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What Everybody Should Know About Gross Domestic Product (GDP)

Economics Corner: What Everybody Should Know About Gross Domestic Product (GDP)



Gross Domestic Product, often written simply as GDP, is a key economic statistic we often see in news reports about the economy. But we aren’t all economists, and many of us don’t understand economic statistics and terminology. Besides, the measurement for GDP is in the trillions of dollars, and the average American can’t easily put such huge dollar amounts into proper perspective. What should a layman know about GDP so that these news stories become relevant?


The key to making GDP relevant to the layman is to understand that this economic statistic is a measurement of the overall size of the economy. But at the same time, “size” isn’t total assets or some other balance sheet item. The economy is measured according to economic activity within a specific time frame; namely one year. GDP is a measure of economic activity. The health of the economy depends on economic activity. GDP is in a sense a measurement of the health of the economy.


More specifically, the economic activity being measured is production. GDP is a measurement of production in the overall economy. This production includes manufactured goods, but it also includes services. When production occurs, the economy grows. GDP is a measurement of economic growth.


This is how GDP is defined:


Gross Domestic Product (GDP) is the market value of all final goods and services produced in a year within a country’s borders.



Of course, knowing the definition of GDP won’t, by itself, make these economic news stories relevant to the average American. But it’s a start. Some more information is necessary. Gross Domestic Product is still a huge number. The economy of the United States is very large. How can we as laymen relate to such large numbers?


Well, we can’t. What is important to know isn’t the magnitude of the numbers, but the comparison of the numbers to other numbers. I mentioned that the economy grows whenever production of goods and services occurs. But that happens all the time. We also know that the economy sometimes shrinks, especially during recessions. How can the economy shrink at times if the measurement for growth is always a positive number?


What we should care about isn’t really the total amount of production, as measured by a positive number too big to comprehend. What is important is the amount of production this year compared to the amount of production last year. If we measure GDP as a percentage increase or percentage decrease from the previous year, then we have a number that becomes relevant. If the percentage is positive, then GDP increased during the year, and we say that the economy grew. If the percentage is negative, we say that the economy shrank. When we see GDP measured as a dollar amount in the trillions, we can’t relate. But if we see GDP as a percentage of increase or decrease, then we have some sort of comparison that we can relate to.


But wait. According to the definition, GDP is a measurement of “market value” of production. If we use this measurement to compare different time periods, couldn’t inflation automatically make the market value of this year’s production worth more than last year’s, even if we didn’t actually produce more? Yes, inflation does distort the numbers. But we keep track of estimates of inflation. We adjust the GDP figures according to an index for inflation, and the result is called “Real GDP.” Real GDP, and not the unadjusted nominal value for GDP, becomes the more relevant value for comparison purposes.


We now have enough information so that we can relate to news headlines such as this one:


“Real gross domestic product…increased at an annual rate of 0.2 percent in the first quarter of 2015”



A layman without the benefit of the above explanation might not have a clue what this headline means. But with this explanation, it becomes relevant. The headline itself clearly states “Real GDP,” so we know that the number has already been adjusted for inflation. The headline doesn’t mention the actual dollar amount - which we know we couldn’t relate to anyway - and instead mentions the percentage increase during the time frame in question, which is the first quarter of 2015.


With this information, we can relate to what the headline is saying, except for one important part: How do we know if this is good news or bad news?


Take another look at the headline. It is saying that if the rate of GDP increase during the first quarter stayed the same for the entire year, then at the end of the year the economy would have grown by 0.2 percent for the year. The economy grew, so that much of the news is good. But 0.2% economic growth for a year? That is very low; close to zero. Since records have been kept, the United States has never had an annual growth rate that low unless it was related to a recession. Economists prefer a growth rate of about 3%. Growth that is too slow signals that unemployment has risen or could rise in the near future. Growth that is relatively fast (say, above 5% per year) signals that inflation could increase soon – but plenty of jobs should be available.


The slow annual growth rate of 0.2% is based on economic data from one quarter of 2015. It isn’t uncommon for GDP to fluctuate within a given year, and 2015 economic growth could end up well within the range of a healthy economy. But the low number is a red flag; something for policy-makers to take a look at.


Another important factor regarding GDP is the population. The population of the country is steadily rising. A larger population requires more economic activity, and therefore a higher GDP, just to keep up. A useful statistic in this regard is Real GDP Per Capita, calculated by dividing Real GDP by the total population. This measurement is often used as a substitute for the unmeasurable concept of Standard of Living. It isn’t a perfect measurement. It doesn’t take into consideration whether the general population participates in growth, or if the gains all go to a small percentage of the people.


If the economies of different countries are to be compared, Real GDP Per Capita is the only measurement that is relevant. There has been a lot of discussion about China overtaking the United States as the world’s largest economy, based on GDP numbers. But China has a lot more people. When you consider GDP on a per capita basis, the United States still has a larger economy. China has more mouths to feed; more people to share the growth. They need more overall growth just to keep up.

How is GDP measured?



Unless you are a student in an economics class, or your job is to do so, you don’t really need to know how GDP numbers are calculated. But it doesn’t hurt to understand what sorts of things are counted and which things are not counted.


