inventories of unsold goods, and also spending to buy or maintain buildings (whether a home or a shopping mall) that will be rented out by its owners.

Government spending includes everything on federal, state, and local budgets, including public works (roads and schools), military upkeep, social assistance (Social Security and Medicare/Medicaid), and public-sector employee wages.

The export category actually reduces GDP for the United States, because it has run a large trade deficit for several decades by importing many billions of dollars more in goods and services than its businesses sell abroad.

How does GDP help us understand the economy?

To paraphrase Nobel Prize-winning economist Paul Samuelson, GDP reports are like the orbital satellites of our economy. By summarizing vast amounts of data in a few straightforward assessments, they can provide a (reasonably) current picture of the entire economic landscape from far above.

The growth rate that headlines each month's GDP report tells us if the economy is growing or shrinking, and how rapidly, and is the most important number in every report. Looking at the various components of GDP can also help us figure out which parts of the economy are strong or weak, and this can be helpful to policymakers looking for the best way to prop up an ailing economy or make a healthy one stronger.

The production account of GDP reports is full of data on the various sectors of the economy, including their growth rates, contributions to overall GDP growth, and rates of price inflation, which can vary quite a bit from sector to sector. The income account is particularly helpful in assessing the relative power of workers and businesses, which has shifted from businesses to workers and back to businesses since GDP was first calculated.

Virtually every country in the world regularly reports its GDP to the public, so one country's GDP can be used as a measure of its economic strength relative to other countries. However, national GDP figures may not be the best way to measure the relative economic strength of a country because they don't account for differences in population size.

For example, China has the world's second-largest economy, which is larger than the economies of Germany, Italy, Russia, and Brazil combined. But because it has 1.3 billion citizens, each of them individually accounts for less GDP per capita than the citizens of any of these other countries. GDP per capita can often help us to understand the differences in standards of living between countries better than GDP on its own. Purchasing power parity also affects GDP considerations, and we'll discuss that further in the next section.

What are the drawbacks and limits to GDP?

GDP is a very helpful tool, and Simon Kuznets certainly deserved the Nobel Prize for his work. However, GDP is hardly the final word for today's economists and policymakers.

Calculating the size of a nation's economy is a huge undertaking, and no one could ever calculate it in a way that's both timely and completely accurate. As such, each GDP report is subject to several revisions, which take months to finalize. Quarterly GDP data can undergo large changes from its earliest estimates to its final revisions. In the span of four months, the United States' GDP for the first quarter of 2014 plunged from a growth rate of 0.1% in its first estimate to a "final" estimate showing a 2.9% contraction, before an annual revision finally showed first-quarter GDP declining by 2.1%. These rather large inconsistencies from month to month often provoke skepticism toward the BEA's reports, particularly from those who believe that the reports might be manipulated for political gain. But such inconsistencies are inevitable when the BEA starts with incomplete data and fills in the gaps later.

Analystsgdp

Source: Federal Bureau of Investigation.

There are also a number of drawbacks in the way GDP is often presented. As you saw earlier, China has the world's second-largest economy, but each Chinese citizen accounts for far less GDP than the citizens of developed nations like Germany or Japan. Even these figures can be deceptive because they typically fail to account for purchasing power parity, which assesses the relative strengths of various national currencies and how far the equivalent of a dollar can actually be stretched from country to country. In the chart above, you can see that China's per-capita GDP is three times as large as India's, but each Indian citizen actually has about half the purchasing power of a Chinese citizen because of the lower relative cost of goods and services in their country.

Examining GDP by itself can also lead us to miss important long term trends. Japan's economy is the third-largest in the world today, but it was the second-largest from 1967 until 2010, when China finally overtook it. That's because Japan's economy has been stagnant for years -- it's only grown by 15% since 1995. While China's economy is still smaller than the United States', it's grown far faster -- since 1990, the United States' economy has grown by 76%, but China's is nearly nine times larger than it was in 1990!

GDP's foundation in an era dominated by heavy industry has also left it with some rather large blind spots when it comes to measuring the value created by an increasingly digital society. The smartphone in your pocket, for example, provides you with many free or low-cost digital versions of resources that would have cost thousands of dollars to assemble decades ago. But GDP calculations can't assess the value of things we get for free, or services (like taking a picture, writing a funny story, or offering expert advice on a public forum) we might now provide to others free of charge thanks to these new tools. The multitrillion-dollar underground economy is also a big black hole in GDP data, since it's virtually impossible to tally up cash transfers unless participants report them -- and one of the biggest reasons why people engage in cash transfers is to avoid reporting them in the first place.

GDP is essential, but flawed

GDP has many limitations, but there's no other single figure out there that's so comprehensive and so adaptable to our needs. GDP can be used to examine the strength or progress of an economy, to compare multiple economies over time or against each other, or to help us understand what's really driving our economy. GDP can also be used in conjunction with other economic and demographic figures to paint a far more nuanced picture than we can get from the headline numbers alone.

In recent years, a number of alternatives have been developed that purport to better express national or regional success than GDP. Some economists prefer to focus on gross national product, or gross national income, which measures the worldwide production or earnings of every citizen rather than what's produced or earned by anyone inside a nation's borders. Others have highlighted more esoteric indicators, such as sustainable progress, national happiness, or open governance, as ways to measure the strength or desirability of the world's many countries. However, many of these indicators rely on GDP as a starting point rather than discarding it altogether.

GDP is a starting point from which anyone can begin to understand an economy. It's not the final word in economics, nor was it ever meant to be -- but without it, we'd have a much harder time figuring out how the many moving parts of our economy fit together, to drive us forward or to hold us back.

Follow Alex Planes on Twitter @TMFBiggles or connect with him on LinkedIn for more insight into investing, markets, economic history, and cutting-edge technology.

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