Key Takeaways
- Gross domestic product (GDP) is the value of everything produced in a particular country.
- To calculate GDP, add personal consumption expenditures to business investments, government spending and the difference between imports and exports.
- GDP can be measured or compared in a number of ways, including real GDP and GDP per capita.
- GDP can impact you in a number of ways—including through its influence on monetary policy and investors.
How GDP Works
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., theBureau of Economic Analysis(BEA) measures GDP quarterly, and it revises the quarterly estimate every month as it receives updated data.
How to Calculate GDP
Thecomponents of GDPincludepersonal consumption expenditures(C), business investments (I),government spending(G),exports(X), andimports(M). GDP is equal toC + I + G + (X - M).
Types of GDP Measurements
There are many different ways to measure acountry's GDP, so it's important to know all the different types and how they are used. A country'snominal GDPis 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 fourth quarter of 2021,the nominal U.S. GDPwas $24 trillion.
Real GDP
To get thereal GDP, the Bureau of Economic Analysis (BEA) removes the effects ofinflation. 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 calculatesreal GDPby 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 ofexchange ratesand trade policies. Real GDP is lower than nominal GDP, and at the end of the fourth quarter of 2021, it was $19.8trillion. The BEA uses 2012 as the base year for its real GDP data.
GDP Growth Rate
TheGDP growth rateis the percentage increase in GDP from quarter to quarter, and it changes as the economy moves through thebusiness cycle. If the growth rate is negative, the economycontracts, and it signals arecession. If it contracts for years, that's adepression. If the growth rate is too high, it creates inflation. The BEA provides theU.S. GDP growth ratemonthly, and at the end of the fourth quarter of 2021, the U.S. nominal and real GDP increased by 7.1% and 6.9%, respectively.
Note
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.
GDP Per Capita
Some countries have a big GDP only because of their large population.GDP per capitais the best way to compareGDP between countriesbecause it divides the GDP by the number of residents, and measures the country's standard of living.
In the fourth quarter of 2021, the U.S. GDP per capita was $50,553. 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 theirasset allocation, as well as compare country growth rates to find their best international opportunities. They purchasesharesof companies that are in rapidly growing countries.
Note
The Federal Reserve, the central bank in the U.S., uses the growth rate to determine monetary policy.
Interest Rates
The Fed implementsexpansionary monetary policyto ward off recession andcontractionary monetary policyto prevent inflation. Its primary tool is the federal funds rate. For example, if the growth rate is increasing, then the Fed raisesinterest ratesto 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.
Unemployment
If growth slows or becomes negative, then you should update your resume because low economic growth leads to layoffs andunemployment. 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 the2008 financial crisis. This report also helps you determine whether you should invest in, say, a tech-specificmutual fundinstead 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 is 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 orblack 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.
Frequently Asked Questions (FAQs)
How do you increase GDP?
There are various ways to increase GDP, also known as "stimulating economic growth." This can come from increasing the factors of production within the economy itself, as well as from stimulus from the government. Increasing factors of production usually involves investing and deregulation, while government stimulus can come in the forms of tax cuts, lower interest rates, or increased government spending.
Which country has the highest GDP?
The U.S. has the largest total GDP in the world. However, in terms of GDP per capita, Liechtenstein comes in highest, while the U.S. ranks 12th.
What is potential GDP?
Potential GDP is a theoretical measurement of what a country's economic output would be if it had employed the factors of production at the maximum rate that would balance growth with stable inflation. When a GDP is far below its potential, that is a sign of a recession. However, GDP above its potential could mean that production is unsustainable and that the economy is at risk of inflation.
