What Does GDP Tell You?
The basic function of GDP is to gauge the overall health of the economy over time. Generally speaking, the better the GDP, the more likely businesses are to prosper and the lower unemployment will be.
When comparing the current GDP estimates to previous values, we can say that the economy is either:
- Expanding - Producing more goods and services than in the previous period
- Contracting - Producing fewer goods and services than in the previous period
With this information, policymakers and economists can make important decisions about how the economy may be trending and if any actions are necessary. For example:
- The White House may use the GDP data to support new legislation. This could result in changes to the federal budget or tax code.
- The Federal Reserve will consider GDP data as well as many other economic factors when it meets to set monetary policy. With this information, they may decide to raise, lower, or keep the federal funds rate the same.
- Business leaders may look at GDP values for their industry and make predictions about what may happen over the next year. This could mean adjustments to their earnings forecasts to potentially result in workforce hiring or layoffs.
GDP can also be used to compare the U.S. to other countries around the world. This gives world leaders and decision-makers a better understanding of how the global economy may be performing as a whole.
Real GDP
It’s important to remember that because GDP is measured over various periods, the time value of money must also be considered. For this reason, economists will take the nominal (current) values of GDP and adjust them for inflation. This gives what’s called the “real GDP” value making them more comparable.
GDP and Recessions
For many decades, GDP has been associated with a recession. A recession can be defined as a significant decline in economic activity. Most recessions are characterized by lower business earnings, higher unemployment, and a downturn in the stock market.
In the past, the rule of thumb was that if the real GDP declined for two or more consecutive quarters, then the country was considered to be in a recession. However, in 2022, the National Bureau of Economic Research (NBER) - the committee that officially declares recessions - revised its stance on how recessions should be determined. They have now said that while GDP is an important factor, they also look at several other key pieces of economic data before drawing a conclusion.
What's Included in GDP?
Gross Domestic Product includes the sale of all final goods and services to its end users. This can be described using the following equation:
GDP = C + I + G + (X-M)
Where:
- C = Personal Consumption Expenditures - The total of all goods and services purchased by consumers. Also known as consumer spending, this category covers everything from food to gas and even insurance coverage.
- I = Gross Private Investment - The total amount of purchases made by businesses for fixed assets. This generally includes things like buildings, machinery, equipment, etc. This category also includes new home purchases by consumers.
- I = Gross Private Investment - The total amount of purchases made by businesses for fixed assets. This generally includes things like buildings, machinery, equipment, etc. This category also includes new home purchases by consumers.
- X - M = Exports minus Imports - The value of goods exported from the U.S. against those imported into the U.S. using U.S. dollars. This category is also referred to as “net exports”.
What's Not Included in GDP?
While GDP encompasses a wide range of transactions across various sectors, it does not include the sale of all goods and services. The following are items that may be excluded from this figure:
- Used goods - Items resold such as existing homes and used cars.
- Goods produced outside the U.S. - Products such as TVs or appliances are imported from another country and sold in the open market.
- Intermediate goods - Items within a supply chain that are sold between businesses. For example, bread sold to consumers is included in GDP while the flour sold to the bread manufacturers is excluded.
- Pure financial transactions - The trading of stocks, bonds, mutual funds, ETFs (exchange-traded funds), etc.
- Wear and tear - Assets and capital that get used over multiple years (appearing as depreciation on financial statements).
- Volunteer work - Service hours and unpaid work.
- Black-market activities - The sale of illegal goods and services.
Who Measures GDP in the U.S.?
In the U.S., gross domestic product is measured by the BEA or "Bureau of Economic Analysis". They do this by estimating the nation's GDP each year and quarter. The BEA also releases new GDP statistics each month; however, these are just forecasts about what the upcoming quarter values may be based on the best available data at the time.
Who Came Up with GDP?
GDP, as we know it today, was developed in 1934 by economist Simon Kuznets for a 1934 U.S. Congress report. Previously, the government relied on a different metric called GNP or “gross national product” - the value of all the finished goods and services produced by the country's factors of production irrespective of their location.
In the years leading to Kuznet’s creation, the U.S. had just experienced one of the greatest stock market crashes in history and began sliding into what became known as the Great Depression. The government needed a better way to prevent financial crises like these from happening in the future, and so Kuznets was put to the task. After the Bretton Woods conference in 1944, GDP became widely accepted as the main tool for measuring a country's economy.
The Bottom Line
Measuring the gross domestic product of a country helps policymakers to know if the economy is expanding or contracting. This gives them a basis for steering important decisions ranging from taxes, monetary policy, and business activity.
Because GDP focuses only on the sale of final goods and services to end users, it does not include important sectors such as the resale of existing homes and cars. It also excludes intermediate goods sold by suppliers and those items produced outside the U.S. Therefore, it's important to only use GDP alongside other economic metrics to holistically gauge how a region or industry may be performing.