What is GDP and Why Does It Matter?

The constant chatter of a looming recession has cast a spotlight on a key measure of the country’s economic health—Gross Domestic Product or GDP. Economists use the GDP number to gauge whether the economy is growing or shrinking, which makes it a vital decision-making tool for investors, business leaders, and policymakers.

All eyes are on the GDP as negative numbers reported over two consecutive quarters indicate the country has entered a recession.

So, what exactly is GDP, and why does it matter?

What is GDP?

GDP is a measure of the monetary value of all goods and services produced in a country over a period of time. It’s actually an equation that totals the many components of measurement, such as the country’s level of consumption, investment, government spending on goods and services, and the difference in profits between exports and imports.

GDP = Consumption + Investment + Government Spending on Goods and Services + (Exports – Imports)

The Bureau of Economic Analysis (BEA) is responsible for collecting data from several sources, including builder, manufacturer, retail, and trade flow reports and surveys.

Here is a breakdown of each component:

Consumption: The sum of goods and services purchased by consumers. Consumption is the largest component of GDP, comprising about 70% of the total. So, when consumption increases, it’s viewed as an indication of a healthy economy.

Investment: Refers to investments in business activity that will produce future benefits, such as buying equipment and inventory or expanding operations. Increasing investment leads to higher production capacity and employment rates.

Government spending: Your taxes fuel government spending on education, military, transportation, and infrastructure. When government tax collections exceed its spending, it runs at a deficit rather than a surplus.

Exports minus imports: When the export of goods and services produced within the U.S. is greater than imports purchased by consumers, the country has a trade surplus, which is a positive.

Nominal vs. Real GDP

There are two ways to calculate GDP—nominal GDP using current market prices without factoring in inflation and real GDP that factors in inflation, accounting for the overall rise in the price level. Nominal GDP measures general economic changes, while real GDP provides a more accurate representation of the country’s economic health.

Why it Matters

As a critical measure of the economy’s performance and direction, GDP is scrutinized by economists, investors, policymakers, and consumers. GDP is reported quarterly as a year-over-year measurement of the economy’s growth or decline. If GPD shows a year-over-year gain, the economy is growing because it is more productive. If the number declines, the economy is shrinking because it is less productive. Low GDP growth—under 3%-means the economy is sluggish. Negative GDP growth, represented as a negative number, indicates the economy is contracting. Two consecutive quarters of negative GDP growth means the economy is in a recession.

In addition to providing a comprehensive measure of the economy’s performance and health, an analysis of GDP and its components provides valuable insights into the factors driving or slowing economic growth.

Generally, more robust economic growth translates into higher corporate profits, which results in higher share prices. When GDP trends higher over time, it indicates to investors that corporate profits are rising, and it’s a good time to invest. When GDP trends lower, it’s a sign that companies are becoming less productive and investing less, prompting investors to prepare for lower share prices.

Tracking GDP numbers can be especially useful for investing in emerging markets. Many emerging markets have GDPs far exceeding the U.S., presenting opportunities for higher returns on investment.

It’s important to note that GDP is not a leading indicator. It provides a comprehensive appraisal of the economy’s performance by looking back at data and events that have already occurred. Therefore, the GDP number must be viewed in the context of the reports that preceded it, along with other timelier indicators.