Gross Domestic Product - GDP

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What is 'Gross Domestic Product - GDP'

Gross domestic product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in a specific time period. Though GDP is usually calculated on an annual basis, it can be calculated on a quarterly basis as well (in the United States, for example, the government releases an annualized GDP estimate for each quarter and also for an entire year).

GDP includes all private and public consumption, government outlays, investments, private inventories, paid-in construction costs and the foreign balance of trade (exports are added, imports are subtracted).  Put simply, GDP is a broad measurement of a nation’s overall economic activity – the godfather of the indicator world.

'Gross Domestic Product - GDP'

 

The Significance of GDP

GDP is commonly used as an indicator of the economic health of a country, as well as a gauge of a country's standard of living. Since the mode of measuring GDP is uniform from country to country, GDP can be used to compare the productivity of various countries with a high degree of accuracy. Adjusting for inflation from year to year allows for the seamless comparison of current GDP measurements with measurements from previous years or quarters. In this way, a nation’s GDP from any period can be measured as a percentage relative to previous periods. An important statistic that indicates whether an economy is expanding or contracting, GDP can be tracked over long spans of time and used in measuring a nation’s economic growth or decline, as well as in determining if an economy is in recession (generally defined as two consecutive quarters of negative GDP growth).

GDP’s popularity as an economic indicator in part stems from its measuring of value added through economic processes. For example, when a ship is built, GDP does not reflect the total value of the completed ship, but rather the difference in values of the completed ship and of the materials used in its construction. Measuring total value instead of value added would greatly reduce GDP’s functionality as an indicator of progress or decline, specifically within individual industries and sectors. Proponents of the use of GDP as an economic measure tout its ability to be broken down in this way and thereby serve as an indicator of the failure or success of economic policy as well.
 

 
Providing a quantitative figure for GDP helps a government make decisions such as whether to stimulate a stagnant economy by pumping money into it or, conversely, to slow down an economy that's getting over-heated.

Businesses can also use GDP as a guide to decide how best to expand or contract their production and other business activities. And investors also watch GDP since it provides a framework for investment decision-making. The "corporate profits" and "inventory" data in the GDP report are a great resource for equity investors, as both categories show total growth during the period; corporate profits data also displays pre-tax profits, operating cash flows and breakdowns for all major sectors of the economy.

How to Determine GDP

There are three primary methods by which GDP can be determined. All, when correctly calculated, should yield the same figure. These three approaches are often termed the expenditure approach, the output (or production) approach and the income approach.

GDP Based on Spending

The expenditure approach or spending approach, which is the most common method, calculates the monies spent by the different groups that participate in the economy. For instance, consumers spend money to buy various goods and services and businesses spend money as they invest in their business activities (buying machinery, for instance). And governments also spend money. All these activities contribute to the GDP of a country. In addition, some of the goods and services that an economy makes are exported overseas, their net exports. And some of the products and services that are consumed within the country are imports from overseas. The GDP calculation also accounts for spending on exports and imports.

 

This approach essentially measures the total sum of everything used in developing a finished product for sale. To return to the example of the ship, the finished ship’s contribution to a nation’s GDP would here be measured by the total costs of materials and services that went into the ship’s construction. This approach assumes a relatively fixed value of the completed ship relative to the value of these materials and services in calculating value added.

A country's gross domestic product can be calculated using the following formula: GDP = C + G + I + NX. C is equal to all private consumption, or consumer spending, in a nation's economy, G is the sum of government spending, I is the sum of all the country's investment, including businesses capital expenditures and NX is the nation's total net exports, calculated as total exports minus total imports (NX = Exports - Imports).

GDP Based on Production

The production approach is something like the reverse of the expenditure approach. Instead of exclusively measuring input costs that feed economic activity, the production approach estimates the total value of economic output and deducts costs of intermediate goods that are consumed in the process, like those of materials and services. Whereas the expenditure approach projects forward beyond intermediate costs, the production approach looks backward from the vantage of a state of completed economic activity.

