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Rick Welch: Dollars and Sense -- What is GDP?

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Gross Domestic Product or GDP is defined as “the market value of all final goods and services produced within a country in a given period of time.”

The GDP growth rate is the percent increase (or decrease) of a country’s GDP from one quarter to the next.

During the first quarter of 2020, the U.S. economy contracted at an annual rate of -5.0%, suggesting the extent of the damage caused by an unprecedented set of business operational halts and widespread stay-in-place orders.

Forecasts for Q2 GDP are far more grim, with a range from -16.8% to an unprecedented contraction of -35.6%. This, of course, would qualify as a recession, which is defined as two consecutive quarters of negative GDP growth or contraction.

For comparison, during the 2008-09 financial crisis we saw significantly lower contraction rates of -8.9% for 2008 Q4, -6.7% for 2009 Q1 and -0.7% for 2009 Q2. Nominal GDP is used when comparing different quarters of output within the same year, while real GDP is used to compare the GDP of two or more years. Over the past fifty years, the US economy has grown on average about 3.0% per year.

GDP measures two things at once: the total income of everyone in the economy and the total expenditure on the economy’s output of goods and services. If you are following this closely, you will realize that total income and total expenditure are just mirror images of each other and, in fact, for an economy as a whole, income must equal expenditure.
Remember that each dollar you, as a buyer, spend (expenditure) is a dollar of income for the seller. GDP includes both tangible goods (food, clothing and cars) and intangible services (beauty salon, repairs and medical). In the case of goods, GDP only considers the value of the final product – think of the final value of the car, not the value of each individual part or component.

This points, perhaps, to a limitation of the GDP calculation in that it ignores intermediate spending and transactions between businesses and overstates the importance of consumption relative to production.
Other excluded items from GDP consideration are the sales of used goods and the sales of black market (illegal) goods and services. GDP measures the value of production within the geographic boundaries of a country, thus, items are included in a nation’s GDP if they are produced domestically, regardless of the nationality of the producer.

I recall a college economics professor referring to GDP as like “adding apples and oranges together.” There is good reason behind that analogy. GDP is the sum of four very different components and in mathematical terms is written like this: GDP = C + I + G + NX.

The “C” is for consumption or the spending by households on goods and services. Consumer spending accounts for about 70% of GDP.
“I” is for investment, which includes both the purchase of new housing and the investment by businesses in new plants, equipment and inventory. Investment accounts for about 18% of GDP.

The “G” stands for the purchases of goods and services by local, state and federal governments. “G” accounts for about 17% of GDP.

Did you notice my new math? Not to worry. When we add “C” (70%) and “I” (18%) and “G” (17%) we arrive at 105%. The last component of GDP, “NX” stands for net exports, which are calculated by subtracting imports from exports. As a nation of consumers who consume more than we export, NX is typically about -5% of GDP.

At present, our international trade deficit is over $620 billion per year which means that the U.S. is earning less on the overseas sales of American-produced goods while spending more on foreign products. A widening trade deficit (which would result in a larger negative value for “NX”) can act as a drag on domestic economic growth.

Rick Welch is a Registered Investment Advisor (RIA) and chief investment officer of Academy Wealth Advisers. He can be reached at 215-603-2976 or rickwelch@academywealthadvisers.com.
 
  

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