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Understanding Gross Domestic Product


Why Is Gross Domestic Product
So Important?

The idea of gross domestic product is about as esoteric a concept as you can find within the popular culture. Why, then, is it so important?

We have already discussed why economists are interested in GDP estimates: they use them to measure how an economy is changing over time, as well as to compare one economy with another. This only makes sense. Because the GDP is an estimate of the value of all the goods and services produced in a specific region, it is also an indirect measure of the overall economy of that region.

Recall two of the examples I showed you earlier. From 2011 to 2012 the GDP of the United States increased by 4 percent. Thus, we can estimate that, during this time, the U.S. economy increased by 4 percent. This is the power of the GDP: it is a readily accessible number that let's us quantify the economic vitality of a region.

Second example: In 2012, the GDP of the United States was about 8.6 times the GDP of Canada. From this we can infer that, in 2012, the U.S. economy was about 8.6 times as large as the Canadian economy.

Aside from economists, other types of professionals use GDP estimates in a variety of ways, some of which affect our lives more obviously. For instance, there are researchers who use economic principles to study and solve practical problems (this is referred to as APPLIED ECONOMICS). Such researchers often make use of GDP estimates in their work to study population change, health care, labor supply, public policy, monetary control, and so on. These areas of study have a significant influence on how resources — especially large amounts of money — are allocated. Governments, in particular, often use applied economics to help decide where money needs to be spent.

One of the more interesting examples of applied economics is how GDP values are used by CENTRAL BANKS, the organizations that manage the money supply and interest rates for a country or region. (In the U.S., the central bank is the Federal Reserve; in the European Union, it is the European Central Bank; in Canada, the Bank of Canada.)

One of the principal jobs of central bankers is to figure out how to grow the economy without creating too much inflation. (After all, if the GDP goes up by 5 percent but inflation is 7 percent, the economy is actually shrinking, not growing.)

Central bankers exert control over the economy indirectly, mostly by setting specific interest rates and by increasing or decreasing the money supply. Whether you know it or not, central bankers have a significant influence on your life. For example, they influence your mortgage rate, your credit card interest rate, the value of your fixed-income investments, how easy it is for you to get a job, the price of many of the things you buy, and so on.

As you might imagine, such control is necessarily imperfect and, most of the time, central bankers can't do a whole lot more than make sensible decisions and hope for the best. However, what they can do — with the help of their staff — is monitor the GDP and other economic indicators in order to make the best possible decisions and fine-tune their strategies. And, because the GDP is so important to the central bankers it, it is, indirectly, important to you.

Another way in which GDP estimates are used is for market research. Companies, trade associations, and labor groups often use GDP estimates — especially for cities and small regions within the country — to help make decisions regarding the allocation of money, labor, and other resources. In this way, changes in the GDP can influence business strategies, as organizations fine tune their decision-making in order to maximize competitiveness, efficiency and profitability.

Finally, the GDP is an important part of the popular culture, because it is a reference point for the health of local, regional, national, and global economies round the world. This is why you will see changes in the GDP discussed in financial news reports. It is the easiest way to show what is happening to a particular economy. For this reason, you will also see such numbers used in analyses issued by governments, central banks, and financial commentators.

As a general rule, a high GDP is better than a low GDP, because a more productive economy is better than a less productive economy. More precisely, life is better when the GDP is rising, as long is inflation is not a problem. A rising GDP indicates that more goods and services are being produced, which means that people are (on the average) wealthier and have a better life. Moreover, a healthier economy leads to a more stable political system, which is good for everyone.

For this reason, the goal of both politicians and central bankers is to raise the GDP of their country as much as possible without causing inflation. This principle — which is more important than most people recognize — can be expressed by the following two equations.

First, for politicians:

High GDP + Low Inflation = Reelection

For central bankers:

High GDP + Low Inflation = They can relax for the weekend

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