What Is GDP and Why Is It So Important to Economists and Investors? (2024)

Gross domestic product (GDP) is one of the most widely used indicators of economic performance. Gross domestic product measures a national economy's total output in a given period and is seasonally adjusted to eliminate quarterly variations based on climate or holidays. The most closely watched GDP measure is also adjusted for inflation to measure changes in output rather than changes in the prices of goods and services.

Annual GDP totals are frequently used to compare national economies by size. Policymakers, financial market participants, and business executives are more interested in changes in the GDP over time, which are reported as an annualized rate of growth or contraction. This makes it easier to compare annual and quarterly rates.

Real (inflation-adjusted) U.S. GDP increased by 1.3% on an annualized basis for the first quarter of 2024 compared to an increase of 3.4% in the fourth quarter of 2023.

Key Takeaways

  • Gross domestic product tracks the health of a country's economy.
  • It represents the value of all goods and services produced over a specific time period within a country's borders.
  • Economists can use GDP to determine whether an economy is growing or experiencing a recession.
  • Investors can use GDP to make investment decisions—a bad economy often means lower earnings and stock prices.

Understanding Gross Domestic Product (GDP)

GDP measures the monetary value of goods and services produced within a country's borders in a given time, usually a quarter or a year. Changes in output over time as measured by the GDP are the most comprehensive gauge of an economy's health.

GDP figures are reported in the United States every month by the Bureau of Economic Analysis (BEA) both in nominal as well as real, or inflation-adjusted, terms. One month after the end of each quarter, the BEA releases an advance estimate of the previous quarter's GDP. In the two succeeding months, the second and third estimates are released. This information incorporates previously unavailable data.

While it is possible to deconstruct the GDP in various ways, the most common is to view it as the sum of a country's private consumption, investment, government spending, and net exports (or exports less imports).

The consumption and investment components of the GDP tend to be more reliable economic indicators than government spending or net exports. The 1.3% annualized increase in the first quarter of 2024 was linked to an increase in consumer spending, government spending, and nonresidential fixed investment.

The U.S. was the world's largest economy in 2024 according to the International Monetary Fund (IMF). It was followed by the economies of China and Germany.

Nominal vs. Real GDP

GDP can be expressed in nominal or real terms. Nominal GDP is calculated based on the value of the goods and services produced as collected, so it reflects not just the value of output but also the change in the aggregate pricing of that output. In other words, in an economy with a 5% annual inflation rate nominal GDP will increase 5% annually as a result of the growth in prices even if the quantity and quality of the goods and services produced stay the same.

1.3%

U.S. real GDP growth rate (annualized) during the fourth quarter of 2023, compared to an annualized increase of 3.4% in the first quarter of 2024.

In contrast, real GDP is adjusted for inflation. This means that it factors out changes in price levels to measure changes in actual output. Policymakers and financial markets focus primarily on real GDP because inflation-fueled gains aren't an economic benefit.

To estimate real GDP, the BEA constructs chain indexes that allow it to adjust the value of the goods and services to the change in prices of those goods and services.

Measuring GDP

There are three primary ways of calculating GDP: first, by adding up what everyone earned (known as the income approach) or by adding up what everyone spent in a year (the expenditure method). Logically, both measures should arrive at roughly the same total.

The income approach, which is sometimes referred to as GDP(I), is the sum of the aggregate compensation paid to employees, business profits, and taxes less subsidies. The expenditure method already discussed is the more common approach and is calculated by adding private consumption and investment, government spending, and net exports.

Finally, GDP can be measured based on the value of the goods and services produced (the production or output approach). Because economic output requires expenditure and is, in turn, consumed, these three methods for computing GDP should all arrive at the same value.

In general, the following simplified equation is often employed to calculate a country's GDP via the expenditure approach:

BEA's estimates of U.S. GDP are based on national income and product accounts (NIPAs) for sectors including businesses, households, nonprofit organizations, and governments. NIPAs are compiled from seven summary accounts tracing receipts and outlays for each of those sectors. Detailed NIPA data also forms the basis for BEA GDP reports by state and industry.

BEA's GDP estimates omit illegal activities, care of own children, and volunteer work for lack of reliable data. A BEA researcher estimated counting illegal activities would have increased nominal U.S. GDP by more than 1% in 2017. At the same time, the GDP figures include BEA estimates of what homeowners would have paid to rent equivalent housing so that the GDP does not increase every time an owner-occupied home is rented.

GDP for Economists and Investors

GDP is an important measurement for economists and investors because it tracks changes in the size of the entire economy. In addition to serving as a comprehensive measure of economic health, GDP reports provide insights into the factors driving economic growth or holding it back.

Economic health, as measured by changes in the GDP, matters a lot for the prices of financial assets. Because stronger economic growth tends to translate into higher corporate profits and investor risk appetite, it is positively correlated with share prices. Conversely, stronger GDP growth can hurt fixed-income investments, like bonds, by making their returns less attractive on a relative basis.

While GDP reports provide a comprehensive estimate of economic health, they are not a leading economic indicator but rather a look in the economy's rear-view mirror. Markets track GDP reports in the context of those that preceded them, as well as other more time-sensitive indicators relative to consensus expectations.

What Is Real and Nominal GDP?

Real and nominal GDP are two different ways to measure the gross domestic product of a nation. Nominal GDP measures gross domestic product in current dollars; unadjusted for inflation. Real GDP sets a fixed currency value, thereby removing any distortion caused by inflation or deflation. Real GDP provides the most accurate representation of how a nation's economy is either contracting or expanding.

