At the end of this week, the U.S. Government’s Commerce Department will provide its first estimate of the country’s 3rd quarter (July-September 2008) gross domestic product or GDP. This upcoming GDP report is of particular interest to the world since it will provide an important measurement of how much the U.S. economy has slowed or even recessed over the last several months. Many economists predict that the upcoming GDP report will show either no significant economic growth or, very likely, negative growth.

Let me try and make the concept of GDP easy to understand and explain why it is considered the most important, single macroeconomic measurement.

GDP is simply a calculation that measures the market value (final price) of all the final goods and services produced within the borders of our country. Thus, U.S. GDP includes Toyotas produced in Alabama but excludes Cadillac’s made in Canada. GDP includes all U.S. exports but excludes all U.S. imports since imports, by definition, are produced in some other country and are a part of that country’s GDP.

If you think about it, ultimately our economic satisfaction is better measured by the goods and services that are produced and that we have access to more so than in any other single measurement, which is why GDP is the measurement that is synonymous with “economic growth”. In addition, rising GDP (more goods and services) is the ultimate economic goal of any economy which can best be accomplished through the means of the two other key macroeconomic measurements of employment and productivity.

Let’s describe how the GDP calculation is made. Each quarter, the Government compares the final value of the domestic goods produced and services rendered in the current quarter to the final value of the goods produced and services rendered in the previous quarter. The calculation then takes the percentage gain, current quarter versus previous quarter, and annualizes the percentage. The comparison is always restated for inflation so that the figures are comparable from one period to the next. For purists, we call this “real GDP” which is the only GDP reported by the media, even though the word “real” is almost always dropped to avoid confusion with the average citizen. For example, the second quarter 2008 U.S. GDP report highlighted a 2.8% GDP annualized growth rate. This means that the second quarter final value of goods and services produced was approximately .7% higher than the first quarter final value of goods and services produced. Thus, the quarter over quarter growth of approximately .7% was reported at an official 2.8% annual growth rate for the second quarter.

Now let me get to my favorite point on GDP, which even many economists lose sight of. GDP growth is precisely the same as income growth! For example, in the second quarter of 2008 we can say that incomes for Americans grew by 2.8% restated for inflation. You probably never thought about it this way but every time you purchase something, every dollar you spend is going to someone as income, whether it is the workers as wages, the landlord as rent, a bank that has made a loan as interest income, or to the owners of the business as profits. I tell my students that GDP = Income and we review how the Government calculates GDP both in terms of the final market value of the goods and services as well as how that same production value is reconciled to the incomes of others.

I find the preceding paragraph, GDP = Income, to be a break through moment for a lot of citizens in truly understanding the GDP measurement. It is easier for most citizens to think in terms of income percentage growth in lieu of GDP growth. Most citizens are surprised to find that incomes or GDP, restated for inflation, have increased by 17.4% from 2000 – 2007. This 8-year growth rate in GDP or incomes still equates to a below average historical average performance. More specifically, over the last 8 years our average annual GDP or income growth rate was only 2.2% versus our historical average growth rate of 3.2%. However, the final point of caution is that the GDP or income growth rate is a collective average, thus the growth in GDP or incomes does not indicate how those income gains are accruing to the various socioeconomic classes or professions.

About the author:  Mr. Latter teaches various business courses at Paul VI Catholic High School in Fairfax, Virginia (USA) including AP Economics, Accounting, Marketing, and Personal Finance. Mr. Latter is a Certified Public Accountant (CPA) and former Chief Financial Officer with 10 years of high school business teaching experience. Prior to his career change to teaching in 2000, Mr. Latter spent 21 years in various auditing, accounting, and financial positions with Price Waterhouse, Sprint, and Teleglobe.

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