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What Is GDP?



GDP per capita measures the country's standard of living.

Photo: Blend Images - John Lund/Marc Romanelli

Real GDP is the best way to compare GDP growth from year to year.

Photo: Don Bishop/Getty Images
What Is GDP?

Auto manufacturing has been a backbone of the economy.

Photo: Bill Pugliano/Getty Images

The best way to understand a country's economy is by looking at its Gross Domestic Product (GDP). This economic indicator measures the country's total output. This includes everything produced by all the people and all the companies in the country. To get everything produced by a country's citizens, no matter where they are in the world, you should look at Gross National Product (GNP), also called Gross National Income (GNI).

The components of GDP are: Personal Consumption Expenditures plus Business Investment plus Government Spending plus (Exports minus Imports). Now that you know what the components are, it's easy to calculate GDP using the standard formula: C + I + G + (X-M).

Nominal GDP:

In 2013, U.S. GDP was $17.09 trillion. This is known as nominal GDP, which is the raw measurement that leaves price increases in the estimate. GDP is measured quarterly by the Bureau of Economic Analysis (BEA). However, the BEA revises that quarterly estimate each month as it receives updated data.

GDP per Capita:

If you want to compare GDP between countries, keep in mind some countries have a large economic output because they have so many people. To get a more accurate picture, it's helpful to use GDP per capita. This divide GDP by the number of people, and shows the real productivity of the population.

Real GDP:

To compare GDP from one year to another, it's important to take out the effects of inflation. To do this, the BEA calculates real GDP. It does this by using a price deflator, which tells you how much prices have changed since a base year. Real GDP is gotten by multiplying the deflator by the nominal GDP. To calculate real GDP, the BEA makes three important distinctions:

  1. Income from U.S. companies and people from outside the country are not included, so the impact of exchange rates and trade policies don't muddy up the number.
  2. The effects of inflation are taken out.
  3. Only the final product is counted, so that if someone in the U.S. makes shoelaces, and it is used to make shoes in the U.S., only the value of the shoe gets counted.

Real GDP is, therefore, lower than nominal GDP.  Real GDP for 2013 was $15.942 trillion. The BEA provides real GDP using 2005 as the base year in Table 1.1.6 Real GDP.

Real GDP per Capita:

You've probably already guessed that the best way to compare GDP by year and to other countries is with real GDP per capita. This takes out the effect of inflation, exchange rates and differences in population.

In fact, if you look at U.S. GDP History, you'll see that real GDP per capita has increase 180% since 1960 ($17,747 to $49,800). That sounds great until you realize that nominal GDP for the country has risen 2,992% ($543.3 billion to $16.245 trillion) in that same time period. That's the effect of inflation and population growth.

GDP Growth Rate:

The GDP growth rate is the percent increase in GDP from quarter to quarter. It tells you exactly how fast a country's economy is growing. Most countries use real GDP to remove the effect of inflation.

In the U.S., the BEA calculates the growth rate. For the most recent quarterly report, see Current GDP Statistics. Read U.S. GDP Growth to see the forecast of this important economic indicator, and to compare it each year since 1929 with the business cycle phase.

What GDP Tells You About the Economy:

Nominal GDP tells you the absolute output of any country. Real GDP allows you to compare countries. The U.S. recently regained its position as the world's largest economy. In comparing the economy of two different countries, you've got to take out the effects of inflation and exchange rates. The best way to do this is to use purchasing power parity.

The GDP growth rate measures if the economy is growing more quickly or more slowly than the quarter before. If it produces less than the quarter before, it contracts and the GDP growth rate is negative. This signals a recession. If it stays negative long enough, the recession turns into a depression. As bad as a recession is, you also don't want the GDP growth rate to be too high. Then you'll get inflation. The ideal GDP growth rate is between 2-3%.

How GDP Affects You:

Investors look at the GDP growth rate to see if the economy is changing rapidly so they can adjust their asset allocation. In addition, investors compare country GDP growth rates to decide where the best opportunities are. Most investors like to purchase shares of companies that are in rapidly growing companies.

The Federal Reserve uses the GDP growth rate to decide whether to implement expansionary monetary policy to ward off recession or contractionary monetary policy to prevent inflation. (For more, see The Federal Funds Rate and How It Works).

Let's say the GDP growth rate is speeding up, and the Fed raises interest rates to stem inflation. In this case, you would want to lock in a fixed-rate mortgage, because you know that an adjustable-rate mortgage will start charging higher rates next year.

If GDP is slowing down, or is negative, then you should dust off your resume. Declining GDP usually leads to layoffs and unemployment, but it can take several months. Declining GDP means business revenues are down. It can take awhile before executives can put together a layoff list and package. If you follow GDP statistics, you can be better prepared.

More About GDP:

You could also use the GDP report from the BEA to look at which sectors of the economy are growing and which are declining. This would help you determine whether you should invest in, say, a tech-specific mutual fund vs a fund that focuses on agribusiness. It can also help you find training in sectors that are growing. Even during the 2008 financial crisis, health care related industries continued to add jobs. Article updated July 15, 2014

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