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 episode of the Economic Lowdown Video Series, economic education specialist Scott Wolla explains 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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LOL, IDK, XOXO, BFF, TTYL, GDP. Were you stumped by the last acronym? GDP stands for Gross Domestic Product. You probably don't see many references to it on social media, but GDP conveys an important message on the economy. Economists use this measurement to tell the story of the economy.
They use this measurement to determine the size of the economy at a point in time and growth of the economy over time. 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 appliances, cars, and clothing. Services are actions—things people do for us such as haircuts, car repairs and customer service.
Let's take a look at three phrases used to define GDP.
The first phrase is "Total market value." The value of a good or service is determined by the price paid for that item in the marketplace. When you add those prices together you have the total 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. Let's look at it this way. Tires are sold to a company that produces automobiles. Those tires installed on a new car are not counted in GDP. Why?
Because the tires are not a final good. The tires are an intermediate good—a good used in the production of final goods and services. The value of the tires will be reflected in the total price of the car when it's sold to the end user. However, when new tires are purchased by the end user to replace the worn out tires on the car, this value is counted in GDP. Those tires are a final good because they were sold to the end user.
The third and final 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 take the national ownership of the business that produces the good or service into consideration.
So, a car produced in Kentucky counts as U.S. GDP even if it's produced by a foreign company; but a car produced in Mexico does not count as U.S. GDP even if it's produced by a U.S. company.
So, GDP measures the size of the economy—the total market value of all final goods and services produced within an economy in a given year. GDP is among the most important and widely reported pieces of economic data. A wide variety of people, from business owners to policymakers, use GDP in decision making.
Economists use actual market prices to calculate the value of GDP. And as you know prices are constantly changing and those 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 more goods and services produced and higher prices.
GDP can be looked at 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—that is, production of goods and services.
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.
A general rule of thumb is that two consecutive quarters of declining 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.
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 its 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 and more goods and services for its population. And, generally speaking, more is better. 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.