How many MBA students will need to measure GDP at some point in their careers? My guess is none. So why do we cover it? Just to ensure that you have a basic understanding of what the terms mean and how to interpet it. Nominal GDP is calculated using current dollars; that is, one multiplies the amount of each good produced in the period by the price of the good and then sums up the value for all goods and services. A problem when interpreting the result is that GDP can rise due to either a higher price or more goods being produced (thus, higher prices can lead to higher nominal GDP). For example, in 1982, nominal GDP rose by 4%, apparently a pretty good year. Once you remove the effects of inflation (higher prices), GDP declined by 1.9%, indicating a severe recession. Since production is what's supposed to be measured, economists typically consider real GDP (which removes the effect of inflation). Real GDP is measured using constant dollars. Instead of multiplying the amount of each good produced by the current price, an average price is estimated over a period of years (called a "chain-weighted" price index; don't worry, since you won't be measuring GDP in your careers, you don't need to worry about the details about how to calculate a chain-weighted index!). This same average price is used regardless of the year being considered. For example, when estimating real GDP for 2014 or 2015, the same average price will be used. In this way, only increases in production can increase real GDP. From now on, when we refer to GDP, we mean real GDP.
Seasonal Adjustment
In certain months, economic activity is affected by such things as weather and holidays. For example, a large portion of retail sales take place in November and December because of Christmas, but then sales decline significantly in January. In addition, the weather in most parts of the country tends to be quite cold and/or snowy in January and February, leading to less construction. Since Christmas and the effects of bad weather are normal during that time of year, GDP and other economic data are seasonally adjusted to remove these effects. Otherwise, GDP would show the economy doing very well at the end of each year followed by a recession in January and February. It should be noted that if a winter is particularly harsh such as in 2014, there can be a temporary effect on economic data since the data is adjusted for a normal winter (harsh winter may lead to slightly lower GDP, mild winter may lead to slightly higher GDP).
Annualizing Quarterly Growth Rates
When measuring economic growth, economists typically consider the annualized rate. For example, suppose real GDP rises by 1% from the third quarter to the fourth quarter; if it kept that same pace up for one year, it would grow by 4.1% (more precisely, 4.06%). How do you annualize quarterly data? One can use the following formula (where the quarterly growth rate is in decimals, not percentages):
annualized growth rate = (1+quarterly growth rate)4 - 1
Thus, in our example, one would calculate (1+0.01)4 -1 = .0406, which is 4.06%. Unfortunately, different countries report economic growth data in different ways - sometimes it's reported SAAR (seasonally adjusted at an annualized rate ) while other times it's not seasonally adjusted or not at an annualized rate. What's the benefit of annualizing the data? Suppose that normal or trend growth for the US economy is 4% per year (for example), if the economy grew by 1% for a quarter, it may be hard to interpret the data (is it good, bad or normal?). Some people may initially think that 1% is less than 4%, so it would be a sign of a weak economy. However, once you annualize it, you'll find out that it's close to normal (4.06%). US data are typically reported SAAR while European data is seasonally adjusted but not always reported at an annualized rate. Until recently, Chinese data were not seasonally adjusted, and so they were typically reported compared to the same quarter in the previous year (instead of as quarterly growth). By comparing it to the same quarter of the previous year, it was comparing it to the same season and thus there's no need to seasonally adjust it. However, that makes it difficult to interpret the short-term behavior of the economy. Will you need to annualize data? The data on quarterly economic growth typically reported by the EU are not annualized, so you'll need to annualize the data.
Stop and Think: Why is there a need to seasonally adjust economic data? What is the benefit of annualizing the economic growth rate instead of just reporting the simple quarterly growth rate?
Next: the components of GDP