GDP: The Scorecard of a Country's Economy

Think of an athlete whose stats are tracked all season. A country gets a scorecard too, showing how busy its economy was over the year. The most basic rule for that scorecard is geography: the country's borders.

Say a foreign company builds a plant in Korea and makes cars there. Those cars count toward Korea's GDP. But say a big Korean company makes smartphones at its factory in Vietnam or the U.S. Those phones do not count toward Korea's GDP. What matters is where the production happens, not who owns the company. To be precise, the count covers output from producers based in that country (its residents).

That's why a foreign worker's paycheck from a Korean factory, or a foreign professor's pay from a Korean university, is part of Korea's GDP too. GDP measures all the activity and productive power inside a country's territory, so we can compare the size of different economies.

Investors and governments around the world watch this number to see how busy a country's factories are and how crowded its shops are. In the end, GDP is a barometer of the real size of production across all the economic engines running on that country's land.

Picture everything that happens before a loaf of bread reaches a customer. A farmer harvests and sells $0.50 worth of wheat. A mill grinds it into $0.80 worth of flour. A neighborhood bakery bakes it into a $1.50 loaf and sells it to a customer.

If you simply add up every sale along the way, $0.50 + $0.80 + $1.50 = $2.80, you get a big error. The wheat's value is baked into the flour and again into the bread, so the wheat gets counted three times.

So when calculating GDP, we leave out the cost of the ingredients and add up only the price of the final product that the last customer bought. Another way is to add up just the new value added at each stage of production.

The same logic applies to used goods. Selling a 10-year-old car or last year's phone on a resale app doesn't count toward GDP. Nothing new was made. The item just changed hands, so it isn't new value being created. The one exception is the service part of the deal. A used-car dealer's markup for helping the sale happen is newly created value, so that part does count.

Suppose the bakery makes 100 loaves, the same as last year, but the price doubles from $1 to $2. The number of loaves hasn't changed, yet the total on the receipts has doubled. That's an illusion.

The number you get by simply adding up money at current prices is called nominal GDP. The number that statistically removes the effect of prices going up or down, and measures only the real change in goods and services produced, is called real GDP.

The economic growth rate, which shows how much stronger the economy actually got compared with last year, is based on the growth of real GDP. That way we don't fool ourselves into feeling richer just because prices shot up, and we can see the country's true productive strength.

GDP does have limits, though. It leaves out activities where no money changes hands, like housework and volunteering. It also doesn't reflect social problems like pollution or inequality. That's why economists look at other indicators too, to understand people's real quality of life.