How Is Real GDP Calculated?

Real GDP is calculated by using a price deflator. A price deflator is the difference between prices in the current year that GDP is being measured and some other fixed base year. For example, if prices rose by 8% from the base year, the price deflator would be 1.08. The nominal GDP would then be divided by this deflator to reach real GDP.

What Is the Real GDP?

The real GDP of the U.S. as of the fourth quarter of 2023 was 1.3%. That's compared to an increase of 3.4% in the first quarter of 2024.

The Bottom Line

A single GDP number, whether an annual total or a rate of change, conveys a minimum of useful information about an economy. In context, it's an important tool used to assess the state of economic activity.

What Is GDP and Why Is It So Important to Economists and Investors? (2024)

FAQs

What Is GDP and Why Is It So Important to Economists and Investors? ›

Key Takeaways. Gross domestic product tracks the health of a country's economy. It represents the value of all goods and services produced over a specific time period within a country's borders. Economists can use GDP to determine whether an economy is growing or experiencing a recession.

Why is GDP so important to economists and investors? ›

GDP is important because it gives information about the size of the economy and how an economy is performing. The growth rate of real GDP is often used as an indicator of the general health of the economy. In broad terms, an increase in real GDP is interpreted as a sign that the economy is doing well.

What is GDP and its importance? ›

Gross Domestic Product (GDP) is one of the most widely used measures of an economy's output or production. It is defined as the total value of goods and services produced within a country's borders in a specific period—monthly, quarterly, or annually.

How does GDP affect investors? ›

Weak GDP tends to send fixed income prices higher and stocks lower. The opposite is true when GDP is strong.

What is the simple definition of GDP? ›

Gross domestic product (GDP) is the most common measure for the size of an economy, and it measures the value of total final output of goods and services produced by that economy in a certain period of time.

Why do economists need to use real GDP? ›

Economists use real GDP rather than nominal GDP to gauge economic well-being because real GDP is not affected by changes in prices, so it reflects only changes in the amounts being produced. You cannot determine if a rise in nominal GDP has been caused by increased production or higher prices.

Which GDP is more important? ›

Real GDP is a better indicator of economic growth because it can be compared with base year GDP. While nominal GDP cannot be compared to any previous year's GDP. Q.

Who uses GDP and why? ›

The White House and Congress use GDP numbers to plan spending and tax policy. The Federal Reserve uses them when setting monetary policy. State and local governments rely on GDP numbers, too. Business people use these stats when making decisions about jobs, expansion, investments, and more.

Why is economic growth important? ›

Why Does Economic Growth Matter? In the simplest terms, economic growth means that more will be available to more people, which is why governments try to generate it. However, it's not just about money, goods, and services. Politics also enter into the equation.

How is GDP related to economic growth? ›

Economic growth refers to an increase in the size of a country's economy over a period of time. The size of an economy is typically measured by the total production of goods and services in the economy, which is called gross domestic product (GDP).

Why is investment important to GDP? ›

Businesses make capital investments in real estate, facilities, computers, and equipment. An increase in capital spending helps improve economic growth, as measured by GDP. Economic growth in the United States is driven by consumer spending and capital investment. Federal Reserve Bank of Richmond.

How do investors affect the economy? ›

Investment adds to the stock of capital, and the quantity of capital available to an economy is a crucial determinant of its productivity. Investment thus contributes to economic growth.

What goes into investment in GDP? ›

In calculating GDP, investment does not refer to the purchase of stocks and bonds or the trading of financial assets. It refers to the purchase of new capital goods, that is, business equipment, new commercial real estate (such as buildings, factories, and stores), residential housing, and inventories.

Why is the GDP important? ›

Gross domestic product tracks the health of a country's economy. It represents the value of all goods and services produced over a specific time period within a country's borders. Economists can use GDP to determine whether an economy is growing or experiencing a recession.

How do you explain GDP to a child? ›

Gross domestic product, or GDP, is a measure used to evaluate the health of a country's economy. It is the total value of the goods and services produced in a country during a specific period of time, usually a year.

What is the real meaning of GDP? ›

Real gross domestic product (GDP) is an inflation-adjusted measure that reflects the value of all goods and services produced by an economy in a given year. Real GDP is expressed in base-year prices. It is often referred to as constant-price GDP, inflation-corrected GDP, or constant-dollar GDP.

Why is it important for economists to calculate real GDP per capita? ›

Real GDP per capita is an economy's production per person. It is often viewed as an indicator of the population's general welfare and standard of living and is a good indicator of a countries economic development when compared to other economies.

Why is it important for economists to determine factors influencing real GDP? ›

As an economist, it is important to determine the influences on a nation's real GDP in order to understand and analyze the overall health and performance of the economy. By identifying these influences, economists can gain insights into the factors that drive economic growth and make informed policy recommendations.

Why do economists use real GDP quizlet? ›

Real GDP per capita provides a better way to compare economies because no two counties are like so it takes into consideration GDP – every country is on different economic level and population – there is differences between populations of every country.

Why does an economist prefer to work with real GDP figures over GDP figures? ›

Real GDP is preferred by economists because it allows for a more accurate comparison of economic output over time. Since Real GDP accounts for changes in price level (inflation or deflation), it can represent the 'real' growth or contraction of a country's economy.

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