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Friday, January 28, 2011

What is GDP?

To do a poor man's overview of the macroeconomy, you need to know 3 things:  GDP, inflation, and the unemployment rate. With a nice tie and the ability to riff on these 3 magnitudes, you are ready for a stint on CNBC. Throw in a couple remarks about foreign exchange, especially the Yuan, and they might offer you a guest commentator spot.

But what exactly is GDP (if you're a former student of mine I hope you don't need to keep reading), and why do markets care?

Incidentally, the advance estimate of 4th quarter GDP is released today at 8:30 am. There are two revisions to the advance estimate based on more complete data released at a later date. To find out what economists expect (you should know this if you're headed for the CNBC studios), go to the Bloomberg calendar. There you find that real GDP (GDP after taking out the impact of inflation) is expected to increase 3.5%, and the inflation measure derived from the data (called the GDP deflator) is expected to show an increase of 1.5%.

GDP Source:Bloomberg

Scroll down at the Bloomberg site and you'll see a graphical presentation of both of these magnitudes, useful for gaining a longer term perspective. The graph shows the "Great Recession" as a sharp dip and then the sharp spike off the bottom that economists are talking about today--and that stock market investors are cheering on.

So what exactly does GDP measure?  By definition, it is the market value of all final goods and services produced within a country over a given period of time. The reason we look at "final goods and services" is to avoid what is called double counting. When you buy a car, the value of the car includes what the car company paid for the tires, sound system etc. To count these separately, and then the value of the car, would include their values twice.

Notice that the focus is on the rate of growth and not the magnitude. For those who need to know, GDP totals approximately $15 trillion. To gain some perspective, it takes a bit over 31 years to reach a billion seconds and 1 trillion is 1,000 billion. To look at GDP from another perspective, it would $15 trillion to buy all the goods and services produced in the U.S. over a 12-month period. That's some big bucks - even to the likes of Warren Buffett and Bill Gates.

In interpreting the growth rate of real GDP (which is the important magnitude), there is a sort "Goldilocks" thing going on - you don't want it too hot or too cold. If the growth rate goes above 5%, say, for a protracted period, people worry about inflation. At much less than 3.5%, the worry is deflation and a possible recession and the loss of jobs. Because the U.S. is job challenged at the moment, the higher the better for the GDP growth rate!

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