Among the most familiar economic indicators is gross domestic product or GDP. It is the broadest measure of aggregate economic activity, encompassing every sector of the economy and provides the framework for central bank economic analysis. First quarter 2007 GDP data will begin to become available this week when the United States releases its advance results for the quarter. The United Kingdom will follow next week. The U.S. report differs from the UK report and the others that will follow in the ensuing weeks. All GDP data are a subset of national accounts data but the classifications systems used are different. While most countries have switched to the international classification system called the System of National Accounts (SNA93), the U.S. continues to use the National Income and Product Accounts (NIPA). Below is a primer on understanding GDP better.

Although the data are very important, they are available only with a considerable time lag. For example, GDP data for Canada and Australia are not available until two full months after a quarter’s end, while for the European countries it is at least a six-week wait, and then there is no detail. The United Kingdom offers minimal data within a month of a quarter’s end, while the United States provides full preliminary estimates for all components, but subject to extensive revisions the following month.

Despite the time delay, these data give the most complete picture of the relative strength of different sectors of the economy. For example, the data will tell you if the consumer sector is growing and how investment is stoking growth. This could be a clue of where to look for growth companies for your investment portfolio. And since central banks include GDP in their arsenal of data, they are an important input for potential changes in monetary policy.

There are several ways to measure overall growth. In the U.S., the common way is to use an annualized quarterly growth rate — that is, what growth would be if the economy performed in the same way for all four quarters. However, in most other countries, growth is measured by a simple quarter-over-quarter percent change (first quarter over fourth quarter) or simple year-over-year percent change (first quarter compared with the same quarter in the previous year). For inter-country comparisons, it is critical to use the same measure. Accurately describing a country’s performance has ramifications that go beyond national borders. Economic growth impacts exchange rates, interest rates, and stock prices, along with government policies and the political environment.

The graph below shows comparative Group of Seven GDP 2006 rates — the United States, Japan, Canada, the United Kingdom, Germany, France, and Italy as measured by year-over-year percent change.

What is GDP and how is it measured?

GDP measures aggregate economic activity that represents the unduplicated value of production. It is measured two ways — by incomes arising from production and by final expenditures on production. The first is the sum of factor incomes generated by productive activity or the incomes representing returns to the labor and capital employed. The second is the sum of all sales to final users (consumers, governments, business on capital account, and exports less imports). The statistical discrepancy measures the difference between the income and expenditure estimates.

Growth estimates for GDP components can be split into two parts. The first are estimates of current price values in different periods or nominal GDP. The second separates changes in current prices into a price change and a quantity change. Values measured in nominal terms are expressed in a common currency unit and are additive across different products. While measuring the change in aggregate value is conceptually straightforward, dividing the change into a price change and a quantity change is not. This is because aggregate price changes and aggregate quantity changes must be estimated because they cannot be observed directly in economic terms.

In order to measure volume growth, price change effects are eliminated. Until recently, a common practice was to keep prices constant by choosing a base year and then aggregating volume changes in subsequent periods using the price structures and weights of the fixed base year. Most recently, the year 2000 has been the base year of choice. Thus, the value of the aggregates in subsequent periods were said to be expressed in constant 2000 prices. Cross-country comparisons have stumbled in part because of varying base years.

Over time, base year relative prices were found to be progressively less relevant the farther away from the base year the growth estimate period became. To adjust, the base year was updated about every five years. However, such updating, even at shorter intervals, had its shortcomings. For example, the information, communication, and technology goods sectors have demonstrated how dramatic price changes can be in a short period of time.

As a result, GDP measurement has been going through methodological overhaul over the past 10 years worldwide. Most countries now have changed over to the chain-link method of calculating growth from base year or are in the process of doing so. Indeed, all the countries included here have adopted chain methodology.

The basic idea of chain linking is to update the base year more frequently and to link short-term movements. In Europe and elsewhere, updates are on an annual basis. In this case, period-to-period changes of volumes (the links in the chain) are calculated using the prices (i.e., weights) of the previous year. That way the use of up-to-date price structures is ensured. (This was why Japan’s GDP was subject to such large revisions when the new methodology was introduced, given the country’s chronic problems with deflation.)

