How Does the GDP Affect a Country's Economy?

The gross domestic product (GDP) is a vital measure of a nation's overall economic activity. It's important to understand the GDP's effect on an economy.

A rising GDP is a sign of a growing national economy. A GDP that doesn't change very much from year to year indicates an economy in a more or less steady state, while a lowered GDP indicates a shrinking national economy.

What, Exactly, Is GDP?

The gross domestic product of the United States is the most widely used measure of the size of the overall economy. Commonly referred to by its initials - GDP - it is a calculation of the total market value (that is, the total selling price) of all goods and services produced in the country. It includes commercial goods, which are physical items that are sold – such as an automobile, a piece of jewelry, a book or a cantaloupe. It also includes some intangible items, like downloadable music or software that are also classified as goods.

A service, in comparison, is an action that people do for others. A barber cutting your hair, a lawyer drawing up a will and a doctor examining your health are all performing services. Items consumed at the point of purchase are regarded as services rather than goods. For example, your restaurant meal is classified as a service.

The Components of the GDP

The GDP is calculated by the Bureau of Economic Analysis, a branch of the U.S. Department of Commerce. BEA includes the following components in its calculation of the nation's GDP:

  • GDP = C + I + G + NX 

C is consumer spending - the things we all spend money on in our day-to-day lives, from groceries to our monthly car payments.

I stands for investment, but in the language of the BEA, it refers to general business spending on fixed assets - that is, investments, chiefly by businesses, in equipment, facilities, inventory and the like. This category also includes consumer home purchases.

G represents spending by the government. The largest government spender is Uncle Sam, buying everything from office supplies to guided missiles. But spending by state and local governments also figures into this category.

NX stands for net exports. This category accounts for items made in the United States and then sold outside the country after subtracting the value of imports because the imports sold in this country are not produced within the boundaries of the country.

Adding up the total value in each category yields the gross domestic product.

The Difference Between GDP and GNP

Another measure of the overall national economy is the GNP or gross national product. This is similar to the GDP, but also takes into account some income not included in the GDP, particularly earnings that come into the country from foreign investments. The "domestic" part of the GDP emphasizes the distinction between the two terms since GDP includes only domestic production.

Both GNP and GDP are reported regularly. However, GDP has become the metric of choice for referring to the overall status of the economy. The GNP was a common feature of economic reports in decades past but is not used very frequently in modern-day financial and economic reporting.

The GDP of the United States

In the latter part of 2019, the BEA pegged the GDP of the United States at slightly more than $19 trillion a year. Or perhaps the real figure was more than $21.3 trillion. You get your choice because, as is the case with many economic statistics, the GDP is adjusted for a number of factors. The key adjustments have to do with factors like inflation and seasonal adjustments. These adjustments are made to account for calendar-related variability during the course of the year. The adjustments are intended to allow for realistic comparisons from quarter to quarter or year to year, but the multiplicity of values can also be somewhat confusing.

Many analysts pay more attention to the GDP growth rate than to the absolute value. As the Bureau of Economic Analysis puts it, "The growth rate of GDP is the most popular indicator of the nation's overall economic health."

The 2019 GDP, for example, represented an increase of 2.1% over the value from the previous year. Thus far in the 21st century, year-to-year growth rates of from 1 to 3% have been fairly typical.

GDP by Sectors

The GDP can be parsed in many different ways to reveal details of the status of the American economy. Dividing the GDP into individual sectors shows the types of activities that are dominant in the economy, those that play a minor role and the overall changes in status over time.

For example, the real estate industry is the largest overall business component of the GDP, accounting for around 13% of total national economic activity. Government spending, banking and finance and health-care services occupy the next three tiers, in that order.

Trend data over time also reveals changes in overall contributions to the GDP. Spending in the health-care sector has expanded rapidly in the past few decades, thrusting this sector into one of the top tiers of GDP components.

The Geography of GDP

Similarly, each state, county, city or other area has its own gross domestic product that can be taken from the national data. California has long held the number-one spot among states, with a GDP of about $3 trillion. Put another way, the economy of this one state, California, is pretty much the same size as the overall GDP of the United Kingdom.

Texas comes in at second place, with an overall GDP of slightly under $2 trillion. In terms of growth, West Virginia has, of late, had one of the fastest-growing economies of all the states; Hawaii, in comparison, is trudging along at a fairly low rate of growth.

How the Economy Affects the GDP

Because GDP is a measure of overall economic activity, it stands to reason that a growing economy will lead to an increase in GDP. Conversely, as the economy slows, the growth of the GDP slows as well, and may even head into negative territory. That is, the size of the overall U.S. economy can shrink from one year to the next. This actually happened during the 2008 to 2009 recession, when the GDP shrank by 2.5% before beginning to bounce back to year-over-year growth.

In times of unusual economic activity, the GDP can skyrocket. During World War II, the United States routinely experienced double-digit growth of its GDP, peaking in 1942 at an astounding increase of 18.9%.

How the GDP Affects the Economy

Government policy-makers prefer to see the GDP increase in the 2 to 3% range from year to year. Less than that raises concerns about an economic slowdown or a pending recession. Faster growth rates than that raise alarms about price inflation, possibly spiraling to unhealthy levels.

The federal government may actively intervene to influence the overall economy based on the latest round of GDP numbers. The White House and Congress may agree to adjust federal spending or modify taxes to increase spending, in the case of too-slow GDP growth, or put the brakes on the economy if the GDP appears to be overheating.

Similarly, the Federal Reserve Bank can adjust monetary interest rates or take other measures in an attempt to modify the pace of change of the GDP.

It's not just the overall economy that is influenced by GDP reports. If a particular sector or geographic area looks to be experiencing difficulties in terms of its specific economic activity, then policy-makers at the federal and local levels may also try to intervene in these more limited areas to influence the pace of change of the GDP.