The gross domestic product (GDP) is a figure that’s used to measure the size of a nation’s economy. By definition, it is “the output of goods and services produced by labor and property in the United States.” GDP is an important statistic used to help keep the country’s economy on track.
There are a few ways to calculate GDP.
- Add all the money spent in the country. That’s done by summing consumption, investment, government spending, and net exports.
- Add all the income received by producers in the country.
- Add the market value of all goods and services produced in the country.
The first method of adding all the money spent in the country is the most common way of calculating GDP.
Four Parts That Make Up Gross Domestic Product
There are four key figures that are used to calculate GDP.
- Consumption is the total of all consumer spending in the country.
- Investment accounts for the amount businesses spend on capital.
- Government spending is the total of all government spending.
- Net Exports is the difference between gross imports and gross exports.
Remember, GDP is equal to Consumption (C) + Government spending (G) + Investments (I) + Net Exports (NX)
Real GDP vs. Nominal GDP
The Bureau of Economic Analysis (BEA) publishes a quarterly report on the US gross domestic product. The report includes the current GDP, whether GDP increased or decreased, an explanation of the change in GDP, and the impact of the change on the economy.
When the BEA reports GDP, it uses real GDP, that is GDP that removes the effects of inflation. Real GDP also excludes both imports and income from companies and citizens that are outside the country. That way, GDP isn’t adjusted for exchange rates. When real GDP is calculated, it uses the value of goods and services in a base year. For example, the price of goods in 2000 may be used to calculate GDP.
Nominal GDP, on the other hand, is affected by inflation. The current value of goods and services in the current year is used to calculate nominal GDP. So, in periods of inflation (rising prices), nominal GDP will be higher than real GDP. On the other hand, when there is deflation, nominal GDP will be lower than real GDP.
GDP Growth Rate
The GDP growth rate is a more important indicator of economic health than GDP itself. The GDP growth rate is the percentage that GDP increased or decreased from the previous period. GDP growth rate will increase when spending and exporting increase, but will decrease when imports increase.
Ideally, GDP growth rate should be growing. In a growth situation, there will be more jobs, personal income, and businesses. However, when GDP growth slows down, employment and investing will both slow down as people wait for the economy to turn around. Even worse, a declining GDP growth rate could indicate a looming recession.
Why is GDP Important?
The most important use of gross domestic product is to help gauge growth of the economy. Analysts often compare the current GDP to that of the previous quarter and the same quarter of the previous year.
GDP makes it easier to compare the size and growth rate of economies all over the world.
The Federal Reserve uses GDP to determine whether to raise or lower interest rates to stimulate or restrain the economy. For example, if the GDP growth rate is increasing rapidly, the Fed might increase interest rates to encourage inflation. Rising prices would slow spending and bring the GDP growth rate to a more desirable interest rate. On the other hand, when GDP growth rate is declining, the Fed may lower interest rates to encourage spending.