All of the countries included here use chain methodology, which should make comparisons easier, except — and there always seems to be an exception — the base years differ. And different base years harm comparability. Japan uses 2000 as a base year, while Canada uses 1997 and the United Kingdom uses 2002. Australia does not use the calendar year; rather, its base year spans the third quarter of 2002 to the second quarter of 2003. However, Germany, France, Italy, and the EMU all use chained 2000 euros.

GDP Components

The GDP accounts, regardless of the system used to calculate them, provide a wealth of information on consumption and investment to a varying degree of detail. While detail varies from country to country, the table below compares what is included for countries using SNA methodology and the U.S. using NIPA. The key sectors in any GDP analysis are private and government consumption, private gross fixed-capital formation by structure and equipment type, public gross fixed-capital formation by government source and defense, inventory change, and international trade (exports and imports).

With most industrialized economies reliant on consumer spending for over 60 percent of GDP, the data in the consumption sector focuses in on the main growth driver. For example, Germany’s GDP growth suffered in 2005 because domestic consumption was almost nonexistent. In the SNAs, consumption includes government spending as well as the private sector while in the U.S., GDP NIPA accounts do not (government is a separate category). The gross capital formation sector in the SNAs includes data by major industries such as agriculture, transport, metal products and machinery, and so on. This differs from the U.S. GDP. For example, the United States counts capital spending on military hardware such as nuclear missiles as investment that contributes to its GDP, while other countries include only military investment that has possible civilian uses, such as army hospitals.

While most in the statistics community applaud the efforts to have comparable data, the United States is alone in using the National Income and Product Accounts (NIPA) rather than the standardized version. According to the U.S. Department of Commerce Bureau of Economic Analysis, the System of National Accounts (SNA) does not accurately reflect U.S. economic activity. But the Bureau of Economic Analysis (BEA) has been working with other members of the international statistical community to narrow differences during the recently authorized review and update of the SNA. And BEA does restate gross domestic product (GDP) on an SNA basis on an annual basis for submission to the Organisation for Economic Co-operation and Development (OECD).

In an article in the December 2004 Survey of Current Business entitled “The NIPAs and the System of National Accounts” by Charles Ian Mead, Karin E. Moses, and Brent R. Moulton, the authors set out a detailed comparison between the SNA and NIPA accounts. The restated accounts are derived from published NIPA data that are then converted to the SNA basis in a series of reconciling adjustments that are based on underlying detail and related estimates. However, the adjustments do not deal with all the differences between the NIPAs and the SNA. For example, information is simply not available to cover illegal production, which, according to the SNAs, should be included as part of the production measured by GDP.

Both the NIPAs and the SNAs organize major economic institutions (households, businesses, governments, and nonprofit institutions) and their transactions so that the resulting estimates are meaningful for economic analysis, forecasting, and policy creation. The SNA is organized as a series of accounts that summarize the transactions of groups of institutions (or sectors), of groups of establishments engaged in production (or industries), and of the total economy. It includes a sequence of accounts that flow from one to another.

The SNA encompasses accounts that are organized as separate sets of accounts in the United States. The NIPAs are organized as seven summary accounts with nearly 300 underlying tables, and cover the transactions that are grouped in the SNA as the production account, the distribution and use of income accounts, and the capital accounts. In particular, in the NIPAs, the domestic income and product account provides estimates of GDP and corresponds to the SNA production account for the total economy. The domestic income and product account also provides information about the income from production that accrues to labor (compensation of employees), to capital (net operating surplus and consumption of fixed capital), and to government (taxes on production and imports) while in the SNA, these flows are included in the generation of income account.

According to the SNA, the accounts of the related estimates for each of the domestic institutional sectors can be added to obtain an account of the total economy. In the SNAs, a nation’s economic institutions are grouped into five major sectors: nonfinancial corporations, financial corporations, general government, nonprofit institutions serving households, and households. Each institution is classified in one of these sectors, and all of the accounts for the institutions (production, distribution and use of income, capital, financial, and balance sheets) are included in the accounts for that sector. Each sector can be divided into subsectors; for example, in the general government sector, accounts can be compiled for central government, state government, local government, and social security funds.

In the NIPAs, economic institutions are also grouped into sectors, but the sector classification scheme is more complicated than in the SNA. Institutions are grouped in one way for measuring their contribution to production and are grouped in another way for measuring income, outlays, and saving. In contrast, the SNA sector definitions are the same for all of the accounts. For measuring the contribution or value added of various institutions to production, the nation’s producers are grouped into three sectors: business, households and institutions, and general government.

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