Gross Domestic Product and How It Affects You

what is gdp
Image by Catherine Song. © The Balance 2019

Gross domestic product (GDP) is the total value of everything produced in a country, regardless of if its citizens or foreigners produced it. When economists talk about the "size" of the economy, they are referring to GDP.

To avoid double-counting, GDP includes the final value of the product, but not the parts that go into it. For example, a U.S. footwear manufacturer uses shoelaces and other materials made in the U.S., but only the value of the shoe gets counted; the shoelaces don't. In the U.S., the Bureau of Economic Analysis measures GDP quarterly, and each month, it revises the quarterly estimate as it receives updated data.

The components of GDP include personal consumption expenditures (C), business investments (I), government spending (G), exports (X), and imports (M). GDP is equal to C + I + G + (X - M).

Types

There are many different ways to measure a country's GDP, so it's important to know all the different types and how they are used. A country's nominal GDP is the raw measurement that includes price increases. At the end of the third quarter in 2019, nominal U.S. GDP was $21.54 trillion.

To get the real GDP and compare it by year, the Bureau of Economic Analysis (BEA) removes the effects of inflation. Otherwise, it might seem like the economy is growing when it's actually suffering from double-digit inflation. The BEA calculates real GDP by using a price deflator, which tells you how much prices have changed since a base year. Income from U.S. companies and people from outside the country are not included, which removes the impact of exchange rates and trade policies. Real GDP is lower than nominal, and at the end of the third quarter in 2019, it was $19.121 trillion. The BEA provides this figure using 2012 as the base year.

The GDP growth rate is the percentage increase in GDP from quarter to quarter, and it changes depending on the phase of the business cycle. If the growth rate is negative, the economy contracts, signaling a recession. If it contracts for years, that's a depression. If the growth rate is too high, it creates inflation. The BEA provides the U.S. GDP growth rate monthly, and at the end of the third quarter in 2019, the U.S. nominal and real GDP increased by 3.8% and 2.1%, respectively.

Many economists agree that the ideal growth rate for developed economies is between 2% and 3%. Rates that are faster than that can lead to inflation and asset bubbles.

Some countries have a big GDP only because of their large population. GDP per capita is the best way to compare GDP between countries because it divides the GDP by the number of residents, and measures the country's standard of living. In 2019, the U.S. GDP per capita was $57,997. The best way to compare GDP per capita by year or between countries is with real GDP per capita. This takes out the effects of inflation, exchange rates, and differences in population. 

How GDP Affects You

GDP impacts personal finance, investments, and job growth. Investors look at a nation's growth rate to decide if they should adjust their asset allocation, as well as compare country growth rates to find their best international opportunities. They purchase shares of companies that are in rapidly growing countries.

The U.S. central bank, the Federal Reserve, uses the growth rate to determine monetary policy. 

The Fed implements expansionary monetary policy to ward off recession and contractionary monetary policy to prevent inflation. Its primary tool is the federal funds rate. For example, if the growth rate is increasing, then the Fed raises interest rates to stem inflation. In this case, you should lock in a fixed-rate mortgage. Your payments on an adjustable-rate mortgage will rise along with the fed funds rate.  

If growth slows or becomes negative, then you should update your resume because low economic growth leads to layoffs and unemployment. It may take a few months because it takes time for executives to compile the layoff list and prepare exit packages, but it's inevitable for many companies. 

Use the GDP report from the BEA to determine which sectors of the economy are growing and which are declining. Even during hard economic times, particular sectors continue to add jobs; take the health care industries during the 2008 financial crisis, for example. This report also helps you determine whether you should invest in, say, a tech-specific mutual fund versus a fund that focuses on agribusiness.

Problems With GDP

One of the biggest criticisms of GDP it that it doesn't count environmental costs. For example, the price of plastic is low because it doesn't include the cost of pollution. GDP doesn't measure how these costs impact the well-being of society. A country will improve its standard of living when it factors in environmental costs.

Another criticism is that GDP doesn't include unpaid services. It leaves out child care and unpaid volunteer work, and as a result, the economy undervalues these contributions to the quality of life.

GDP also does not count the shadow or black economy. It underestimates economic output in countries where many people receive their income from illegal activities. These products aren't taxed and don't show up in government records, and although they can estimate, they cannot accurately measure this output. International financial watchdog group Global Financial Integrity estimated the black market contributed up to $2.2 trillion to the $127.8 trillion global economy in 2017.

Likewise, societies only value what they measure. For example, Nordic countries rank high in the World Economic Forum's Global Competitiveness Report. Their budgets focus on the drivers of economic growth, including world-class education, social programs, and a high standard of living. These factors create a skilled and motivated workforce. These countries also have a high tax rate, which slows GDP growth. However, they use the revenues to invest in the long-term building blocks of economic growth.

Riane Eisler's book, "The Real Wealth of Nations," proposes changes to the U.S. economic system by giving value to activities at the individual, societal, and environmental levels.

Article Sources

  1. Bureau of Economic Analysis. "Measuring the Economy," Page 3. Accessed Jan. 14, 2020.

  2. Bureau of Economic Analysis. “Gross Domestic Product, Third Quarter 2019 (Third Estimate)." Accessed Jan. 14, 2020.

  3. Stanford University. "The Facts of Economic Growth," Page 2. Accessed Dec. 30, 2019.

  4. Federal Reserve Economic Data. "Real Gross Domestic Product Per Capita." Accessed Jan. 19, 2020.

  5. Bureau of Economic Analysis. “National Income and Product Accounts." Accessed Jan. 19, 2020.

  6. Federal Reserve Bank of Atlanta. "Gross Domestic Product - An Economist's Perspective." Accessed Jan. 19, 2020.

  7. Riane Eisler. "The Real Wealth of Nations: Creating A Caring Economics," Page 233. Accessed Jan. 19, 2020.

  8. Central Intelligence Agency. “The World Factbook.” Accessed Jan. 19, 2020.

  9. Global Financial Integrity. “Transnational Crime and the Developing World.” Accessed Jan. 20, 2020.