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Know Your Numbers: GDP

By Dan Caplinger - Updated Nov 15, 2016 at 5:41PM

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Basic knowledge can help you comprehend releases of economic data.

The scope of economic data related to the U.S. economy is immense. Because economic activity is a fundamental part of everyday life in America, measuring basic economic concepts like output and consumption is a monumental task. Yet in order to gauge the success of policy-making agencies and organizations that try to manage economic growth and avoid painful downturns, it's critical to have good information about what effect their policies are really having. Without accurate data, overseeing an economy is like driving a truck with no headlights on a moonless night.

The primary way to measure the size of a country's economy is by calculating its gross domestic product. The Commerce Department's Bureau of Economic Analysis is responsible for calculating U.S. GDP figures. Because the growth or contraction of the overall economy has huge implications for every facet of economic activity within a country, GDP figures are scrutinized closely by economists, business and government analysts, and investors. This article takes a closer look at the definition of the gross domestic product and the way data is collected and analyzed to measure GDP.

The basic concept
Economists define gross domestic product as the sum of several components. Specifically, GDP is calculated by adding together four figures: the amount of consumption of goods and services by private individuals and businesses; business investment in capital for production of goods and services; the amount of spending and consumption by government agencies at all levels; and the net amount of exports to other countries. For the United States, because the value of imported goods and services exceeds the value of exported goods and services, this final component of GDP is a negative number.

To compile GDP numbers, the BEA uses a number of different methods that depend on the industry. For some data, actual values are available; others require the BEA to use a variety of estimation methods. The BEA uses source data from other government agencies, when available, to assist it in calculating components of GDP.

The current GDP of the United States is approximately $13.2 trillion. Of this amount, about $9.2 trillion constitutes personal consumption, $2.2 trillion is used for private business investment, and $2.5 trillion is spent by the government. Offsetting these numbers are net imports of about $800 billion.

In addition to these overall economic figures, the BEA release also includes valuable information used to calculate GDP. For example, the BEA produces a price index that measures prices that Americans pay for domestic purchases. This figure, also known as the GDP deflator, provides a useful comparison with the Labor Department's Consumer Price Index, which calculates a similar measure in a slightly different way. Furthermore, the BEA breaks down overall data into several categories of interest to particular industries and segments of the economy. Because GDP figures incorporate the economic activity of the entire country, the BEA releases two sets of monthly preliminary figures before making its final revision of the quarterly data. Today's release showed that these revisions can often be substantial; the reduction in growth from 2.9% to 2.6% represents about $40 billion in lost economic activity.

Limitations of GDP
As a gauge of economic activity, GDP figures do a reasonably good job, but they have their limitations. For instance, GDP figures only include reported monetary transactions. As a result, many types of economic activity are not included in GDP, including black-market and other under-the-table transactions, bartering of goods and services, and unpaid household and volunteer work. For example, open-source software like Linux is undoubtedly of great economic value, as companies like Microsoft (NASDAQ:MSFT), Red Hat Software (NASDAQ:RHAT), and Novell (NASDAQ:NOVL) can attest. Yet its full value is not included in GDP, because free code sharing and redistribution do not generate countable monetary transactions.

Furthermore, GDP only measures the aggregate output of the entire economy. Although overall economic conditions affect everyone, the root sources of economic growth and contraction tend to differ in subtle ways from cycle to cycle. In order to identify the driving force behind the current state of the economy, it's necessary to search other types of data for extraordinary strength or weakness in particular sectors. The aggregate nature of GDP also fails to address how economic activity is distributed across the economy; countries with similar GDPs could potentially have much different distributions of wealth and work across their populations.

Economic implications
In general, economic policymakers seek steady, moderate growth in GDP. When GDP growth slows, stops, or becomes negative, the economy is apt to enter a phase of recession. Recessions are times of significant risk for the economy; although they can quickly lead into the next phase of expansion in the business cycle, they can also be long and painful, causing a host of other economic problems. One need only go back to the recessions of the late 1970s and early 1980s to see some of the potential impacts of economic downturns: high unemployment, high inflation and interest rates, and significant drops in housing and stock prices.

At the other extreme, not all growth is good for an economy in the long term. Short-term growth that is faster than the economy can sustain also carries risks. In overheated economies, opportunities for profitable business investment are plentiful, and obtaining capital becomes the key factor in determining how much investment will take place. As a result, prices often rise, and especially for developing countries, the threat of hyperinflation looms as a potentially catastrophic outcome.

Many countries, including the United States, use interest rate adjustments to respond to changes in economic conditions. The Federal Reserve looks closely at GDP figures to determine whether interest rate cuts are needed to boost growth or hikes are needed to curb growth. Because changes in interest rates often have marked impacts on returns on investment, stock and bond prices, and the ability of companies to obtain financing for operations, investors look to GDP figures to guide their investment strategies. Also, from a political standpoint, growth in the economy is often vital for the success of the political party currently in power.

As global investing becomes more popular, GDP is becoming an important indicator not just for the United States, but also for measuring the economic output of foreign countries. Although you have to be careful when considering the source of any economic data you use, there are generally accepted standards for measuring GDP that allow for comparison of data among various countries. Knowing the local economic conditions can be extremely valuable in considering whether or not to invest overseas.

In summary, GDP is widely considered to be the mother of all economic indicators. As the primary indicator of economic activity, GDP is the main feedback mechanism economic policymakers use when determining the paths they aim to follow. Whether or not the economy is growing is vital to making informed decisions about economic matters in both your personal and your professional life.

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Fool contributor Dan Caplinger does his part to keep GDP numbers high. He doesn't hold positions in any of the companies mentioned in this article. Microsoft is a Motley Fool Income Investor selection. The Fool'sdisclosure policykeeps up with your growing portfolio.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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