GDP Based on Income

Considering that the other side of the spending coin is income,  and since what you spend is somebody else’s income, another approach to calculating GDP – something of an intermediary between the two aforementioned approaches – is based on a tally of the national income. Income earned by all the factors of production in an economy includes the wages paid to labor, the rent earned by land, the return on capital in the form of interest, as well as an entrepreneur’s profits. An entrepreneur’s profits could be invested in his own business or it could be an investment in any outside business. All this constitutes national income, which is used both as an indicator of implied productivity and of implied expenditure.

In addition, the income approach factors in some adjustments for some items that don’t show up in these payments made to factors of production. For one, there are some taxes – such as sales taxes and property taxes – that are classified as indirect business taxes. In addition, depreciation – which is a reserve that businesses set aside to account for the replacement of equipment that tends to wear down with use – is also added to the national income.

GDP and GNI

Another adjustment can made for foreign payments made to Americans, which is income for Americans and U.S. payments made to foreigners, to arrive at the net foreign factor income. Subtracting the payments made to foreigners from the payments made to Americans provides a net foreign factor income.

With this approach, the GDP of a country is calculated as its national income plus its indirect business taxes and depreciation, as well as its net foreign factor income.  GDP calculated in this way – incorporating income received from overseas – is also referred to as gross domestic income (GDI), or as gross national income (GNI). In an increasingly global economy, GNI is increasingly being recognized as possibly a better metric for overall economic health than GDP because it measures national income, regardless of whether the income is earned by people within a country's borders or elsewhere in the world.

Because certain countries have most of their income withdrawn abroad by foreign corporations and individuals, their GDP figures are much higher than those of their GNI. For instance, in 2013, Luxembourg recorded $60.1 billion of GDP, while its GNI was $38.2 billion due to large payments it made to the rest of the world. In contrast, in 2013, the GDP in the United States was $16.8 trillion, while its GNI was $17 trillion, reflecting the fact U.S. corporations and U.S. citizens received net income from abroad.

Impact of the Balance of Trade

The balance of trade is one of the key components of a country's (GDP) formula. GDP increases when the total value of goods and services that domestic producers sell to foreigners exceeds the total value of foreign goods and services that domestic consumers buy, otherwise known as a trade surplus. If domestic consumers spend more on foreign products than domestic producers sell to foreign consumers – a trade deficit – then GDP decreases.

At first glance, it is tempting to believe protectionism leads to increased GDP. However, fewer imports directly lead to fewer exports. The vast majority of economic literature suggests that protectionist policies reduce the GDP of both domestic and foreign nations. And, as a logical corollary, strong evidence suggests trade liberalization, or the removal of protectionist barriers by a home country, creates significant productive benefits and expands GDP.
 

How Is the U.S. GDP Calculated?

The U.S. GDP is measured based on the expenditure approach. The Bureau of Economic Analysis (BEA) estimates the components used in the calculation from data ascertained through surveys of retailers, manufacturers, and builders and by looking at trade flows. Examples of these surveys include the Annual Survey of Manufacturers or the Housing Market Index. All output from offices located in the U.S., even if produced by foreign companies operating in the U.S., is included in the calculation. Usually, the U.S. gross national income (GNI) and gross domestic product (GDP) do not differ substantially.

Nominal vs. Real GDP

Considering that GDP is based on a monetary value of an economy’s output, it is subject to inflationary pressure. Over a period of time, prices typically tend to go up in an economy and this is reflected in the GDP. Thus, just by looking at an economy’s unadjusted GDP, it is difficult to tell whether the GDP went up as a result of production expanding in the economy or because prices escalated.

That’s why economists have come up with an adjustment for inflation to arrive at an economy’s real GDP, rather than its nominal GDP, which ignores inflation and deflation. By adjusting the output in any given year for inflation so that it reflects the price levels that prevailed in a reference year, called “the base year,” economists adjust for the inflation effect. This way, it is possible to compare a country’s GDP from one year to another and see if there is any real growth.

Real GDP is calculated using a GDP price deflator, which is the difference in prices between the current year and the base year. For example, if prices rose by 5% since the base year, the deflator would be 1.05. Nominal GDP is divided by this deflator, yielding real GDP.

Nominal GDP is usually higher than real GDP because inflation is typically a positive number. Real GDP accounts for the change in market value, which narrows the difference between output figures from year to year. A large discrepancy between a nation's real and nominal GDP signifies significant inflationary forces (if the nominal is higher) or deflationary forces (if the real is higher) in its economy.

