GDP stands for Gross Domestic Product. Put simply, it is the total combined value of all produced goods and provided services in a country over a set period of time. Most often, it is calculated annually or quarterly. It is always expressed in the local currency and only covers final goods and services created and rendered within the country.
In short, it provides an overview of a country’s current economic health and standing, how it has grown or declined, and an estimate of how it may look in the near future.
- 1 Components of GDP
- 2 How Is GDP Calculated?
- 3 Why Are These Calculations Useful?
- 4 Types of GDP
- 5 Pros and Cons of GDP
- 6 The Bottom Line
Components of GDP
GDP is made up of several types of goods and services, which can be categorized in the following way:
Consumption is the largest section of GDP, accounting for roughly 55-60%. It is broken down into three groups:
- Durable goods (appliances and items that should last over three years, for example, furniture, large household appliances, and cars.)
- Non-durable goods (food produce, clothing, gas.)
- Services (everything from banking to education.)
Tracking the nation’s consumption habits and behaviors is essential for understanding the economy.
Purchases that are for the long-term rather than immediate use fall under fixed investment. They represent around 14% of GDP. The two types are:
- Residential investment (housing)
- Non-residential investment (equipment, machinery, commercial property)
Fixed investment reports give an understanding of how much new capital is rooted in the economy at any given time.
Change In Inventories
Despite being the most minor factor at roughly one percent of the total report, inventory changes have a significant impact. Business inventories tell us a lot about the market and economy. They can also heavily influence interest rates and stock prices.
If a business sees an unexpected increase in its inventory from one year to the next, it can signal a drop in demand or a change in buyer behavior. Decreased economic activity can be a precursor for recession, so it is vital to keep a close eye.
Changes in inventories also dictate production rates. If a business has twice as many goods left over, there may not be the need to manufacture the same amount going forward. Because the total amount is so low, this is considered part of fixed investments for the purpose of calculation.
Also referred to as government consumption, this category covers around 15% of a county’s GDP. It does not include transfers of money (for example, benefits or social security) but focuses on outright spending. Examples of government purchase included are:
- Military equipment and contracts
- Payroll for public servants
Generally speaking, this consumption does not fluctuate significantly. This part of GDP helps track a country’s budget deficit when compared to revenue and income.
Net Exports (Trade Balance)
Put simply, the trade balance is the country’s total exports minus the total imports. Imports reduce the GDP whereas exports are added to the total, so ideally, the latter should be higher. Net exports account for 10-15% of the final report. They can have quite an impact; however, they do not tend to have much of an effect on the markets.
How Is GDP Calculated?
The final GDP calculation is the sum of each component.
Consumption + fixed investments + government purchase + net exports = GDP.
This is known as the expenditure approach and is the method used by most countries (including the US.)
Why Are These Calculations Useful?
GDP tells banks, governments, and decision-makers a lot about the health and status of the economy. Although not infallible, this report can show if the economy is doing well or struggling, growing or shrinking, and can help make clear what action must be taken.
Types of GDP
The nominal GDP takes everything at face value. It is calculated based on current prices without any adjustments made for inflation rates. Without secondary reports, the nominal GDP figures can be misleading and inaccurate.
You may think the economy has grown if the nominal GDP is $2000 compared to the previous year’s total of $1990. If the inflation rate was the standard two percent, then you have actually seen a decrease. See real GDP for further information.
This economic measure is adjusted to allow for inflation rates and provides a more realistic picture of how a market has progressed. Rather than using the final total of goods and services measured, calculations are made with inflation incorporated.
To give an example, if the nominal GDP was $2000, but the annual inflation rate was two percent, the real GDP would be $2000 divided by 1.02 = $1960.
Potential GDP is the ideal number that a country’s economy can achieve if capital and resources are used to maximum potential. In theory, Potential GDP is the goal to work towards. The primary purpose for calculating the potential GDP is to track how successful the year or quarter has been, what areas can be improved, and what moves should be made for better results.
At any given moment, the current status of the economy is known as the actual GDP. Banks, governments, and other national influencers use this kind of measurement to track how things are progressing between final reports.
Pros and Cons of GDP
- GDP provides a broad picture of the economy.
- Allows decision-makers to put plans in place based on overall growth or decline.
- Calculations are easily comparable year-on-year.
- It is an effective tool for analysis.
- It does not factor in non-financially motivated activities know as non-market transactions. These include home-grown crops and services rendered to friends and family for free.
- Sustainable growth rates are not considered.
- Income inequality is not factored in.
- GDP completely overlooks several essential economic and human factors.
The Bottom Line
GDP (Gross Domestic Product) is not a detailed, in-depth look at the facts and figures that make up an economy. It is a tool to provide an overview of general progress and to measure overall growth and decline.
Although it is an essential part of economic tracking and strategizing, it must be used in tandem with other analyses and should always be adjusted for inflation rates to ensure it provides an accurate representation.
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