What Is GDP and Why Is It Important? A Guide
Gross Domestic Product (GDP) is one of the most widely used indicators of economic performance. GDP measures the total output of a national economy during a given period and is seasonally adjusted to remove quarterly variations based on weather or holidays. The most closely watched measure of GDP is also adjusted for inflation to measure changes in output rather than changes in the prices of goods and services.
Annual GDP totals are frequently used to compare national economies by size. Policymakers, financial market participants, and business executives are more interested in changes in GDP over time, which are presented as an annualized rate of growth or contraction. This makes it easier to compare annual and quarterly rates.
For example, for Q2 2022, real GDP (adjusted for inflation) in the United States decreased by 0.9% on an annualized basis compared to Q1 2022. An annualized rate compares this decline to the 5.7% annual increase in US real GDP in 2021.
Key points to remember
- Gross domestic product tracks the health of a country’s economy.
- It represents the value of all goods and services produced over a specific period of time within the borders of a country.
- Economists can use GDP to determine whether an economy is growing or in recession.
- Investors can use GDP to make investment decisions – a bad economy often means lower earnings and lower stock prices.
Definition of Gross Domestic Product (GDP)
GDP measures the monetary value of goods and services produced within a country’s borders over a period of time, usually a quarter or a year. Changes in output over time, as measured by GDP, are the most comprehensive indicator of the health of an economy.
According to the International Monetary Fund, in 2022, the United States is the world’s largest economy, followed by China and Japan.
GDP figures are reported in the United States on a monthly basis by the Bureau of Economic Analysis (BEA) both in nominal terms and in real or inflation-adjusted terms. One month after the end of each quarter, the BEA publishes an advance estimate of GDP for the previous quarter. Over the next two months, the bureau releases second and third estimates that incorporate previously unavailable data.
Although it is possible to deconstruct GDP in different ways, the most common is to think of it as the sum of private consumption, investment, government expenditure and a country’s net exports (or exports minus imports ).
The consumption and investment components of GDP tend to be more reliable economic indicators than government spending or net exports. The 0.9% annualized decline in U.S. GDP in the second quarter of 2022 was primarily the result of the growing U.S. trade deficit, slowing private inventory investment, and a near-term decline in defense spending.
Nominal GDP vs Real GDP
GDP can be expressed in nominal or real terms. Nominal GDP is calculated on the basis of the value of goods and services produced as collected, so it reflects not only the value of production, but also the change in the overall price of that production. In other words, in an economy with an annual inflation rate of 5%, nominal GDP will increase by 5% per year due to price growth, even if the quantity and quality of goods and services produced remain the same.
-0.9%
US real GDP growth rate (annualized) in the second quarter of 2022, following an annualized decline of 1.6% in the first quarter of 2022.
Real GDP, on the other hand, is inflation-adjusted, meaning it excludes changes in price levels to measure changes in real output. Policymakers and financial markets focus primarily on real GDP because inflation-fueled gains are not an economic benefit.
To estimate real GDP, the BEA constructs chain indices that allow it to adjust the value of goods and services by changes in the prices of these goods and services.
Measuring GDP
There are three main ways to calculate GDP: first, by adding up what everyone earned (called the income approach) or by adding up what everyone spent in a year (the expenditure method). Logically, the two measures should arrive at approximately the same total.
The income approach, sometimes referred to as GDP(I), is the sum of total compensation paid to employees, business profits and taxes less subsidies. The expenditure method already discussed is the most common approach and is calculated by adding private consumption and investment, government expenditure and net exports.
Finally, GDP can be measured on the basis of the value of the goods and services produced (the production or output approach). Since economic production requires expenditure and is, in turn, consumed, these three methods of calculating GDP should all arrive at the same value.
In general, the following simplified equation is often used to calculate a country’s GDP via the expenditure approach:
BEA estimates of US GDP are based on the National Income and Product Accounts (NIPA) for sectors including businesses, households and nonprofit institutions, and governments. The NIPAs are compiled from seven “summary accounts” showing revenue and expenditure for each of these sectors. The detailed NIPA data also forms the basis of the BEA’s reports on GDP per State and industry.
The BEA’s GDP estimates omit illegal activities, childcare and voluntary work due to lack of reliable data. A BEA researcher estimated that counting illegal activities would have increased nominal US GDP by more than 1% in 2017. At the same time, the GDP figures include BEA estimates of what owners would have paid to rent an equivalent dwelling, so GDP does not increase each time an owner-occupied dwelling is rented.
GDP for Economists and Investors
GDP is an important measure for economists and investors because it tracks changes in the size of the entire economy. In addition to serving as a comprehensive measure of economic health, GDP reports provide insight into the factors driving or holding back economic growth.
Economic health as measured by changes in GDP matters a lot for financial asset prices. Since stronger economic growth tends to translate into higher corporate earnings and investor risk appetite, it is positively correlated to stock prices. Conversely, stronger GDP growth can hurt fixed-income investments like bonds, making their yields less attractive on a relative basis.
Although GDP reports provide a comprehensive estimate of economic health, they are not a leading economic indicator, but rather a look in the rear view mirror of the economy. Markets follow GDP reports in the context of those that have preceded them as well as other indicators that are more time sensitive and relative to consensus expectations.
The essential
A single GDP figure, whether an annual total or a rate of change, conveys minimal useful information about an economy. In context, it is an important tool used to assess the state of economic activity.