GDP, the business cycle and economic indicators

Output, and output at constant prices

Gross domestic product (GDP) is the market value of all final goods and services produced inside a country in a period. Measured at the prices of the period it is nominal GDP; it rises when prices rise even if nothing more is produced. To see the quantity alone, divide by a price index — the GDP deflator — with its base year set to 100:

$$\text{Real GDP}=\frac{\text{Nominal GDP}}{\text{Deflator}/100}$$

Worked example — a $2,900 billion year

Suppose a country's nominal GDP is $2,900 billion and the deflator stands at 116 (prices are 16 % above the base year). Real GDP is $2{,}900 / 1.16 = \mathbf{2{,}500}$ billion in base-year dollars: =B2/(B3/100). If real GDP the following year is $2,550 billion, real growth is $2,550/2,500-1=2.0\%$: =B5/B4-1. Growth is always computed on the real series — a nominal growth rate mixes price changes into the quantity.

Two neighbours the paper likes to swap in: GDP per capita divides by population and measures living standards, not output; and imports are subtracted in the expenditure identity ($C+I+G+(X-M)$) because they were produced elsewhere.

The cycle: five words in order

Real GDP does not grow in a straight line. The business cycle runs expansion → peak → contraction → trough → recovery, and recovery is simply the early part of the next expansion. A contraction that is deep and long enough is a recession; the popular rule of thumb — two consecutive quarters of falling real GDP — is a shorthand, not a definition, and the dating bodies weigh employment and income too. The phases matter for markets because the Bank of Canada leans against them (Lesson 8.4) and because a contraction is when credit risk on corporate bonds shows up (Lesson 9.6).

Indicators: which way do they look?

An economic indicator is a series watched for what it says about the cycle. The classification is by timing, not importance:

• Leading indicators turn before the economy does — the yield curve's slope (Lesson 8.7), stock prices, building permits, new orders. They are what forecasters watch.
• Coincident indicators move with it — real GDP, employment, industrial production, retail sales.
• Lagging indicators turn after it — the unemployment rate (firms hire only once recovery is confirmed), inflation, the prime rate. They confirm a turn that has already happened.

The unemployment rate is the trap: it is the most-quoted number and it is lagging — a rising jobless rate in early recovery does not mean the recovery has failed.

Recompute

Deflator 120 instead of 116: =2900/(120/100) = 2,416.67 billion — the same nominal output buys less real output when prices are higher. Real GDP falling from 2,500 to 2,450: =2450/2500-1 = −2.0 %, a contraction.