GDP Definition: How the Gross Domestic Product Affects You
Gross domestic product (GDP) is the total value of everything produced within a country's borders. 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 (BEA) measures GDP quarterly, and it revises the quarterly estimate every month 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).
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. It's also known as the "current-dollar" GDP because it is measured with current market prices. At the end of the first quarter of 2020, the nominal U.S. GDP was $21.538 trillion.
To get the real GDP, the Bureau of Economic Analysis (BEA) removes the effects of inflation. The real GDP allows economists to compare figures from different years. 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. Incomes 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 GDP, and at the end of the first quarter of 2020, it was $18.988 trillion. As of May 22, 2020, the BEA uses 2012 as the base year for its real GDP data.
The GDP growth rate is the percentage increase in GDP from quarter to quarter, and it changes as the economy moves through the business cycle. If the growth rate is negative, the economy contracts, and it signals 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 first quarter of 2020, the U.S. nominal and real GDP decreased by 3.5% and 4.8%, respectively.
Many economists agree that roughly 2% is an ideal growth rate that allows for sustainable economic growth. Rates that are faster than that can lead to inflation and asset bubbles, both of which can contribute to economic downturns.
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 the first quarter of 2020, the U.S. GDP per capita was $57,621. 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 Federal Reserve, the central bank in the U.S., 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. The federal funds rate affects any interest rate you encounter in your life, from mortgages to personal loans to yields on your savings account. In this example, the Fed is raising rates, so you should lock in a fixed-rate mortgage. Your payments on an adjustable-rate mortgage would 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 to see the corresponding job loss because it takes time for executives to compile the layoff list and prepare exit packages, but when economic growth slows, it's inevitable for many companies. This delay between economic growth rates and the impact on individual workers makes unemployment a lagging indicator.
Finding Opportunities During Downturns
The BEA offers breakdowns of GDP data that examine specific sectors and products. You can use these details to determine which sectors of the economy are growing and which are declining. Even during hard economic times, particular sectors continue to add jobs, such as the health care industry during the 2008 financial crisis. This report also helps you determine whether you should invest in, say, a tech-specific mutual fund instead of a fund that focuses on agribusiness.
Problems With GDP
The GDP is designed to measure the market value for all products and services within a country's borders. Since the measurement hinges on market price, there are many aspects of society—including many aspects that factor into economic well-being—that aren't included in the GDP numbers.
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 more accurate measurement of a country's standard of living may include environmental conditions.
Another criticism is that GDP doesn't include unpaid services. It leaves out unpaid child care and volunteer work, for example, despite the significant impact they have on the economy and a country's 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. One estimate that is referenced by the Bureau of Labor Statistics pegs the shadow economy's size as 8.8% of the GDP.