Summary - Businesses and investors rely on the gross domestic product (GDP) as an indication of where our economy is at in terms of the business cycle. When GDP is rising and the economy is growing, inflation will rise because supply and demand are reaching what is termed “full utilization”. In response, a government’s central bank will try to moderate the economy by tightening their monetary policy with actions such as raising interest rates.
These actions, in turn, cause companies and consumers to cut back. As supply and demand decreases, businesses may begin to lay off employees, thus raising the unemployment rate and causing consumer confidence to sink lower. This will, in turn, lead a government to loosen monetary policy in an effort to stimulate growth and avoid or mitigate the effects of, a recession.
This business cycle illustrates most of the components that make up GDP. Consumer spending (which accounts for about 2/3 of GDP), business investment since it impacts the national employment level, and government spending which tends to increase at times when consumers and businesses are spending less.
Another component of GDP is our trade balance. A trade surplus is a positive addition to GDP. Conversely, a trade deficit is a drag on GDP.
GDP can be measured using one of three models: The expenditure approach, the production approach, or the income approach. Each method comes at the calculation from a different point of view. However, if the numbers are properly calculated the net result should be very similar. The United States uses the expenditure method when calculating GDP.
GDP is typically calculated as an annual figure, however, in many cases, it is reported quarterly and adjusted on an annualized basis. Often the quarterly figure you hear for the United States GDP is adjusted upwards or downwards the following quarter based on new data.
The importance of GDP is that it is seen as one of the broadest measures of economic activity. However, it is just a snapshot that indicates a rate of economic growth that does not always provide the proper context. With that in mind, there are other economic indicators such as Real GDP, Real National Income (RNI) and Real National Product (RNP) that use GDP as a starting point but include offsets to help refine the number into something that can provide a clear direction on the state of a country’s economy.
According to the U.S. Bureau of Economic Analysis, the U.S. economy expanded at a rate of 2.6% in the fourth quarter of 2018. It beat analysts’ expectations for a growth rate of 2.2%. For the entire year, the economy grew at a rate of 2.9%. But what does that mean?
The answer to the question is – it’s hard to say. The 2.6% growth rate is a measurement of the country’s gross domestic product (GDP), one of the broadest measurements of overall economic activity in the country. GDP only looks at what has happened; the data is not predictive in and of itself.
In this article, we'll break down the meaning of the gross domestic product. In addition to a basic definition, we’ll discuss what components are included in GDP, why it is significant, how it differs from other economic indicators and what it says about the business cycle and inflation.
What is the gross domestic product (GDP)?
Gross domestic product is a measurement of the monetary value of all the final goods and services that a country produces within its borders over a specific time period. The GDP of a country is typically calculated as an annual measurement, but it can be calculated on a quarterly basis. The United States releases annualized GDP estimates every quarter as well as for the entire year.
What is included in the gross domestic product?
GDP is a broad measure of overall economic activity. It includes all consumption (both public and private), government outlays, investments, private inventories, paid-in construction costs and the foreign balance of trade (exports-imports). Gross domestic product is sometimes confused with the gross national product (GNP). However, GNP excludes domestic production by foreigners.
Why is gross domestic product significant?
GDP is a broad measurement of where a country is at in their business cycle. When GDP is rising it is usually an indication that the economy is healthy and strong. When GDP is declining it usually indicates that the economy is slowing down. This could be an indicator that the economy is headed for or confirm the existence of, a recession. While neither of those statements is an absolute, GDP can be used to help businesses and investors make decisions. For a business, GDP can be one measurement that they use to make strategic decisions such as increasing or cutting back their production or whether to pursue acquisitions. Investors can find information such as corporate profits and inventory numbers that are broken down by individual sectors. Governments can use the GDP figures to set things like monetary policy which includes the pace and amount of interest rate adjustments and it can offer guidance on the rate of inflation.
How is gross domestic product measured?
There are actually three different ways that a country determines GDP. When calculated correctly, they should all lead to roughly the same result.
- Expenditure Approach– this is also known as GDP based on spending and it is considered the most common approach. This approach accounts for both consumer spending and government spending. It also takes into account the goods and services that are made in a country and exported overseas (net exports) as well as the goods and services that are purchased in this country but brought in from overseas (net imports). One way to look at the expenditure approach is that it measures the sum of all the materials and services that are used to develop a finished product for sale.
The formula for calculating GDP using the expenditure approach is:
GDP = C + G + I + NX
C = Consumer Spending
G = Government Spending
I = Sum of a Country’s Investments (including capital expenditures)
NX = Total Net Exports (Net Exports – Net Imports)
- Production Approach– this approach estimates the total value of economic output and deducts from that the costs of intermediate goods that are consumed in the process. It is different from the expenditure approach because it is not looking forward to project economic activity, but is looking backward at the economic activity that has been completed.
