What Is GDP and Why Is It So Important to Economists and Investors?

Gross domestic product (GDP) is one of the most widely used indicators of economic performance. GDP measures a national economy's total output in a given period, and is seasonally adjusted to eliminate quarterly variations based on climate or holidays. The most closely watched GDP measure 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 the GDP over time, which are reported as an annualized rate of growth or contraction. This makes it easier to compare annual and quarterly rates.

For Q3 2022, real (inflation-adjusted) U.S. GDP increased by 2.6% on an annualized basis. An annualized rate makes it possible to compare that decline with the 5.7% annual increase in real U.S. GDP in 2021.

Key Takeaways

  • Gross domestic product tracks the health of a country's economy.
  • It represents the value of all goods and services produced over a specific time period within a country's borders.
  • Economists can use GDP to determine whether an economy is growing or experiencing a recession.
  • Investors can use GDP to make investments decisions—a bad economy often means lower earnings and stock prices.
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What Is GDP?

Gross Domestic Product (GDP) Defined

GDP measures the monetary value of goods and services produced within a country's borders in a given time period, usually a quarter or a year. Changes in output over time as measured by the GDP are the most comprehensive gauge of an economy's health.

According to the International Monetary Fund, in 2022, the U.S. 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 as well as real, or inflation-adjusted, terms. One month after the end of each quarter, the BEA releases an advance estimate of the previous quarter's GDP. In the two succeeding months, the bureau releases second and third estimates that incorporate previously unavailable data.

While it's possible to deconstruct the GDP in various ways, the most common is to view it as the sum of a country's private consumption, investment, government spending, and net exports (or exports less imports).

The consumption and investment components of the GDP tend to be more reliable economic indicators than government spending or net exports. The 2.6% annualized increase in the third quarter of 2022 U.S. GDP was primarily the result of a jump in exports, consumer spending, government spending, and investment.

Nominal vs. Real GDP

GDP can be expressed in nominal or real terms. Nominal GDP is calculated based on the value of the goods and services produced as collected, so it reflects not just the value of output but also the change in the aggregate pricing of that output. In other words, in an economy with a 5% annual inflation rate nominal GDP will increase 5% annually as a result of the growth in prices even if the quantity and quality of the goods and services produced stays the same.

2.6%

U.S. real GDP growth rate (annualized) during the third quarter of 2022, after an annualized decline of 0.6% in the second quarter of 2022.

Real GDP, in contrast, is adjusted for inflation, meaning it factors out changes in price levels to measure changes in actual output. Policymakers and financial markets focus primarily on real GDP because inflation-fueled gains aren't an economic benefit.

To estimate real GDP, the BEA constructs chain indexes that allow it to adjust the value of the goods and services by the change in prices of those goods and services.

Measuring GDP

There are three primary ways of calculating GDP: first, by adding up what everyone earned (known as the income approach) or by adding up what everyone spent in a year (the expenditure method). Logically, both measures should arrive at roughly the same total.

The income approach, which is sometimes referred to as GDP(I), is the sum of the aggregate compensation paid to employees, business profits, and taxes less subsidies. The expenditure method already discussed is the more common approach and is calculated by adding private consumption and investment, government spending, and net exports.

Finally, GDP can be measured based on the value of the goods and services produced (the production or output approach). Because economic output requires expenditure and is, in turn, consumed, these three methods for computing GDP should all arrive at the same value.

In general, the following simplified equation is often employed to calculate a country's GDP via the expenditure approach:

BEA's estimates of U.S. GDP are based on national income and product accounts (NIPAs) for sectors including businesses, households, nonprofit organizations, and governments. NIPAs are compiled from seven "summary accounts" tracing receipts and outlays for each of those sectors. Detailed NIPA data also forms the basis for BEA GDP reports by state and industry.

BEA's GDP estimates omit illegal activities, care of own children, and volunteer work for lack of reliable data. A BEA researcher estimated counting illegal activities would have increased nominal U.S. GDP by more than 1% in 2017. At the same time, the GDP figures include BEA estimates of what homeowners would have paid to rent equivalent housing so that the GDP does not increase every time an owner-occupied home is rented.

GDP for Economists and Investors

GDP is an important measurement 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 insights into the factors driving economic growth or holding it back.

Economic health as measured by changes in the GDP matters a lot for the prices of financial assets. Because stronger economic growth tends to translate into higher corporate profits and investor risk appetite, it is positively correlated with share prices. Conversely, stronger GDP growth can hurt fixed-income investments like bonds, by making their returns less attractive on a relative basis.

While GDP reports provide a comprehensive estimate of economic health they are not a leading economic indicator but rather a look in the economy's rear-view mirror. Markets track GDP reports in the context of those that preceded them as well as other more time-sensitive indicators and relative to consensus expectations.

The Bottom Line

A single GDP number, whether an annual total or a rate of change, conveys a minimum of useful information about an economy. In context, it's an important tool used to assess the state of economic activity.

Article Sources
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  1. Bureau of Economic Analysis. "Gross Domestic Product, Third Quarter 2022 (Advance Estimate)."

  2. Bureau of Economic Analysis. "Gross Domestic Product (Third Estimate), Corporate Profits, and GDP by Industry, Fourth Quarter and Year 2021."

  3. International Monetary Fund. "GDP, Current Prices."

  4. U.S. Bureau of Economic Analysis (BEA). "Gross Domestic Product."

  5. Bureau of Economic Analysis. "Chained-Dollar Indexes: Issues, Tips on Their Use, and Upcoming Changes."

  6. Bureau of Economic Analysis. "Concepts and Methods of the U.S. National Income and Product Accounts," Pages 2-28 - 2-31.

  7. Bureau of Economic Analysis. "Why Isn't Household Production Included in GDP?"

  8. Bureau of Economic Analysis. "Concepts and Methods of the U.S. National Income and Product Accounts," Pages 2-2.

  9. Bureau of Economic Analysis. "Including Illegal Activity in the U.S. National Economic Accounts."

  10. Bureau of Economic Analysis. "Concepts and Methods of the U.S. National Income and Product Accounts," Pages 2-5, 5-45.

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