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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.
A simple way to define Gross Domestic Product is to break down the three words making up the term:
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:
The formula for calculating GDP uses the underlined letters from above:
C + I + G + NX = GDP
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, Congress could pass legislation to spur economic growth if GDP shows that the economy is in a downturn. Likewise, the Federal Reserve Board will look to GDP as one of many inputs of economic health when determining whether to reduce or increase the federal funds rate.
The economy moves in a four-part cycle:
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 maximize returns and minimize losses in cyclical stocks.
