A Thing Called GDP
January 30, 1998

The Bureau of Economic Analysis (BEA) reported an advanced estimate of fourth quarter Gross Domestic Product (GDP) growth today. The fourth quarter growth rate was a strong 4.3% annualized. The BEA contributed the increase to personal consumption, exports, and changes in business inventories.

by Alex Schay (TMF Nexus 6)

Gross Domestic Product (GDP) is the sum total of all final goods and services produced within the United States, and although its shortcomings as an economic indicator continue to spark debate, it is commonly viewed as the most important measure of overall economic activity. Virtually all other economic indicators provide information that relates to one or more of the component parts of GDP or have something to say about GDP itself -- like the monthly employment report and capacity utilization data.

For those with some exposure to economics, the equation GDP = C + I + G + (X - M) will probably spring to mind. The four major moving parts related to GDP as outlined, include consumption, investment, government spending, and net exports (exports minus imports). The sum of these elements gives economists and investors a window through which the health of the economy can be viewed and assessed. GDP is also the primary method by which other countries measure their output, according to international guidelines set forth in the System of National Accounts.

Before August 1991, the most commonly used measure of production in the U.S. was Gross National Product, or GNP. Both GDP and GNP measure goods and services produced by the U.S., but GNP represents all those items produced by U.S. residents anywhere in the world, while GDP confines the measure to goods and services produced on U.S. soil. For example, if a U.S. firm produces goods in Japan, that output would be included in GNP calculations. However, the production of foreign firms that manufacture goods in the U.S. is not included in GNP.

It is important to note that GDP includes the output from foreign firms located in the U.S., for it is a measure of the goods and services produced in the U.S. To translate from GDP back to GNP, economists add "factor income receipts from foreigners" to Gross Domestic Product and then subtract "factor income payments to foreigners" to yield Gross National Product. Guess what? Net receipts from foreigners minus payments to foreigners in any given year virtually negate each other. Meaning that the amount of foreign production on U.S. soil is roughly equivalent to the total level of production by U.S. firms outside of the country. For example, in 1994 the level of GDP was only $6.7 billion higher than GNP -- the difference represented roughly 0.001% of total GDP.

As mentioned previously, Gross Domestic Product consists of consumption, investment, government spending, and net exports. Consumer outlays, or consumption, is by far the largest portion of the GDP pie, representing 58% of the total. This figure is arrived at by dividing the total level of personal consumption expenditures (minus the portion that represents purchases of imported goods) by the level of GDP. The consumption group can be further subdivided into durable goods, which are items expected to last three years or more like cars and furniture (15% of the total); nondurable goods, which are those goods that aren't going to last three years like food and clothing (31% of the total); and services like legal fees and medical care (the remaining 54%).

Investment, referred to officially as "gross private domestic investment," is comprised of three elements that together represent 16% of GDP. The first component is "nonresidential" investment, which consists of spending by various businesses on "property, plant and equipment." The second component is "residential" investment, which is spending on single-family and multi-family homes. The final component of investment spending accounts for changes in business inventories. Remember, Gross Domestic Product is a measure of production. When economists tally GDP they are in essence adding together the dollar amounts purchased by consumers, businesses, and government. To account for all goods produced, economists need to take into consideration what is left over in the inventories of the various businesses that are taken into consideration. If inventories are rising, the resulting increases must be added to GDP, while falling inventories are subtracted from GDP because they have already been accounted for in sales.

Government spending -- which includes spending at the federal, state and local government levels -- accounts for roughly 15% of GDP. Finally, the last component of GDP is net exports, although many economists now somewhat derisively refer to it as "net imports" because the size of the "imports" portion of the equation in recent years has dwarfed the export side. The deficit in goods and services, roughly $110 billion, would seem to imply that X - M should cut into GDP totals. However, in the GDP quarterly report the net export balance is indeed positive due to "invisibles" such as freight and insurance, which together compensate for the large deficit in goods and services and ultimately contribute to 11% of GDP.

Before 1995 the Department of Commerce utilized a "fixed weight" measure of GDP, meaning that goods and services were valued in relation to their prices at a fixed, base period. In this way economists hoped to distinguish between nominal GDP, the total rise in expenditures, and real GDP, which attempted to net out the gains in total expenditures that were due to rising prices (inflation). The problem with this measure is that fixed price weights overstate growth in the current period. For instance, in recent years prices of new computers have dropped substantially. If GDP were to measure unit consumption of computers in 1997 based on their price in 1990, the obvious result would be an overstatement of growth in dollar terms.

To eliminate any bias of overstating growth, the Commerce Department came up with a "chain-weighted system" that calculates GDP growth rates solely on the basis of prices for the current year and previous years (not a far-off base year). This method avoids the big revisions that occur when the base year is changed, but the chief drawback of the system is that it gets away from dollar figures for GDP and uses an index number instead (which translates into a percentage figure). In order to get around some of these problems, the Commerce Department implemented the "dollar series" in 1992, providing dollar levels for GDP and its various components. However, the parts do not add up to the whole, but again the discrepancy is small and the elimination of bias more than makes up for the inaccuracies.

The GDP is published by the Bureau of Economic Analysis (a bureau within the Department of Commerce) between the 21st and 30th of the month on a quarterly basis, with revisions occurring monthly. The financial markets' reaction to GDP is largely determined by the consensus forecast. In general, the bond market likes weak GDP growth, because in that situation the Federal Reserve is less likely to raise interest rates and threaten bond prices (when interest rates go up, bond prices drop). The stock market likes strong GDP growth because it contributes to corporate revenue growth. However, corporations don't want GDP growth so strong that it elicits a negative response (an increase in interest rates) from bond market participants and the Fed.

[For investors interested in learning more about economic indicators, an excellent book on the subject is By the Numbers: A Survival Guide to Economic Indicators by Stephen D. Slifer and W. Stansbury Carnes.]

Related Links:
Bureau of Economic Analysis
Bureau of Economic Analysis -- Q4 GDP Report (Advance)

Discuss GDP: Economy and Markets message board