What GDP measures, and what it leaves out
Gross domestic product is the most quoted number in economics. Here is how the U.S. measures it, how to read a quarterly GDP report and what the figure was never designed to capture.
When a news report says the economy "grew at a 2.5% rate last quarter," it is talking about gross domestic product, or GDP. It is the broadest single measure of economic activity, and it moves markets, shapes Federal Reserve decisions and settles political arguments. It is also widely misunderstood. GDP measures one specific thing well and many other things not at all.
The definition
GDP is the market value of all final goods and services produced within a country during a period of time. Each part of that sentence matters.
- Market value means things are counted at their prices, so a car counts for more than a sandwich.
- Final goods and services are those bought by the end user. The steel sold to a carmaker is not counted separately, because its value is already included in the price of the car. Counting both would double-count.
- Within a country means production located inside the borders, regardless of who owns the business. A foreign-owned factory in Ohio counts toward U.S. GDP.
- During a period means GDP is a flow, measured per quarter or per year, not a stock of wealth.
In the United States, GDP is produced by the Bureau of Economic Analysis (BEA), part of the Commerce Department.
The spending formula
The most familiar way to break down GDP is by who buys the output:
GDP = consumption + investment + government spending + net exports
- Personal consumption expenditures are household purchases of goods and services. In the U.S., this is by far the largest component, roughly two-thirds of GDP in recent decades.
- Gross private domestic investment includes business spending on equipment, software and structures, residential construction and changes in inventories.
- Government consumption expenditures and gross investment include federal, state and local spending on goods, services and public investment. Transfer payments such as Social Security benefits are not counted here, because they do not pay for current production. They show up later when recipients spend the money.
- Net exports are exports minus imports. Imports are subtracted because they were produced elsewhere and are already included in the spending categories above.
Nominal versus real
Nominal GDP is measured in current prices. If prices rise 3% and output does not change at all, nominal GDP rises 3%. Real GDP removes the effect of price changes, so it reflects changes in the quantity of output. Headlines about growth almost always refer to real GDP.
How to read the quarterly headline
The U.S. reports quarterly real GDP growth as a seasonally adjusted annual rate. That means the growth from one quarter to the next is expressed as if it continued for a full year. A quarterly increase of about 0.5% is reported as roughly 2% at an annual rate. Many other countries report the simple quarter-over-quarter change instead, so comparisons across countries need care.
The BEA publishes each quarter's estimate in stages. The advance estimate comes out about a month after the quarter ends. Second and third estimates follow in the next two months as more complete data arrive. Annual updates and periodic comprehensive revisions can change the figures again, sometimes noticeably. A quarter that first looked weak can later look stronger, or the reverse.
Two quarters of decline is not the official definition of recession
A common rule of thumb says a recession is two consecutive quarters of falling real GDP. In the United States, recessions are dated by the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER), a private nonprofit research organization. The committee describes a recession as a significant decline in economic activity that is spread across the economy and lasts more than a few months, and it looks at a range of indicators, including employment, income and spending, not only GDP.
GDP versus GDI
In principle, total spending on output should equal total income earned from producing it. The BEA also publishes gross domestic income (GDI), which adds up wages, profits and other incomes. In practice, the two estimates differ because they draw on different data sources. The gap is called the statistical discrepancy. When GDP and GDI tell different stories, economists often look at an average of the two.
What GDP leaves out
GDP was designed to measure market production. Simon Kuznets, who developed early U.S. national income accounts in the 1930s, warned Congress in 1934 that the welfare of a nation could scarcely be inferred from a measure of national income. Many things that matter are outside its scope.
- Unpaid work. Cooking, childcare and caring for relatives at home are not counted when done without pay. The same work counts when someone is hired to do it.
- Distribution. GDP is a total. It says nothing about how income is shared. GDP can rise while median household income stagnates.
- Depletion and damage. Using up natural resources or damaging the environment is not subtracted. Spending to clean up a disaster can add to GDP.
- Quality and free products. Improvements in quality and free digital services are hard to capture fully in price-based measures.
- Leisure. A country where people work fewer hours for the same comfort is not rewarded in GDP.
The BEA has developed supplementary statistics, including distributions of personal income across households, to address some of these gaps. Other measures, such as the United Nations' Human Development Index, combine income with health and education indicators.
Per person, and per hour
Comparing total GDP between a large and a small country mostly tells you which one is larger. Dividing by population gives GDP per capita, a rough guide to average living standards. Dividing by hours worked gives output per hour, a measure of productivity. When comparing countries, economists often adjust for differences in price levels using purchasing power parity.
The bottom line
GDP is a careful, useful measure of how much an economy produces and how fast that production is changing. Read the headline as an annualized, seasonally adjusted, inflation-adjusted and preliminary number that will be revised. And remember what it was built to do. It measures output, not well-being.
This article is general information, not investment advice.