Gross domestic product (GDP) is one of the most closely watched indicators of a country’s economic health. You’ll often hear the term on the news or see it in articles as a reference point for a nation’s financial well-being. But GDP isn’t just about economics on the world stage. It has ramifications for small businesses, employment, inflation and more.
We’ll explore GDP, how it’s calculated, how it affects employment and what GDP means for small business owners.
GDP, or gross domestic product, is the measurement of an economy’s overall health and well-being. In other words, it’s the monetary value of all the finished goods and services produced within a country’s borders – its total output – during a given period. It takes into account all the goods and services produced, imports and exports, and government spending.
Gross national product (GNP) and gross national income (GNI) are two other ways to quantify a country’s economic strength.
GDP per capita is production “per head,” or per person. It’s calculated by dividing GDP by the country’s population. GDP per capita is helpful because it allows for meaningful comparisons between countries of different population sizes.
GDP is the most closely watched economic indicator. Domestically, it determines whether the economy has grown or contracted since the previous quarter. For example, when the GDP drops for at least two consecutive quarters, the economy is considered to be in a recession. GDP is also used to compare the size and growth rate of economies worldwide.
GDP is the sum of four components:
The calculation of GDP, then, is represented by the following formula:
C + G + I + NX = GDP
Here’s a deeper look at each component:
There are three methods for determining GDP: expenditure, production (value added) and income. While the mathematical approaches are different, all yield the same final figure when done correctly.
Not all production that takes place within a nation’s borders is accounted for in GDP. Unpaid work or activity in the underground economy, or “black market” – where illegal drugs; weapons; pirated music, movies and games; and exotic animals are bought and sold – is considered when calculating GDP.
GDP also does not include unpaid household labor, such as sewing or food production. As a result, some see GDP as flawed, as this exclusion disproportionately affects agrarian societies, where much of the production is done at home.
Whereas nominal GDP represents the raw calculation, real GDP adjusts for inflation. Since inflation is the decrease in the value of currency, inflation will cause prices to rise and thus GDP to artificially rise, even if the value of goods and services remains the same. For that reason, real GDP more accurately measures changes in an economy during periods of inflation.
In the United States, GDP is measured by the Bureau of Economic Analysis and publicly reported each quarter. Real GDP is calculated by setting a base year and adjusting the GDP in the following years with a GDP price deflator to reflect the value of consumer goods in the base year. For example, if prices inflate by 10% from the base year, the nominal GDP would be divided by the price deflator 1.10 to yield the real GDP.
Most stand-alone GDP figures will be nominal GDP since real GDP varies depending on the base year. Real GDP is used for comparison over time.
Employment represents one factor of a country’s economy, whereas GDP measures total economic performance. This means that while employment alone does not drive GDP, employment levels and GDP are historically correlated. The relationship between unemployment and GDP is known as Okun’s law, after economist Arthur Okun.
The exact correlation in Okun’s law has changed over time, but roughly, a 1% fall in the unemployment rate yields a 3% rise in GDP.
Economist Simon Kuznets first introduced GDP measurements in the U.S. in the 1930s. In a report to Congress, Kuznets proposed a single economic indicator to measure a country’s economic output.
However, it wasn’t until 1944, following the establishment of the International Monetary Fund and the International Bank for Reconstruction and Development, that GDP was used as the standard economic measurement worldwide.
Historically, the U.S. GDP Growth Rate has averaged 3.2%. GDP reached an all-time high of 17.2% in 1950 and a low of -10.4% eight years later.
When reviewing its accomplishments in 1999, the U.S. Department of Commerce declared the GDP to be one of the greatest inventions of the 20th century.
GDP provides an overall snapshot of the economy’s health, which can help business owners make projections. When GDP is high, consumers are more likely to feel flush and be ready to spend. For many companies, that may be the right moment for expansion and business growth. When GDP is low, retrenchment may be a more appropriate strategy.
However, some businesses are countercyclical; they are more likely to succeed when the economy is doing poorly. Financial advisors, companies associated with home and auto repair, grocery stores, and discount stores tend to fare better when consumers feel pinched.
There is no one-size-fits-all approach for businesses to respond to new GDP numbers, but thoughtful business owners know what changes mean for them. Taking the time to understand how GDP affects your industry allows you to shift your strategy accordingly when new GDP figures are announced, helping you recession-proof your business.
Ross Mudrick and Chad Brooks contributed to the writing and reporting in this article.