Personal Finance: What determines GDP, what does increase mean?

Personal Finance: What determines GDP, what does increase mean?

September 4th, 2013 Chris Hopkins in Business Diary

Chris Hopkins

Photo by Patrick Smith/Times Free Press.

Q: I read that GDP was revised higher. What does that mean?

A: GDP, or Gross Domestic Product, is the primary metric by which the economic health of a nation is measured. In the United States, the Bureau of Economic Analysis at the Commerce Department is responsible for collating thousands of data points each quarter into a composite statistic that gauges how much the economy grew or contracted. The quarterly release is closely followed since it influences so much of Government policy.

While some of us are old enough to remember another measure called Gross National Product, this number has lost much of its relevance in a globally integrated economy. GDP does a better job of measuring output within the borders of a nation, and has therefore been emphasized as the preferred benchmark by the BEA since 1991.

GDP is defined as the sum total of all goods and services produced within the boundaries of a country. In the U.S., for example, this would include all the Fords and Chevys manufactured in America, but would exclude the Fords built in Brazil or China. Likewise, Volkswagen Passats assembled in Chattanooga are counted in U.S. GDP. Services provided by Americans to customers at home or elsewhere are also included. To avoid double counting, only final goods are included (like cars) and not intermediate goods (like the engines under the hood).

GDP is composed of four broad subcategories. The most significant constituent in the U.S. is consumption spending, the total spent on goods and services by American consumers. This subset comprises about 70 percent of total U.S. GDP, which is why so much attention is paid to retail sales, automotive production and consumer sentiment. In 2012, consumption spending contributed $11 trillion of the $15.7 trillion U.S. economy. Spending for services accounts for 60 percent of the category, while physical goods make up the remaining 40 percent.

Government spending at all levels is the second-largest element of output, making up 20 percent of the total. The third constituent is private investment, including capital spending on machinery, real estate and changes in inventories. Investment spending represents 16 percent of GDP.

Finally, net exports (the difference between exports and imports) is actually a drag on GDP, since the balance is negative (more imports than exports). This factor reduced total GDP by about 4 percent last year.

Knowledge of two other subtleties regarding GDP can help interpret the data. First, the number popularly reported is "real GDP", meaning the base-level growth in the economy ignoring inflation. The BEA computes so-called "nominal" GDP and then backs out inflation to produce a number that is comparable over time regardless changes in the price level.

Secondly, the initial release of the data for a given quarter necessarily includes lots of estimates, and is therefore considered preliminary. The numbers are successively refined over the next two months to produce a final more precise total. That is why last week's release included a revision upward from 1.7 percent to 2.5 percent (annualized) for the second quarter of 2013.

Next week we will look at how US GDP is doing.

Christopher A. Hopkins, CFA, is a vice president for Barnett & Co. in Chattanooga.