- Income Approach– this approach looks at the income side of the economy. The theory behind it is that everything that makes up national income can be used as implied productivity as well as implied expenditure. So if consumer income is increasing, it should lead to increased spending. If a business owner is making profits, they can apply that to their business or make an investment in something else. It also takes into account the interest earned from investments. The income approach will also take into account some offsetting factors to business income such as property taxes, sales taxes, and depreciation.
How does the United States calculate its GDP?
The United States uses the expenditure approach. The components of the calculation are estimated by the Bureau of Economic Analysis (BEA). The BEA collects data from surveys sent to retailers, manufacturers, and builders. These surveys include key economic indicators such as the Annual Survey of Manufacturers and the Housing Market Index. In addition to looking at the output from these U.S. offices, the BEA also looks at a country’s balance of trade.
How does the balance of trade affect GDP?
Since one of the components is exports minus imports, the balance of trade is considered to play a significant role in a country’s calculation of GDP. When the balance of trade is positive it is known as a trade surplus, which has a positive effect on GDP. When it is negative, it is known as a trade deficit which has a negative effect on GDP.
How is GDP different from GNI?
Gross National Income (GNI) is an additive component to GDP. GNI adds the net income a country receives from overseas. This is known as a country’s net foreign factor income. GDP only counts income that comes from domestic sources. The calculation for GNI is as follows:
GNI = (GDP + indirect business taxes and depreciation) – net foreign factor income
GNI is similar to another measure of economic activity, Gross National Product (GNP). However, whereas GNP measures output, the calculation for GNI is based on income. While GNI is seen to be a more accurate economic indicator than GNP, it is not statistically significant from GDP for most countries. In 2016, for example, the United States had a GNI that was 1.5% larger than its GDP.
What does GDP say about price movement?
One of the limitations to GDP is that it does not adjust for inflation or deflation. Therefore if GDP increases, it can be unclear to say that the growth is due to expanded production or if it’s because prices were increasing (inflation). To compensate for this, economists created a new measurement called Real GDP.
Real GDP uses what is called a GDP price deflator (or implicit price deflator). The implicit price deflator measures the difference in prices between the current year and the base year. For example, if prices rose 4% since the base year, the deflator would be 1.04.
Real GDP = Nominal GDP/1.04
Because inflation is almost always a positive number, nominal GDP will be higher than real GDP. If there is a wide difference between a country’s nominal GDP and real GDP it usually indicates strong inflationary pressure (if nominal GDP is significantly higher) or deflationary pressure (if real GDP is significantly higher).
When comparing two or more quarters within the same year, economists use nominal GDP numbers. However, if looking at the economic growth between two or more years, economists will use real GDP to account for the effects of inflation.
If non-adjusted (nominal) GDP is increasing it means the economy is doing one of five scenarios:
- Producing more at the same prices– This is a state where supply and demand are increasing, unemployment levels are declining and wages are increasing which in turn is fueling even higher demand. This cycle increases GDP and subsequently, increases inflation.
- Producing the same amount at higher prices– This is a state which implies no change in demand, but higher prices. In this case, both GDP and inflation will rise but because of decreased commodity supply and lower consumer expectations.
- Producing more at higher prices– This is a state that implies higher demand but a shortage of supply. In this case, production (by way of employment) increases fueling demand. In this scenario, prices often rise quickly. Frequently this is an unsustainable scenario.
- Producing more at lower prices– This is a state that would suggest high deflation. It is virtually unheard of for a modern economy to sustain such an economy.
- Producing less at significantly higher prices– This is a state known as stagflation and it happens when GDP rises, but less than desired and is met with high inflation and unemployment.
Refining GDP for global comparisons
Because the population and costs of living impact are different around the world, when comparing the GDP of one country to another, economists frequently use refined data to present a more accurate picture. One of the most common is GDP per capita which divides a nation’s GDP by its population. Per capita GDP is often cited when economists try to assess the quality of life (standard of living) between two countries. Another refined model is Purchasing Power Parity (PPP). This model is based on an economic theory that compares the currency of different countries by assuming two currencies are in equilibrium when a basket of goods is priced the same in both countries. A similar model to PPP is the Law of One Price (LOOP). LOOP predicts that after a country accounts for differences in their interest rate and exchange rates, the cost of a good in one country should be the same as that of another country in real terms.
The final word on gross domestic product
Gross domestic product (GDP) is one of the most closely observed economic indicators that our country or any country releases. Although just a snapshot of a country’s economic performance, it can provide businesses and investors with confirmation of what they are viewing or it can point to a reversal of what they are forecasting.
While being a somewhat imperfect measure, GDP does suggest the current state of our nation's employment rate, consumer confidence, and our trade balance. Although useful for comparing economic performance between quarters or years for a single country, GDP often needs to be refined into measurements such as GDP per capita, purchasing power parity (PPP) and the law of one price (LOOP) are used to compare the economic activity of different countries.
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