What is GDP and is it the best way to measure the economy?

Publish date: 2024-08-20

What’s the best way to gauge the health of the economy? Gross domestic product, a measurement that calculates the value of all goods and services produced, has long been a good way to take the financial temperature of the country.

Economists use it to determine whether a nation is in an expansion or a recession. President Donald Trump even put a spotlight on it when he promised to boost GDP growth — the difference in GDP from one year to the next — to 4 percent, up from less than 3 percent annual growth seen during the Obama administration. Annual GDP growth has remained below 3 percent for each of Trump’s years in office.

But since the Great Recession, economists have increasingly questioned whether it is the best way to measure an economy’s health, and whether it disregards key factors that affect people’s well-being.

One way that GDP growth is important to: Americans’ output needs to keep up with population growth if people want to maintain their standard of living. But for most Americans, just maintaining the minimum is not enough.

“For a lot of people, the American dream has often been framed as doing better than your parents did. That almost by definition requires some growth,” said Jay Shambaugh, director of The Hamilton Project and a senior fellow in Economic Studies at the Brookings Institution.

What does this number mean for Americans’ daily lives? To start, you need to know how GDP is calculated.

What goes into the GDP

There are several different ways to think about GDP.

Real GDP accounts for the value of goods and services produced — that means the sum of all of America’s stuff for sale, plus the value of intangible stuff that people do — minus the effects of inflation. GDP per capita measures the value of goods and services if it were divided equally among every person in a country. GDP growth measures the difference in GDP from one year, or one three-month period (quarter), to the next.

That last figure is the one economists watch most closely to determine whether the U.S. economy is on an upward or downward trend.

The U.S. economy grew at a rate of 2.1 percent in the second quarter of this year, for example. That was a steep drop from a growth of 3.1 percent in the first quarter.

So while the U.S. economy is still expanding, it is not growing as quickly as it was a few months ago. The decline is concerning, but economists always look at the underlying data to determine what is causing the slowdown.

GDP is calculated using this formula:

GDP = consumption + investment + government spending + net exports

Consumption, also called consumer spending, makes up about 70 percent of GDP and includes all the goods and services individuals buy. In the second quarter of this year, consumer spending increased, but business investment and exports declined, dragged down in part to tariffs on China, leading to the lower number.

More jobs, higher GDP…usually

Right now, the unemployment rate is at 3.7 percent — the lowest it’s been in nearly 50 years. And the connection between that number and the GDP is fairly simple. The more people who are working, the more likely the GDP is to be higher because workers are producing more.

Technology can also help boost production without more workers, for example, which would increase the GDP.

The economy also feeds off itself, so if people are buying more things, then companies hire more workers or invest in new technology to meet demand. People have more money to spend and then they buy more things and the cycle repeats. All of that contributes to rising GDP.

But if the number of workers increases GDP, a slowing or falling GDP can affect jobs, too, in a growing snowball of negativity. If people spend less, companies have to cut back on workers and the GDP drops. If GDP growth is negative for two consecutive quarters, the economy is in a recession.

So why is growth slowing? Trade tensions are hindering business investment as is fear of an economic slowdown globally. According to the GDP formula, fewer investments means less GDP. The effects of Trump’s tax cuts are also wearing off.

Plus, economists found that GDP was not as directly correlated with unemployment during the Great Recession as it has been historically, although economists are not sure why that is.

Is low GDP growth bad?

From 1987 to 2007, GDP growth in the U.S. averaged 3 percent. But since the Great Recession, it has been lower at around 2.3 percent, prompting some economists to question whether the slower growth is a “new normal.”

Several factors are likely contributing, but the two main factors are lower worker productivity and the fact that baby boomers are retiring and not being replaced as quickly by younger employees in the workforce, according to the Federal Reserve Bank of San Francisco’s researchers.

There are also fewer women entering the labor force than there were in the mid- and late-20th century, when the women’s movement encouraged more women to work outside the home. Many economists say it is reasonable to expect slower GDP growth in the future compared to the past.

What worries economists now is that GDP might be slowing down because people aren’t increasing their productivity. Lower productivity means wages won’t rise as quickly, which can affect people’s quality of life.

Taking care of your kids isn’t counted by GDP…but maybe it should be?

Recently, some global economic leaders have suggested countries should not put so much focus on GDP.

Even Simon Kuznets, the Nobel Prize-winning economist who helped develop the idea of GDP, said it should not be used as a measure for “the welfare of a nation.”

How much consumable stuff people produce leaves out a lot of important factors that contribute to well-being, such as a clean environment and good health.

An oil spill can increase GDP, for example, because it costs money to clean up, but that also contributes negatively to the environment.

GDP also does not take into account unpaid work like housework and child care, which is largely carried out by women.

“Time that you spend taking care of your kids is very valuable time, but it doesn’t get factored into GDP,” said Nancy Folbre, a professor emerita of economics at the University of Massachusetts Amherst.

Some countries are starting to develop alternative ways to account for the value of unpaid work, which Folbre says constitutes about half of the time individuals spend working on average. But until that is regularly factored into GDP, the measurement will only be providing part of the entire economic picture.