Gross domestic product is the holy grail of the modern politician (and not-so-modern economist). Whenever GDP soars, he will tell you your country is doing great—and, of course, it is because of the great job he is doing. When it does not grow much or, God forbid, falls, countries often end up in political turmoil.
But what is gross domestic product, or GDP for short, and why do politicians (and the media) care so much about it? It can be defined as follows:
For example, if a country (perhaps some kind of fruitarian paradise) produced only 1 million apples (and nothing else) in a year and each were sold for \$2, its GDP in that year would be \$2 million. Of course, the money that bought the apples did not come out of nowhere—it was earned by workers working in the apple industry, and the apples were literally the fruit of their work.
Now, suppose the year after that was a very good year, and the country produced 1.1 million apples, but the prices fell to \$1 apiece. That year’s GDP would be \$1.1 million.
GDP was much lower, but people were better off; they had 10% more apples to eat than the year before. How’s that possible?
This is the reason why, when measuring growth, economists do not use so-called “nominal GDP” (where everything is evaluated at current market prices, such as in the example above) but rather its variant called real GDP.
To calculate real GDP, we imagine that all prices remain the same as in the base year of our choice. In the example above, we could use the first year as the base year, so real GDP in that year would still be \$2 million dollars, but real GDP in the second year would be \$2.2 million (1.1 million apples times \$2, which is the price in the base year).
Real GDP measures how much was really produced, not how much was paid for it in a currency whose value may change for reasons unrelated to the economy. When real GDP grows, more is produced, and when it falls, less is produced (at least in theory).
To measure how much the entire economy grows, we take a look at the growth of real GDP:
In our example, GDP fell from \$2 million to \$1.1 million, but real GDP (relative to the first year) grew from \$2 million to \$2.2 million, which is a 10% change. That is, GDP growth was 10%, just like the growth of the actual number of apples produced.
Superficially, GDP growth seems to measure improvement in the standard of living in a country. Politicians and the media love it because it gives them simple answers: positive = good, negative = bad. And economists will often be able to tell you what you can do to pump the number up, at least in the short run.
In reality, GDP growth can be very misleading. There are important components of economic and social activity that are not in any way reflected in GDP, and not all economic activity that is reflected in GDP is good… But more on that later.