Resale items are not counted. You may be contributing to the local economy when people buy your stuff at a garage sale, but such sales are not reflected in the GDP measurement. The stuff was counted the first time it was sold at retail. At that time it represented production. Selling it again doesn’t add to production.


Any activity in the underground economy doesn’t count. If it’s illegal, it won’t be part of GDP, even if a large dollar amount is involved.


Otherwise, an activity generally needs to have money exchange hands in order to count in GDP. If you hire a baby-sitter to take care of your kids while you go out on the town, then the money you pay the baby-sitter is counted – unless the payment goes unreported, in which case it is part of the underground economy. If your mother-in-law volunteers to watch the kids for free, then no money changes hands and you don’t contribute to GDP – even if your mother-in-law is doing the same activity that would get counted if the baby-sitter did it. When you clean your house, it doesn’t count in GDP. But if you hire a housecleaning service to do the same thing, it does count.

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What about when you buy a new car? How does that count in GDP?



Remember, GDP is a measure of production. It only measures final goods and services. But along the way, there can be many intermediate steps which clearly add to production. At the end of any accounting period, there will always be raw materials inventory, work in progress, and finished goods inventory which is a sizable amount in the economy. Production that is done for the purpose of being a final good or service to be sold counts in GDP at the time of production. If it hasn’t been sold at the retail level, it is counted in a GDP category called investment.


So for a new car that you buy: I’ll use a simplified example to illustrate the method of computing GDP. Suppose that the car was assembled in Detroit. The auto manufacturer would have acquired parts and hired laborers to put the parts together, along with other necessary expenses that go into the price of a car. For the sake of simplifying the example, let’s say that the parts were all purchased by the auto manufacturer from a different company. That company would in turn have similar steps in its process – buy raw materials, hire labor, etc. But in terms of the auto manufacturer, we are counting them as raw materials purchased. These auto parts, or raw materials, will eventually go into the final price of the car that you buy. So when the auto manufacturer purchases them, the purchase price is added to GDP as investment.


But wait! Many car parts tend to be imported from Mexico, Germany, and other countries. They aren’t produced in the United States. If we count the value of the parts in GDP, then we are counting production that didn’t occur in the United States. So we don’t count it. The accounting method used is to deduct imports from the calculation. We count the final value of everything, and then deduct the amount of imports, so that it nets out to where imports aren’t counted in GDP.


During the assembly process, workers get paid and the auto manufacturer incurs other expenses. These all get counted as inventory – in the investment portion of GDP. When the manufacturing process is complete, the car goes into finished goods inventory and all of its associated costs have counted as investment.


For the sake of simplification, let’s assume that the auto dealer is the same as the manufacturer. When you buy a car from the dealer, the amount that you pay counts in GDP as consumption. Your purchase price is added to GDP. The car is no longer in inventory, so all of the expenses that were previously counted as investment are deducted. Otherwise, there would be double-counting. At each step in the process – from parts seller to auto manufacturer and from dealer to consumer, for example – any profit included in the transaction is added as part of GDP at the time of the relevant transaction.


For a slightly different example, suppose you didn’t buy the car from the dealer. Instead, somebody in Canada bought the car. The value of the car won’t be counted as consumption in the United States, but it should count in GDP if it was produced here. At the time of sale, it will be deducted from inventory. If we add the value of exports back into GDP, then it will get counted.


What about money that the government spends? When the government pays Social Security, unemployment compensation, welfare, and other types of transfer payments, it doesn’t count in GDP. Nothing is being produced; money is just going from one citizen to another or from one account to another. But when the government itself purchases goods and services, then it counts as production just as if an individual or a corporation had purchased the same thing.


You don’t really need to know this (unless you are a student in economics), but the above explanation means that the formula for calculating GDP is as follows:

GDP = Personal Consumption spending plus net investments plus government purchases of goods and services plus exports minus imports



Of course, nobody counts every single transaction in an economy as vast and as complex as the economy we have in the United States. Aggregate estimates for each category are used.


You might have noticed in these examples that GDP is measured by counting spending in the economy. If you think about it, economic activity is such that somebody’s spending is somebody else’s income. An alternative method for calculating GDP is to add together all income in the economy. That method is more complex (at least many first-year econ students think so), because it involves making adjustments for accounting methods used in the reporting of data. If you would like more information on GDP and methods for calculating GDP – as well as information on other aggregate measures in the economy (Gross National Product, National Income, Personal Income, etc.) – as taught to first-year economic students, see Circular Flow Model, GDP, & National Income Accounting, a page in my free website of basic economics principles, Economics Online Tutor.



We are not all economists, so why does the news media keep bombarding us with economic statistics and terminology we don’t understand? Should the average American even care about such news stories? When politicians talk about the economy, how do we separate the relevant from the rhetorical? More to the point, you might be asking yourself, “How does this affect me?”


Perhaps talk about the economy sounds like a bunch of gibberish to you. But if you had a basic understanding of the terminology being used – not the dictionary definitions, but what the words in their context should mean to a layman – free of misleading political implications, then such talk would mean more to you than just gibberish. The good news is that you don’t have to be an economist or even a student of economics in order to understand the terminology.


“Economics Corner: What Everybody Should Know About…” series is designed as a layman-friendly explanation of important economics terms and concepts. Created by Jerry Wyant.



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Author: 
Jerry Wyant
Date: 
2015-05-16
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