How to Measure Gross Domestic Product (GDP) and Why It's Important
Gross domestic product, or GDP, measures a country's economic progress. To date, it remains the most closely watched indicator of how the economy is doing -- and where it's headed.
If you're thinking about investing in precious metals or expanding your growing coin collection, GDP can help you understand which items will benefit your portfolio the most. The only problem? If you're not in the financial realm, this formula can be a little tricky to navigate.
Today, we're putting it all in layman's terms so anyone can navigate and use it. Read on to discover what GDP entails and how you can apply it to your investment strategy.
What Is Gross Domestic Product?
GDP represents the total monetary value of all the finished goods and services that a country produces within a given timeframe. While it's an accurate way to measure the country's domestic production, it also provides a look into the nation's economic status.
Countries have their unique ways of measuring and reporting on GDP. Most entities release a GDP estimate at least once a year, if not quarterly. For instance, the U.S. government releases an annualized GDP report each fiscal quarter on top of a comprehensive yearly report.
While inflation can naturally affect these numbers, all data sets are reported in real-time terms. This means they're adjusted to reflect current pricing changes to be as accurate as possible.
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What Does It Measure?
When financial leaders calculate a country's GDP, they take as broad of a view as possible. The numbers they use encompass a variety of activities spanning both public and private sectors, as well as the following:
- Investments
- Government outlays
- Paid-in-construction costs
- Private inventory additions
- Foreign balance of trade
As the numbers are calculated, exports increase the total GDP value while imports subtract from it. Thus, while all of these numbers are important, foreign balance of trade is one of the most distinct indicators of economic health.
A country's GDP typically goes up when the total value of goods and services sold to foreign countries exceeds the value of goods and services that a country is required to import. When the balance falls in this way, the country has what's known as a trade surplus. When the pendulum swings the other way and a country purchases or imports more foreign products than it exports to foreign consumers, the situation is called a trade deficit.
When a country is in a designated trade deficit, its GDP is normally lower.
Three Approaches to GDP
There are theoretically three different ways that someone might approach and measure GDP. These include:
- The production approach
- The expenditure approach
- The income approach
Let's review these more closely.
The Production Approach
With the production approach, analysts are most interested in the amount of value that each stage of production adds to the country's economy. In this case, value-added means the total amount of sales minus the value of intermediate inputs required throughout the production process.
For example, if a furniture company is making a dresser, the lumber would be considered an intermediate input, and the finished piece would be the final product. This can also apply to services. For instance, an engineer's services are an intermediate input during the commercial building process, and the building itself is the final product.
The Expenditure Approach
When analysts use the expenditure approach, they sum the value of all purchases made by end users. For example, they might measure how many people consume the loaves of bread that a baker makes. Or, how many televisions an electronics manufacturer sells.
Other elements they might look at when calculating this figure include:
- How much money companies invest in machines
- How many goods and services the government purchases
- How many medical services each household pays for
The idea with this approach is that when the economy is up, expenditures will likewise increase.
The Income Approach
The income approach to GDP measures how much production rates affect income. In this case, income is more than simply the total compensation plans that employees receive. It also includes the operating surplus of that entity, which is usually the total sales minus total costs.
As with expenditures, income numbers will normally rise alongside GDP rates.
Real vs. Nominal GDP
When learning how to measure GDP, there are two main strategies to know: real and nominal. These formulas are generally the same, with one major exception: Real GDP accounts for inflation while nominal GDP does not.
When analysts and investors want to know the most accurate and realistic indicator of their country's economic progress, they'll often use real GDP calculations over nominal. This is especially the case when they're building long-term projections and need to know how inflation might affect those forecasts.
Let's take a closer look at how these two calculations differ.
Real GDP
GDP is based on the current monetary value of a country's goods or services. As such, it's subject to the effects of inflation and deflation.
Real GDP measures the amount of goods and services an economy produces in a year. The formula adjusts for inflation by holding prices constant from one year to the next, so the outcome isn't affected by upticks or declines in pricing that could skew the numbers.
In this way, real GDP is a more accurate indicator of the country's economic output over a specified timeframe. To find it, analysts will gather data on the quantities of goods and services produced that year. Those quantities are often called "real" quantities.
Next, they'll assign base-year prices to those quantities produced, then multiply the quantities by the assigned prices. Finally, they'll add all the products together to get the final GDP.
When they compare real GDP numbers across different years, analysts can clearly see how the economy has shifted based on real output, not subject to the pricing differences that inflation/deflation can cause. With this more accurate information, they're better equipped to perform financial actions, such as:
- Analyzing economic trends over time
- Make better-informed government policy decisions
- Gauge the overall health of the country's economy
Nominal GDP
While real GDP recognizes and accounts for inflation, nominal GDP does not. Instead, this measurement uses "current" dollar rates to find the sum of goods and services consumed, as well as all expenditures, exports, and investments. Once analysts reach that total, they'll subtract the value of the country's total imports that year.
While this can yield similar results to real GDP, the numbers aren't as accurate or forecast-worthy. That's because using current rates only does not account for how the value of a country's currency could change over time. As these numbers fluctuate, it can be hard to tell how much an economy is growing or declining based on the immediate figures.
Instead of using base-year prices like real GDP, analysts look at current market prices when calculating nominal GDP.
What Isn't Included in GDP?
While GDP growth or GDP decline is based on a country's productive activity, certain types of economic changes aren't included in this calculation. Some of the most commonly excluded values include:
- Unpaid work (e.g. volunteer work, work performed at home)
- Black-market activities
- Wear and tear on machinery and buildings
For instance, if a jeweler makes a pair of earrings to sell in his storefront, that sale would contribute to the country's GDP. However, if that same jeweler made a pair of earrings in his home and gave them away to a friend, that transaction would not contribute to the GDP. In that case, the only thing counted would be the materials and supplies purchased to make the item.
Likewise, GDP does not account for the general degradation that machinery and equipment go through when producing output. If analysts do subtract capital asset depletion or depreciation from the GDP, the output is called the net domestic product, not GDP.
Affect on Gold Prices
Why does the GDP matter to precious metal investors?
When the economy is growing quickly and the GDP is on the rise, individuals tend to have a higher income and more purchasing power. In turn, more people have the funds to buy gold and other metals, which drives the prices up.
At the same time, the opposite also holds true. When the GDP declines or stagnates, income levels dip and discretionary spending slows down. This causes the price of precious metals to dip, as supply often exceeds demand.
While this is one theory, it's important to note that the relationship isn't always this simplistic. Some analysts believe the opposite correlation holds, and that there's a negative correlation between GDP growth and the price of gold. Either way, we know that gold prices are not exclusively set by consumer demand, so smart investors will also keep an eye on how other market conditions may affect their portfolios.
Discover Smart Investing Strategies Today
As an investor, you know that the economy never stays the same. It's always ebbing and flowing, and it's smart to stay ahead of the curve. Remaining aware of current and future financial reports, including the GDP, can help you build a portfolio capable of surviving both major dips and periods of great growth.
At the U.S. Gold Bureau, we're here to help you invest wisely and grow a collection you love. To learn more, sign up for our free investor guide today!