Nominal GDP is used when comparing different quarters of output within the same year. When comparing the GDP of two or more years, real GDP is used because, by removing the effects of inflation, the comparison of the different years focuses solely on volume.

Overall, real GDP is a much better index for expressing long-term national economic performance. Take for example a hypothetical country which in the year 2000 had a nominal GDP of $100 billion, which grew to $150 billion by 2010 its nominal GDP. Over the same period of time, inflation reduced the relative value of the dollar by 50%. Looking at merely nominal GDP, the economy appears to be performing well, whereas the real GDP expressed in 2000 dollars would be $75 billion, revealing that in fact an overall decline in economic performance occurred.

Adjustment for Inflation

GDP figures as reported to investors are already adjusted for inflation. In other words, if the gross GDP was calculated to be 6% higher than the previous year, but inflation measured 2% over the same period, GDP growth would be reported as 4%, or the net growth over the period.

The relationship between inflation and the GDP plays out like a very delicate dance. For stock market investors, annual growth in the GDP is vital. If overall economic output is declining or merely holding steady, most companies will not be able to increase their profits, which is the primary driver of stock performance. However, too much GDP growth is also dangerous, as it will most likely come with an increase in inflation, which erodes stock market gains by making money (and future corporate profits) less valuable. Most economists today agree that 2.5-3.5% GDP growth per year is the most that an economy can safely maintain without causing negative side effects.
 

Why Does Inflation Increase with GDP Growth?

The growth of unadjusted GDP means that an economy has experienced one of five scenarios:

1. Produced more at the same prices.
2. Produced the same amount at higher prices.
3. Produced more at higher prices.
4. Produced much more at lower prices.
5. Produced less at much higher prices.

Scenario 1 implies that production is being increased to meet increased demand. Increased production leads to a lower unemployment rate, further increasing demand. Increased wages lead to higher demand as consumers spend more freely. This leads to higher GDP, eventually combined with inflation.

Scenario 2 implies that there is no increased demand from consumers, but that prices are higher. Through the early 2000s many producers were faced with increased costs due to the rapidly rising price of oil. Both GDP and inflation increase in this scenario. These increases are due to decreased supply of key commodities and consumer expectations, rather than increased demand.

Scenario 3 implies that there is both increased demand and shortage of supply. Businesses must hire more employees, further increasing demand by increasing wages. Increased demand in the face of decreased supply quickly forces prices up. In this scenario, GDP and inflation both increase at a rate that is unsustainable and is difficult for policymakers to influence or control.

Scenario 4 is unheard of in modern democratic economies for any sustained period and would be an example of a deflationary growth environment.

Scenario 5 is very similar to what the United States experienced in the 1970s and is often referred to as stagflation. GDP rises slowly, below the desired level, yet inflation persists and unemployment remains high due to low production.

Why GDP Fluctuates

GDP fluctuates because of the business cycle. When the economy is booming and GDP is rising, there comes a point when inflationary pressures build up rapidly as labor and productive capacity near full utilization. This leads the central bank to commence a cycle of tighter monetary policy to cool down the overheating economy and quell inflation.

As interest rates rise, companies and consumers cut back their spending, and the economy slows down. Slowing demand leads companies to lay off employees, which further affects consumer confidence and demand. To break this vicious circle, the central bank eases monetary policy to stimulate economic growth and employment until the economy is booming once again. Rinse and repeat.

Consumer spending is the biggest component of the economy, accounting for more than two-thirds of the U.S. economy. Consumer confidence, therefore, has a very significant bearing on economic growth. A high confidence level indicates that consumers are willing to spend, while a low confidence level reflects uncertainty about the future and an unwillingness to spend.

Business investment is another critical component of GDP, since it increases productive capacity and boosts employment. Government spending assumes particular importance as a component of GDP when consumer spending and business investment both decline sharply, as, for instance, after a recession. Finally, a current account surplus boosts a nation’s GDP, while a chronic deficit is a drag on GDP.

History

GDP first came into use in 1937 in a report to the U.S. Congress in response to the Great Depression after Russian economist Simon Kuznets conceived the system of measurement. At the time, the preeminent system of measurement was the Gross National Product (GNP) (see below). After the Bretton Woods conference in 1944, GDP was widely adopted as the standard means for measuring national economies, though the U.S. actually used GNP as its official measure of economic welfare until 1991, after which it switched to GDP.

