What Is Gross Domestic Product (GDP)?

Gross Domestic Product, or GDP, is a measurement of economic output. It’s the total value of all the finished goods and services produced within a country, region, or industry during a specified time, usually a year or a quarter. GDP helps measure economic health and growth.

What is GDP?

A simple way to define Gross Domestic Product is to break down the three words that make up the term:

• Gross is the total market value of how much goods and services cost in the marketplace.
• Domestic refers to the country or home of the economic output.
• Products are the goods (things made) and services (actions provided) purchased by end-users.

Put together, GDP is the total market value of all the goods and services produced within a country’s borders during a year.

Economists calculate GDP using four inputs:

1. Personal Consumption Expenditures: Total consumer spending on goods and services such as food, entertainment, and medical bills.
2. Investment: Business spending on fixed assets such as land, buildings, and equipment. This category also includes unsold business inventory and homes purchased by consumers.
3. Government Spending: The money spent by federal, state, and local governments on goods and services such as education, infrastructure, and defence.
4. Net Exports: The value of exports minus imports.

The formula for calculating GDP uses the underlined letters from above:

C + I + G + NX = GDP

Types of GDP

GDP can be reported in a variety of different types, each offering a different insight into the health and growth of an economy.

GDP per Capita

By comparing a country’s GDP to the size of its population, investors can determine the level of output per person. This can be quite insightful in determining the general quality of life for individuals and is often stated in nominal or real terms.

When a country has a high level of GDP but a relatively low GDP per Capita, it can indicate a poor distribution of wealth. If a country’s GDP per Capita is growing but the population size remains stable, then it suggests that the country’s production efficiency is improving. This trend is most common among emerging markets where technology and automation are being deployed.

Nominal GDP

Nominal GDP measures a country’s output using current prices. As such, it does not take into consideration the impact and effects of inflation, which can inflate a country’s GDP.

Typically, Nominal GDP is used when comparing the performance of an economy on a quarter-on-quarter basis. For longer-term performance comparisons, the Real GDP is used as this strips out the effects of inflation, allowing the analysis to focus solely on production volume.

Real GDP

As previously mentioned, Real GDP strips out the effects of inflation (as well as deflation) and reflects the quantity of goods and services produced in a single year. This solves the challenge with Nominal GDP, where it’s impossible to determine whether economic growth stems from increased production or merely rising prices.

The Real GDP is calculated by applying a GDP price deflator function, which subtracts the difference in prices between the current and base years. If an economy is experiencing inflation, the Real GDP will be lower than the Nominal GDP. If an economy is experiencing deflation, the Real GDP will be higher than the Nominal GDP.

Why is GDP important?

GDP is a crucial measure of economic health. Rising GDP shows that an economy is expanding. It implies that consumers aren’t worried about their jobs, so they spend more money on goods and services. Businesses, meanwhile, continue to expand because they see opportunities to increase profits.

However, slowing GDP growth or a decline can suggest that the economy is heading toward or has fallen into a recession. That can cause consumers to reduce spending as they worry about job security. It can also cause businesses to reduce their investment levels.

Public policymakers, from legislators to central bankers, use GDP as a guide to determine policy moves. For example, the government could pass legislation to spur economic growth if GDP shows that the economy is in a downturn. Likewise, the Bank of England will look to GDP as one of many inputs of economic health when determining whether to reduce or increase the Bank Rate.

How investors can use GDP

The economy moves in a four-part cycle:

1. Expansion: A period of sustained GDP growth.
2. Peak: A time of slowing GDP growth.
3. Contraction or recession: A time of negative GDP growth.
4. Trough: A brief period where GDP stops declining and starts to recover.

Many industries are susceptible to changes in economic or GDP growth. For example, consumer spending on items such as airline tickets, hotel stays, restaurants, cars, clothing, and consumer products rises when the economy expands and falls when it’s contracting. Companies involved in economically sensitive industries usually see their earnings and stock prices rise and fall with the economic cycle. Investors call economically sensitive companies cyclical stocks.

Given their nature, investors can use GDP as their guide for when to buy and sell cyclical stocks. The best time to buy cyclical stocks is during the trough phase and the early stages of an expansion. Investors should avoid or sell cyclical stocks when GDP growth is slowing. Investors can use GDP to maximise returns and minimise losses in cyclical stocks.

How fast is UK GDP growing?

The Office for National Statistics (ONS) releases its estimate for UK GDP every month. The ONS’s latest release came in mid-April 2023, covering GDP estimates for the month of February. The report showed that GDP grew by 0.4% – slightly faster compared to a year ago.

The GDP report hints that the UK economy is improving and could potentially narrowly avoid a recession. Nevertheless, investors should still position their portfolios for a potential downturn. Possible moves could include reducing their exposure to cyclical stocks and increasing their investment in more recession-proof companies that aren’t as reliant on the economy to drive their growth.

What are the problems with GDP?

While GDP can be a powerful indicator and provide valuable insight, it’s far from a perfect economic measurement. Over the years, several criticisms have emerged that lead to inaccuracies in analysis. Some of the main issues with GDP include:

1. GDP does not account for unrecorded transactions. As such, the impact of volunteering and under-the-table employment are not captured, and both can have a significant impact in some nations.
2. GDP focuses solely on the output of products and services with no consideration for sustainability or society. For example, a country may experience high GDP growth, but it may come at the cost of environmental damage and societal mental strain.
3. As only finalised goods and services are considered, GDP ignores transactions between businesses during the production of those goods and services. As such, the metric is weighted heavily towards the consumption of goods and services rather than its production, with business-to-business activity often ignored.
4. GDP growth can be inflated by private and government spending, even if these investments are unprofitable. As such, unproductive or even destructive activities and sectors receiving financial support from the private sector or the government will push GDP higher despite not actually providing economic benefit.