World Economy

What is GDP and Why is it Important?

  • Mark Edwards ·
  • May 15, 2018

The gross domestic product (GDP) is one of the best ways to measure a country’s economic performance. It is the total estimated value of all final goods and services produced in a country during a specific period (quarterly or yearly).

GDP consists of private consumption expenditure, net exports, government spending, and investment spending (business fixed investment, inventory investment, public investment, and residential construction investment).

Why Is It Important?

Identification of the Economic Health of a Country

As stated above, GDP is one of the best ways to measure the economic well-being of a country. A rising GDP indicates that a country’s economy is growing – this implies that citizens are, on the average, wealthier and have a better life. When the GDP slows down for two consecutive quarters, the economy goes into recession. During a recession, consumer spending decreases, business profits decline, unemployment rises, and government tax collections fall.

Policy Formulation

Governments and central banks use GDP estimates for policy (fiscal and monetary) formulation. Businesses use GDP estimates, for small cities and small regions within a country, to make decisions regarding the allocation of resources (money and labour).

Comparison Between Economies

GDP acts a reference point for the economic performance of regional, national, and global economies around the world.

How to Determine GDP

The GDP of an economy is calculated by adding up consumption (C), government spending (G), business investment (I) and the difference between exports and imports (X – M).

The standard formula for GDP is: C + I + G + (X-M).

GDP can also be measured in three ways. These include:

1. The Expenditure (Spending) Approach

The expenditure approach calculates the total money spent in an economy. The idea behind this approach is that the goods and services produced by a country have to be consumed by final users – households, businesses and the government. As a result, the sum of all expenditures of these groups should equal the total output (goods and services) which is the GDP.

2. The Income Approach

In this approach, GDP is calculated by adding up the income generated by all factors of production in an economy. These include corporate profits, wages and compensation paid to employees, rental income, taxes paid to the government, just to name a few.

3. The Production Approach

The production approach, also known as the output approach, is calculated by deducting the total value of economic output from the value of inputs used in the production process.

How Does GDP Affect the Citizens?

When the economy is strong, businesses tend to hire more workers, and can afford to pay higher salaries – this leads to a decrease in unemployment and more spending by consumers on products and services.

However, if the economy is growing too fast, the central bank may raise interest rates in an effort to ward off inflation – this could mean that loans would be more expensive. Businesses would also find the cost of borrowing for expansion and hiring too expensive.

When the GDP declines, the economy goes into recession – this means declining consumer spending, declining business profits, and unemployment.

GDP estimates give an overall picture of which sectors of an economy are growing and which are declining – this can help gear employees toward training in the sectors that are experiencing growth.

How Does GDP Affect Investments?

Active investors usually keep an eye on GDP figures to determine how, when and where to best allocate their resources. If an economy is not doing well, companies tend to make low profits – this means lower stock prices for some companies.

As stated above, the GDP gives an overall picture of which sectors of an economy are growing and which are slowing down – this can help investors to determine which sectors they should focus their resources on.

A change in GDP, whether up or down, has a significant effect on nearly everyone within the economy. With that said, it is important that you create an investment mix that consistently reflects and contributes to your long-term financial goals.