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What Is GDP and Why Is It So Important to

Economists and Investors?

By Leslie Kramer

Gross domestic product (GDP) is one of the most common indicators used to track
the health of a nation's economy. The calculation of a country's GDP takes into
consideration a number of different factors about that country's economy, including
its consumption and investment.

GDP is perhaps the most closely-watched and important economic indicator for
both economists and investors alike because it is a representation of the total dollar
value of all goods and services produced by an economy over a specific time period.
As a measurement, it is often described as being a calculation of the total size of an
economy. GDP is also a key factor in using the Taylor rule, which is a primary
method used by central bankers to evaluate economic health and set the target
interest rates in an economy.

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 investments decisions—a bad economy means
lower earnings and lower stock prices.

Gross Domestic Product (GDP) Defined

GDP is the monetary value of all the finished goods and services produced within a
country's borders in a specific time period and includes anything produced by the
country's citizens and foreigners within its borders. It is primarily used to assess the
health of a country's economy.

According to the International Monetary Fund, in 2019, the United States is the
world's largest economy, followed by China and Japan.1

The GDP of a country is calculated by adding the following figures together:

personal and public consumption; public and private investment; government
spending; and exports (less imports).

The figure is generally expressed as a percentage because it is expressed as a

percentage change from one period to the next (where the time period is typically
quarterly or yearly). The figure is reported in the United States on a quarterly basis
by the Bureau of Economic Analysis. While quarterly growth rates are a periodic
measure of how the economy is faring, annual GDP figures are often considered the
benchmark for the overall size of the economy.

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Nominal vs. Real GDP

GDP can be expressed in two different ways—nominal GDP and real GDP. Nominal
GDP takes current market prices into account without factoring in inflation or
deflation. Nominal GDP looks at the natural movement of prices and tracks the
gradual increase of an economy's value over time.

-5%

The GDP for the U.S. shrank at a rate of 5% during the first quarter of 2020, amidst
the global COVID-19 pandemic.2

On the contrary, real GDP factors in inflation. meaning it accounts for the overall
rise in price levels. Economists generally prefer using real GDP as a way to compare
a country's economic growth rate. It is calculated using a price deflator—the
difference in prices between the current and base year, which is the reference year.
Real GDP is how economists can tell whether there is any real growth between one
year and the next.

Measuring GDP
There are three primary ways of calculating GDP: first, by adding up what everyone
earned in a year (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 calculated by

adding up total compensation to employees, gross profits for incorporated and non-
incorporated firms, and taxes less any subsidies. The expenditure method is the
more common approach and is calculated by adding total consumption, investment,
government spending, and net exports.

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

In general, the following simplified equation is often employed to calculate a

nation's GDP:

GDP = C + G + I + NX

where:

C = consumption;
G = government spending;
I = investment; and
NX = net exports.

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GDP for Economists and Investors

GDP is an important measurement for economists and investors because it is a
representation of economic production and growth. Both economic production and
growth have a large impact on nearly everyone within a given economy. When the
economy is healthy, there is usually a lower level of unemployment, and wages tend
to increase as businesses hire more labor to meet the growing demand of the
economy. Economists look at positive GDP growth between different time periods
(usually year-to-year) to make an assessment of how much an economy is
flourishing. Conversely, if there is negative GDP growth, it may be an indicator that
an economy is in a recession, or approaching a recession or an economic downturn.

Investors pay attention to the GDP because a significant percentage change in the
GDP–either up or down–can have a significant impact on the stock market. In
general, a bad economy usually means lower earnings for companies. And this can
translate into lower stock prices.

Investors may pay attention to positive and negative GDP growth when they are
devising an investment strategy. However, it's important to note that because GDP
is a measurement of the economy in the previous quarter or year, it is better used to
help explain how economic growth and production have impacted your stocks and
your investments in the past. It is not considered a helpful predictor of how the
market will move in the future.

The Bottom Line

In one number figure, a country's GDP is capable of conveying a range of
information about that country's economy. Because of this, it remains a helpful and
useful data point for economists and investors.

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