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What gross domestic product (GDP) is and why it's key to measuring economic growth

Twenty/20

The U.S. economy is the largest in the world. How do we know that? Because of a standardized formula used to calculate GDP, or gross domestic product. That's the value of all goods and services produced in any given country's economy.

As of 2018, GDP in the United States is valued at more than $20 trillion. But this number alone doesn't mean much. Rather, the GDP growth rate is an economic indicator that's key to understanding a country's overall health during the four stages of an economic cycle. That figure, expressed as a percentage, shows just how quickly an economy is growing, or if it's contracting.

People on and off Wall Street closely track the pace of growth because it helps them to prepare for shifts in the economy that could affect our standard of living. Politicians use this information to help make policy decisions related to government spending and taxes, and GDP growth is a key input that the Federal Reserve relies upon when setting monetary policy, like interest rates.

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Here's what you need to know about GDP — and why this data matters.

What GDP estimates include

The Bureau of Economic Analysis, which is tasked with collecting GDP, calls it "a comprehensive measure of U.S. economic activity." There are different ways to calculate GDP, the most popular of which are known as the income approach and the expenditure approach. The difference comes down to whether you total up the income earned by companies and households, or all of the expenditures on final products and services.

The GDP report lays out the four major categories of expenditures that make up the U.S. economy as follows:

  1. Personal consumption expenditures. In other words, goods and services: everything consumers spend money on, including cars, groceries, housing expenses, and health care.
  2. Gross private domestic investment. This category represents investments made by businesses, encompassing spending on things like buildings, equipment, and software.
  3. Government consumption expenditures and gross investment. All the spending at the federal, state, and local government levels.
  4. Net exports of goods and services. For many years, this has actually been a negative amount because the U.S. imports more goods than it exports.

Why GDP estimates matter

GDP is key to understanding how healthy the economy is at any given time, so policymakers including politicians and central bankers closely watch these reports. Traders use this measure of economic growth, among other reports, to gauge the business prospects for companies in specific countries or regions.

Monitoring the pace of economic growth is also important to those people, like economists, who try to predict recessions. A recession occurs when there's a significant decline in economic activity as consumers and businesses spend less money. Many economists define a recession as two consecutive quarters of declines in GDP.

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What you need to know about the GDP reports

If you read or hear about GDP, it's likely expressed as a percentage in reference to the rate of change, either quarter-to-quarter or year over year.

GDP statistics are generally released the last Thursday of every month. The Bureau of Economic Analysis estimates GDP three times starting in the month after the end of a quarter. Each release incorporates additional data that wasn't previously available, improving the accuracy.

Here's some terminology that can be useful for understanding those GDP reports:

  • Real GDP. This is the preferred measure of production because data has been adjusted for inflation, meaning it excludes the effects of price changes making it easier to compare data from periods of time that are different. Real GDP is expressed as chained dollars, meaning that a base year has been selected for reference (currently that year is 2012).
  • Nominal GDP. By contrast, these GDP estimates are based on market prices, or "current dollars," during the period being measured. These figures aren't adjusted for inflation.
  • Seasonally adjusted. GDP data typically is calculated to remove the effects of yearly patterns, such as winter weather, holidays, or factory production schedules, to better reflect patterns in economic activity. The BEA also releases GDP data that's not seasonally adjusted, which reflects those fluctuations.
  • Seasonally adjusted annual rate (SAAR). In addition to adjusting for seasonal variations, reporting GDP figures at an annual rate makes it easier to compare data each quarter.

The Bureau of Economic Analysis has been collecting annual GDP data since 1929 and quarterly figures since 1947. It also estimates the value of the goods and services produced in each of the 50 U.S. states (in addition to metro area and county), plus the District of Columbia and the four U.S. territories. It also breaks down GDP by various industries.

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How GDP can affect you

When GDP growth is accelerating, the economy is expanding. Employers may be hiring more workers or spending money on big investments — and traders are more willing to push stock prices higher because business prospects are robust. During these periods, the Fed may raise interest rates to keep inflation in check.

Conversely, when GDP growth starts to stall, experts can get nervous. Employers may cut back on hiring or even lay off workers, and hold off on spending on other projects. As a result, traders tend to feel less confident about the business landscape and push stock prices lower. Policymakers cut interest rates when economic growth is slowing in an effort to stimulate activity by making it cheaper for consumers and businesses to borrow money.

While Wall Street may tune in when the GDP reports are released each month, you probably don't need to set your alarm. Understanding how those folks interpret this data can be useful, though, and can help you remember that downturns are a normal part of the economic cycle and, even when you're in one, an upturn is usually not far away.

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