Beginning in the 1950s, however, some began to question the faith of economists and policy makers in GDP internationally as a gauge of progress. Some observed, for example, a tendency to accept GDP as an absolute indicator of a nation’s failure or success, despite GDP’s failure to account for health, distribution of wealth, discrimination and other constituent factors of public welfare. In other words, these critics drew attention to a distinction between economic progress and social progress. Others, like Arthur Okun, an economist for President Kennedy’s Council of Economic Advisers, held firm to the belief that GDP is as an absolute indicator of economic success, claiming that for every increase in GDP there would be a corresponding drop in unemployment.

In recent decades, governments have created various nuanced modifications in attempts to increase GDP accuracy and specificity. Means of calculating GDP have also evolved continually since its conception so as to keep up with evolving measurements of industry activity and the generation and consumption of new, emerging forms of intangible assets.

Refinements to GDP

There are a number of adjustments to GDP used by economists to improve its explanatory power. On its own, nominal GDP is a very poor figure for the purpose of making comparisons. After all, populations and costs of living are not consistent around the world. Nothing much could be gleaned by comparing the nominal GDP of China to the nominal GDP of Ireland. For starters, China has approximately 300 times the population of Ireland. To solve for this problem, statisticians instead compare GDP per capita. GDP per capita is calculated by dividing a country's total GDP by its population, and this figure is frequently cited to assess the nation's standard of living.

Even so, the measure is still imperfect. Suppose China has a GDP per capita of $1,500, while Ireland has a GDP per capita of $15,000. This doesn't necessarily mean that the average Irish person is 10 times better off than the average Chinese person. GDP per capita doesn't account for how expensive it is to live in a country. Purchasing power parity (PPP) attempts to solve this by comparing how many goods and services an exchange-rate-adjusted unit of money can purchase in different countries – comparing the price of an item, or basket of items, in two countries after adjusting for the exchange rate between the two, in effect.

Real per capita GDP, adjusted for purchasing power parity, is a heavily refined statistic to measure true income, which is an important element of well-being. An individual in New York might make $100,000 a year, while an individual in Wyoming might make $50,000 a year. In absolute terms, the worker in New York is better off. But if a year's worth of food, clothing and other items costs three times as much in New York than Wyoming, however, the worker in Wyoming has a higher real income.

Difference between GDP and GNP

GNP differs from GDP in that GNP measures the productivity of a nation’s citizens regardless of their locales, as opposed to the GDP’s measurement of production by geographic location.  In other words, GDP refers to and measures the domestic levels of production within the physical borders of  a country, whereas GNP measures the levels of production of a person or corporation of a particular nationality both at home and abroad. For example, the U.S.'s GNP measures the production levels of any American or American-owned entity, regardless of where the actual production process is taking place, and defines the economy in terms of the citizens.

Depending on circumstances, GNP can be either higher or lower than GDP. This depends on the ratio of domestic to foreign manufacturers in a given country. For example, China's GDP is $300 billion greater than its GNP, according to Knoema, a public data platform, due to the large number of foreign companies manufacturing in the country, whereas the GNP of the U.S. is $250 billion greater than its GDP, because of the mass amounts of production that take place outside of the country's borders.

Though both calculations attempt to measure the same thing, generally speaking, GDP has become the more commonly utilized method of measuring a country's economic success in the world, especially now that the global economy is increasingly interconnected. It is possible for a citizen in one country to produce goods and services in many countries simultaneously over the Internet or through modern supply chains. This raises definitional and accounting issues for GNP calculations. Still, GNP can be useful as well, and it is important to reference both when trying to get an accurate sense of a given country's economic worth.

Using GDP Data

Most nations release GDP data every month and quarter. In the U.S., the Bureau of Economic Analysis (BEA) publishes an advance release of quarterly GDP four weeks after the quarter ends, and a final release three months after the quarter ends. The BEA releases are exhaustive and contain a wealth of detail, enabling economists and investors to obtain information and insights on various aspects of the economy.

