What is GDP and how is it measured?

GDP is a measure - or an attempt to measure - all the activity of companies, governments and individuals in a country. In the UK, new GDP figures are produced every month, but the quarterly figures - covering three months at a time - are the most widely watched.

In a growing economy, each quarterly GDP will be slightly bigger than the quarter before, a sign that people are doing more work and getting (on average) a little bit richer.

Most economists, politicians and businesses like to see GDP rising steadily because rising GDP usually means people spend more, more jobs are created, more tax is paid and workers get better pay rises.

If GDP is falling, then the economy is shrinking, which entail bad news for businesses and workers. If GDP falls for two quarters in a row, that is known as a recession, which can mean pay freezes and lost jobs.

While it's 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 2.6% annualized increase in the fourth quarter of 2022, in the United States GDP was primarily the result of a jump in private inventory investment, consumer spending, non-residential fixed income, federal government spending, and state and local government spending.

GDP can be expressed in nominal or real terms. Real and nominal GDP are two different ways to measure the gross domestic product of a nation. 

Nominal GDP.

Nominal GDP measures gross domestic product in current monetary value; unadjusted for inflation. 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.

Real GDP.

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

The real GDP of the U.S. as of the fourth quarter of 2022 is 2.6%. This is a decrease when compared to the increase in real GDP of 3.2% in the third quarter of 2022.

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. 

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. 

How is GDP measured?

GDP can be measured in three ways:

1. Output: The total value of the goods and services produced by all sectors of the economy - agriculture, manufacturing, energy, construction, the service sector and government.

2. Expenditure: The value of goods and services bought by households and by government, investment in machinery and buildings - this also includes the value of exports, minus imports.

3. Income: The value of the income generated, mostly in terms of profits and wages.

In the UK, the Office for National Statistics (ONS) publishes one single measure of GDP, which is calculated using all three measurements. But early estimates mainly use the output measure, using data collected from thousands of companies.

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.

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.

How does GDP affect me?

If GDP is growing, the government will use that as evidence to say that it is doing a good job of managing the economy. Likewise, if GDP falls, opposition politicians will say the government is running it badly.

But it's not just a report card on how the government is doing. If GDP is going up steadily, people will pay more in tax simply because they're earning and spending more. This means more money for the government to spend on public services, such as schools, police and hospitals.

Governments also like to keep an eye on how much they are borrowing in relation to the size of the economy.

What are its limitations?

GDP growth doesn't tell the whole story. There are lots of things the statistics might not take into account:

Hidden economy: Unpaid work isn't captured in official figures, such as caring for an elderly relative.

Inequality: GDP growth doesn't tell us how income is split across a population - rising GDP could result from the richest getting richer, rather than everyone becoming better off. Just because GDP is increasing, it doesn't mean that an individual person's standard of living is improving.

If a country's population increases, that will push GDP up, because with more people, more money will be spent. But individuals within that country might not be getting richer. They may be getting poorer on average, even while GDP goes up.

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.

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