2/4/13 – What is Gross Domestic Product (GDP)?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Feb 4, 2013 11:40:51 AM

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I have spent some time looking at the fourth-quarter GDP report over the past couple days, but it occurred to me that it might be helpful to step back and take a look at exactly what GDP is, what it is composed of, how growth happens, and what it means. This is essential to understanding any analysis of what happened in the fourth quarter.

I am going to present a relatively simple way to understand this, based on the output approach, but there is a lot more detail available. Wikipedia’s explanation of gross domestic product is a reasonable source.

First, let’s consider the term. Gross means everything, domestic means in the U.S. (or the appropriate country), and product means just what it says—the products made in that country, which also include services. At some point, every product must be sold. So if we take the sum of all the spending, the result has to equate to the value of everything produced—or the value of the economy as a whole over a period of time.

The equation that represents this, which is less complicated than it appears, is:

GDP = C + I + G + (X–M)

Simply, the economy is everything that people buy (C), plus everything that businesses buy (I), plus everything that the government buys (G), plus everything sold to other countries (X, exports) minus what we buy (M, imports) from other countries.

What people buy, C, is called personal consumption. It includes new products or services. For example, a new house would be considered personal consumption, but a used house would not. But the brokerage commission (a service) for purchasing that used house would be considered personal consumption, as would any repairs to the used house. Ditto for a new car versus a used car. If you think about it, it has to be this way—otherwise economic “growth” could be created by simply selling a used car from one person to another, over and over.

C represents what the population as a whole is buying for personal consumption, and, as people buy more, they presumably have a higher standard of living. Growth in personal consumption also leads to growth in the economy as a whole. At about 70 percent of the economy, personal consumption drives whether the economy as a whole is growing or not.

I, business spending, include investments and inventories—that is, what business is spending its money on. It includes buildings, equipment, items to operate businesses and to sell them—basically, any “thing” that businesses would buy. It also includes new construction, both commercial and residential. As with personal consumption, as business grows, it requires more inventory, more buildings, and so on. I is approximately 12 percent of the economy as a whole.

G is government spending, not just federal but also state and local spending. It is about 20 percent of the economy. It includes consumption and investment spending, and again, in theory, as government spends more, the economy grows and people are overall better off.

If you look closely, you will note that these three components actually add up to more than 100 percent. But that is okay because the fourth component, net exports, is negative and will bring us back down to 100 percent.

X, exports, is what we sell to other countries, and it is less than M, imports, what we buy from other countries. We are buying more from abroad than we are selling. This is a negative factor, and it reduces growth.

Given this base, we can now look at the fourth-quarter results for GDP again. C, personal consumption, grew, which was good. I, investment, also grew, which was very good, as this has been the missing piece of the recovery, but I, inventories, declined significantly, subtracting from growth. (As a side note, this could be a good thing. If firms unexpectedly sold more than they had stocked for, they will have to restock, which could result in a higher inventory figure going forward, and more growth.)

G, government, also decreased significantly, due to the largest drop in 40 years in defense spending. This seems due to the fiscal cliff or sequester in some way, and it doesn’t seem to be an ongoing risk if either is resolved. Finally, the fact that M, imports, increased faster than X, exports, was a negative factor as well.

In sum, we can see that the majority of the economy, C, continues to grow. Much of the business sector, I, investment, continues to grow as well, and the drop in I, inventories, may end up a good thing. The change in G is probably a long-term trend, but its magnitude was probably a statistical outlier that won’t be repeated. X minus M, net exports, is also a long-term negative—at least until the rest of the world economy starts to recover.

Overall, then, about 80 percent of the economy (C + I) is growing, and 20 percent is shrinking. Those numbers are why I suggest that the economic recovery is likely to continue, despite the headwinds.

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