Gross domestic product, or GDP, is one of the primary indicators that economists use to measure the health of a country’s economy. Much like an EKG monitors the function of a patient’s heart, GDP provides a picture of how a country’s economy is functioning. An economy’s health could deteriorate for several reasons, leading to a drop in GDP.
Gross domestic product represents the total market value of all the final goods and services produced in a country over a given period of time, typically defined as a quarter or year. The two primary methods for calculating GDP are the income approach, or the sum of what everyone earned, and the expenditure approach, or the sum of what everyone spent. The most widely used definition is the sum of consumer spending, government spending, capital investments and net exports. Furthermore, GDP can be adjusted for inflation, called real GDP, or unadjusted, called nominal GDP.
Consumer Spending Reduction
Consumer spending, or personal consumption expenditures (PCE), represents the sum of all consumer expenditures for products and services. These expenditures are typically divided into durable goods, nondurable goods and services. A reduction in consumer spending in any of these areas, or a combination thereof, will have a negative impact on the country’s overall GDP.
Government Spending Reduction
Government spending represents the sum of all expenditures for products and services. These expenditures are divided into federal spending, state spending and local government spending. At the federal level, expenditures are typically divided into defense and nondefense spending. A drop in government spending will have a negative impact on the country’s overall GDP. For instance, if the government reduces its spending on ammunition or office supplies, then that will affect the GDP.
Capital Investment Reduction
In terms of GDP, investing refers to capital investments by business and housing purchases by consumers. It is not the same thing as saving money or investing in financial instruments. Capital investments include both fixed assets, such as land, structures or machinery, and technological investments, such as computers and software. If businesses invest less money into capital expansion, then GDP is negatively impacted. Likewise, if consumers buy fewer homes, then that will have a negative effect on GDP.
Trade Balance Changes
Because GDP reflects the final market value of products and services produced within a country, exports count toward GDP. However, goods and services purchased within the country that have been produced elsewhere, known as imports, do not count. Therefore, a change in a country’s trade balance that involves increased imports and decreased exports will have a negative impact on GDP.
Rising inflation can cause a drop in GDP. Because GDP reflects the final market value of products and services, an artificial rise in prices will result in an artificial rise in GDP that is not based on a real increase in economic output. However, real GDP accounts for this inflation, and will indicate the true change in the country’s overall economic output.