Gross Domestic Product (GDP) data are among the most important economic data available for measuring economic growth, but measuring the output of a large, dynamic economy is a complex task. In this Economic Lowdown podcast, hear what GDP measures, how it is calculated, how it is useful in determining whether and how quickly the economy is growing, and how GDP can be used as indicator of standard of living.
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How do you know if something has grown?
Maybe your parents marked your growth on a wall. Each mark on that wall represents your size at a specific period in your life. When you compare the most recent mark to those made earlier, it’s easy to see your growth over time.
In a similar way, it‘s possible to measure the size and growth of the economy. These are big things to measure, but it’s possible. The most common measure of the economy is called gross domestic product (or GDP). GDP measures the total market value of all final goods and services produced in an economy in a given year. Goods are items that are touchable, such as shoes, staplers, and computers. Services are actions, such as haircuts, doctor exams, and car repairs. GDP is meant to capture the total value of all this production.
To better understand GDP, let’s take a closer look at three phrases used to define it.
The first phrase is total market value. The value of an item—be it a good or service—is determined by the price paid for that item in the marketplace. When you add all of these prices together, you have the total market value of GDP.
The second phrase is final goods and services. The use of “final” in this phrase refers to goods and services sold to an end user. So, for example, a tire sold to a company that produces automobiles to be installed on a new car still in the making would not be counted in GDP. Why? Because it’s not a final good, and GDP measures the value of only final goods. In this case, the tires are intermediate goods—goods used in the production of final goods and services. So, the value of the tires will be reflected in the total price of the car when it’s sold to the end user—the car buyer. To avoid double counting, only final goods and services are included in GDP calculations. The tires sold to an automobile producer are not counted in GDP, but when you buy tires at your local auto-repair store to replace the worn-out tires on your car, they are counted in GDP. These tires are final goods in this case because you are the end user.
The third phrase is produced within an economy. Only goods and services produced within a country’s borders count in that nation’s GDP. So, to be counted in U.S. GDP, something must be produced within the borders of the United States. GDP does not, however, take the national ownership of the business that produces a good or service into consideration. So, a car produced in Kentucky counts as U.S. GDP—even if it is produced by a foreign company; but a car produced in Mexico does not count as U.S. GDP—even if it is produced by a U.S. company.
So, GDP measures the size of the economy. That is, GDP measures the total market value of all final goods and services produced in an economy in a given year. GDP is among the most important and widely reported pieces of economic data. A variety of people, from business owners to policymakers, use GDP in decision-making.
It’s important to know that actual market prices are used to calculate the value of GDP. As you know, though, prices don’t remain the same over time. In fact, they change constantly. And changing prices can make it difficult to understand a change in GDP. For example, an increase in GDP could mean any of the following: (A) The country has produced more goods and services. (B) The country has produced the same amount of goods and services, but the prices of those goods and services have increased. Or (C), the country has some combination of higher production levels and higher prices.
GDP can be looked at in two different ways. When GDP is presented in its unadjusted form, it’s called nominal GDP.
To calculate the real increase or decrease over time—in the level of final goods and services produced—price changes are removed from GDP data.
This revised measurement is called real GDP.
So real GDP is GDP adjusted for inflation and more accurately reflects the actual increase or decrease in output. A general rule of thumb is that two consecutive quarters of negative real GDP constitute a recession. Although economists have more comprehensive ways to determine the phases of the business cycle, this rule of thumb is widely used. In short, GDP is central to our understanding of the state of the economy.
Just as parents measure their children’s growth by comparing heights over time, economists measure economic growth by comparing real GDP over time. Economic growth is usually presented as a percentage increase or decrease from an earlier period. And, as we’ve already learned, it’s important to adjust GDP for inflation. For example, it might be useful to know that nominal GDP in the third quarter of 2013 was $16.9 trillion, but it’s probably more meaningful to know that real GDP increased by, or the economy grew by, an annual rate of 4.1 percent in the third quarter of 2013. Real GDP removes the effects of price changes, but to discuss growth, we focus on the percent increase in real GDP instead of the total value–or level—of GDP. To put that 4.1 percent in context, consider that real GDP has grown at an average annual rate of 3.3 percent since 1950. Remember, however, that 3.3 percent is an average taken over a long time period—GDP has a tendency to bounce around a bit from quarter to quarter.
While GDP is a good measure of domestic production, it does not capture all economic activity. For example, GDP does not measure economic activity that occurs outside the formal marketplace. So, if you mow your own lawn, the value of that activity does not show up in GDP, but if you hire a lawn service it does. Another category not captured by GDP is the nonmarket by-products of market production, such as pollution. Finally, GDP does not capture illegal goods or services sold in the underground economy, because such transactions are not recorded.
In addition to measuring the economy, GDP can also be used to indicate, on average, the standard of living for people in different countries. Because goods and services are sold for money, and money earned in producing goods and services is income, GDP is a measure of national income. To determine the impact of national income on individual people, GDP is divided by the country’s population. The resulting measurement is GDP per person and is most commonly called GDP per capita. For example, think of two countries—Alpha and Omega—with comparable GDP, say $200 billion each. One might assume that the citizens of Alpha and Omega have a similar standard of living because their countries have comparable GDPs. But, what if Alpha has a population of 200 million people and Omega has a population of 5 million people? Because Alpha’s GDP is divided among a much larger population, each person’s share is much smaller. In this case, Alpha’s GDP per capita is $1,000, while Omega’s is $40,000. So, while their GDPs are the same, once they’re divided by the population it’s easier to see a dramatic difference in the standard of living in these two nations. Notice, though, that GDP per capita is an average. The actual earnings of individual people will likely vary greatly depending on the distribution of income. Changes in real GDP per capita within the same country can be used to estimate changes in the standard of living over time. An increase in real GDP per capita over time is interpreted as an increase in the standard of living—a worthy goal for any society.
GDP helps us identify growth in an economy. And a growing economy is an economy that produces more goods and services for its population. More goods might include increases in the production of smartphones and cheeseburgers, and more services might include increases in health care and education. And, generally speaking, more is better. But greater production of goods and services is only one factor that contributes to well-being—that is, your satisfaction with life. Many meaningful aspects of life cannot be quantified in GDP. An evening walk on the beach or an afternoon playing Frisbee in the park may bring you satisfaction; in fact, you might value these activities so much that you’re willing to trade off work time for more leisure time to do these things. There are trade-offs in the broader economy as well—we trade off some economic production for quality-of-life factors. For example, we may choose to produce fewer goods and services so that we can enjoy more leisure time and a cleaner environment—but this well-being is not captured in GDP.
GDP data are among the most important economic data available, but measuring the output of a large, dynamic economy is a complex task. GDP measures production levels during a period of time and can be adjusted for inflation—a measure called real GDP—and compared with earlier periods to evaluate economic growth. All things being equal, growth is good, and GDP measures growth. GDP cannot, however, capture well-being; but, that’s OK, because it’s not intended to.
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