Why Is GDP Important?
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.
GDP is an accurate indicator of the output of an economy, and the GDP growth rate is probably the single best indicator of economic growth.
Key Takeaways
- GDP enables policymakers and central banks to judge whether the economy is contracting or expanding and promptly take necessary action.
- It also allows policymakers, economists, and businesses to analyze the impact of variables such as monetary and fiscal policy, economic shocks, and tax and spending plans.
- GDP can be calculated through the expenditure, income, or value-added approaches.
- GDP isn't a flawless indicator; it overlooks several important factors.
Understanding GDPs Importance
Paul A. Samuelson and William Nordhaus neatly sum up the importance of the national accounts and GDP in their seminal textbook “Economics.”
While GDP and the rest of the national income accounts may seem to be arcane concepts, they are truly among the great inventions of the twentieth century.
They liken the ability of GDP to give an overall picture of the state of the economy to that of a satellite in space that can survey the weather across an entire continent.
GDP enables policymakers and central banks to judge whether the economy is contracting or expanding, whether it needs a boost or needs to be restrained, and if threats such as a recession or rampant inflation loom.
The National Income and Product Accounts (NIPA) form the basis for measuring GDP. Policymakers, economists, and businesses analyze the impact of variables such as monetary and fiscal policy and economic shocks. This information helps them create tax and spending plans on specific subsets of an economy and the overall economy.
Using GDP Data
Most nations release GDP data every month and quarter. In the U.S., the Bureau of Economic Analysis (BEA) publishes an advance release of quarterly GDP four weeks after the quarter ends, and a final release three months after the quarter ends. The BEA releases are exhaustive and contain a wealth of detail, enabling economists and investors to obtain information and insights on various aspects of the economy.
The advance GDP data has the most impact on the markets as it is the first snapshot of how well the economy is performing. Subsequent releases have limited market impact unless there is a significant variance from the advance GDP figure. This is due to the amount of time that elapses between the quarter-end and these releases.
GDP Calculation
GDP can be calculated through the expenditure approach—the sum of everyone's spending in an economy over a particular period. The income approach—the total of what everyone earned—can also be used. Both should produce the same result. A third method, the value-added approach, calculates GDP by industry.
Expenditure-based GDP produces both real (inflation-adjusted) and nominal values, while the calculation of income-based GDP is only carried out in nominal values. The expenditure approach is the more common one and is obtained by summing up total consumption, government spending, investment, and net exports. GDP is calculated as follows:
GDP = C + I + G + (X – M)
Where:
- C = private consumption or consumer spending
- I = business spending
- G = government spending
- X = value of exports
- M = the value of imports
Factors That Affect GDP
GDP fluctuates because of the business cycle. When the economy is booming and GDP is rising, there comes a point when inflationary pressures build up rapidly as labor and productive capacity near full utilization. This leads the central bank to commence a cycle of tighter monetary policy to cool down the overheating economy and quell inflation.
Interest Rates
As interest rates rise, companies and consumers cut back spending, and the economy slows down. Slowing demand leads companies to lay off employees, further affecting consumer confidence and demand.
To break this vicious circle, the central bank eases monetary policy to stimulate economic growth and employment until the economy is booming once again. This cycle repeats over time.
Consumer Spending
Consumer spending is the biggest component, accounting for over two-thirds of the U.S. economy. Consumer confidence, therefore, has a very significant bearing on economic growth.A high confidence level indicates that consumers are willing to spend, while a low level reflects uncertainty about the future and an unwillingness to spend.
Business Investment
Business investment is another critical component of GDP since it increases productive capacity and boosts employment. Government spending, too, assumes particular importance as a component of GDP when consumer spending and business investment decline sharply, for instance, after a recession.
Finally, a current account surplus also boosts a nation’s GDP since (X – M) is positive, while a chronic deficit is a drag on GDP.
Drawbacks of GDP
GDP does not account for the underground economy. It relies on official data, so it does not consider the extent of the underground economy, which can be significant in some nations.
It is geographically limited in a globally open economy. Gross National Product (GNP), which measures the output from the citizens and companies of a particular nation regardless of their location, is viewed as a better measure of output than GDP in some cases. For instance, GDP does not consider profits earned in a nation by overseas companies that are remitted back to foreign investors. This can overstate a country's actual economic output. For example, Ireland had a GDP of €506.3 billion and a GNP of €362.9 billion in 2022, the difference of €143.4 billion (or 28% of GDP) mainly due to profit repatriation by foreign companies based in Ireland.
GDP emphasizes economic output without considering economic well-being. GDP growth alone cannot measure a nation's development or its citizens' well-being. For example, a country may be experiencing rapid GDP growth, but this may impose a significant cost to society regarding environmental impact and an increase in income disparity.
GDP Globally
GDP is also important because it allows economists to learn about global trends. For instance, China and India have succeeded despite their massive populations, with China's GDP growing from $149.54 billion in 1978 to $17.96 trillion in 2022. India experienced a slower growth pace over the same period—$137.3 billion to $3.39 trillion.
The following image shows that emerging markets and developing nations grew faster than the developed world between 1990 and 2019. The divergence in growth rates began to narrow in 2007. The red line represents the GDP of emerging market and developing economies, the blue line is advanced economies, and the brown line represents the world's GDP.
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In 2011, developing countries collectively recorded GDP growth of 6.4%, while developed nations only grew by 1.7%. By 2019, the gap had tightened, but in 2020, the COVID-19 pandemic interfered with most countries' outputs. By mid-2023, developing countries' collective GDP shrank to 3.9%, while developed nations' GDP shrunk to 1.3%.
The divergence in output prevalent in the first part of the century appears to be reoccurring, according to the International Monetary Fund's World Economic Outlook Update for July 2023.
Total Market Cap to GDP
One interesting metric that investors can use to get a sense of the valuation of an equity market is the ratio of total stock market capitalization to GDP, expressed as a percentage. The closest equivalent to this in stock valuation is the market cap to total sales (or revenues), which, in per-share terms, is the well-known price-to-sales ratio.
Just as stocks in different sectors trade at widely divergent price-to-sales ratios, other nations trade at stock-market-cap-to-GDP ratios that are all over the map. For example, the U.S. had a stock-market-cap-to-GDP ratio of 193.3% as of Q4 2020, China had a ratio of just over 83.2%, and India had a ratio of 97.2%.
However, the utility of this ratio lies in comparing it to historical norms for a particular nation. For example, the U.S. had a stock-market-cap-to-GDP ratio of 137.7% at the end of 2015, surging to 193.3% by the end of 2020. Given the rise in the U.S. stock market by the end of 2020—and with the benefit of hindsight—these readings might be viewed as zones of undervaluation and overvaluation.
What Are 3 Advantages of GDP?
It allows policymakers and central banks to make adjustments and decisions, gives economic analysts data that helps them see the effects of decisions, and it is widely regarded as one of the best indicators of a country's output.
What Are the Pros and Cons of GDP?
While GDP is widely regarded as the most accurate indicator of a country's output, it doesn't include transactions that occur off the market or account for income inequality within that country. It also doesn't consider profits earned in one country and remitted to another.
Which GDP Is Most Important?
Real GDP accounts for inflation, so it is considered to be more accurate than nominal GDP.
The Bottom Line
In terms of its ability to convey information about the economy in one number, few data points can match the GDP and its growth rate. GDP is used for many purposes, from economic analysis to international investing.