GDP data's market impact is generally limited, since it is “backward looking,” and a substantial amount of time has already elapsed between the quarter end and GDP data release. However, GDP data can have an impact on markets if the actual numbers differ considerably from expectations. For example, the S&P 500 had its biggest decline in two months on Nov. 7, 2013, on reports that U.S. GDP increased at a 2.8% annualized rate in Q3, compared with economists’ estimate of 2%. The data fueled speculation that the stronger economy could lead the U.S. Federal Reserve (the Fed) to scale back its massive stimulus program that was in effect at the time.

One interesting metric that investors can use to get some sense of the valuation of an equity market is the ratio of total market capitalization to GDP, expressed as a percentage. The closest equivalent to this in terms of stock valuation is market cap to total sales (or revenues), which in per-share terms is the well-known price-to-sales ratio.

Just as stocks in different sectors trade at widely divergent price-to-sales ratios, different nations trade at market-cap-to-GDP ratios that are literally all over the map. For example, the U.S. had a market-cap-to-GDP ratio of 120% as of Q3 2013, while China had a ratio of just over 41% and Hong Kong had a ratio of over 1300% as of end of 2012.

However, the utility of this ratio lies in comparing it to historical norms for a particular nation. As an example, the U.S. had a market-cap-to-GDP ratio of 130% at the end of 2006, which had dropped to 75% by the end of 2008. In retrospect, these represented zones of substantial overvaluation and undervaluation, respectively, for U.S. equities.

Criticisms of GDP

There are, of course, drawbacks to using GDP as an indicator. Some criticisms of GDP as a measure are:

  • It does not account for several unofficial income sources – GDP relies on official data, so it does not take into account the extent of the  underground economy, which can be significant in some nations. Everything from under-the-table employment to black market activity (Illegal activities that generate a lot of income) doesn't factor into GDP calculations. GDP also fails to quantify the value of volunteer work or the services of a stay-at-home parent.
  • It is an imperfect measure in some cases –  GDP does not take into account profits earned in a nation by overseas companies that are remitted back to foreign investors. This can overstate a country's actual economic output. For example, Ireland had GDP of $210.3 billion and GNP of $164.6 billion in 2012, the difference of $45.7 billion (or 21.7% of GDP) largely being due to profit repatriation by foreign companies based in Ireland. A second issue is population size: China and India have many more possible producers and consumers than, say, Switzerland or Ireland. Most economists advocate using GNP or GDP per capita to account for the real impact of income growth on individuals.
  • It emphasizes economic output without considering economic well-beingGDP growth alone cannot measure a nation's development or its citizens' well-being. For example, a nation may be experiencing rapid GDP growth, but this may impose significant cost to society in terms of environmental impact and increase in income disparity. Some criticize the tendency of GDP to be interpreted as a gauge of material well-being, when in reality it serves as a measure of productivity.

 

Sources for GDP

The World Bank hosts one of the most reliable Web-based databases. It has one of the best and most comprehensive list of countries for which it tracks GDP data. The International Money Fund (IMF) also provides GDP data through its multiple databases, such as World Economic Outlook and International Financial Statistics.

The U.S. Federal Reserve collects data from multiple sources, including a country's statistical agencies and the World Bank. The only drawback to using a Federal Reserve database is a lack of updating in GDP data and an absence of data for certain countries. Another highly reliable source of GDP data is Organization for Economic Cooperation and Development (OECD). The OECD provides not only historical data but also forecasts for GDP growth. The disadvantage of using the OECD database is that it tracks only OECD member countries and a few nonmember countries.

 

The Bottom Line

In their seminal textbook "Economics," Paul Samuelson and William Nordhaus neatly sum up the importance of the national accounts and GDP. They liken the ability of GDP to give an overall picture of the state of the economy to that of a satellite in space that can survey the weather across an entire continent. GDP enables policymakers and central banks to judge whether the economy is contracting or expanding, whether it needs a boost or restraint, and if a threat such as a recession or inflation looms on the horizon.

The national income and product accounts (NIPA), which form the basis for measuring GDP, allow policymakers, economists and business to analyze the impact of such variables as monetary and fiscal policy, economic shocks such as a spike in oil prices, and tax and spending plans on the overall economy and on specific components of it. Along with better informed policies and institutions, national accounts have contributed to a significant reduction in the severity of business cycles since the end of World War II.