Small business owners make decisions based on the state of the economy and its direction. An important measure of the health of the economy is the gross domestic product (GDP), a subset of the larger gross national product (GNP).

While the importance of GNP in making decisions for a business should not be underestimated, it is the GDP that is more likely to affect small businesses.

What is GDP?

Gross domestic product is a statistic that measures the nation's economic activity. GDP calculates the market value of all the goods and services produced by a nation's economy. According to the Bureau of Economic Analysis (BEA), the gross domestic product is the total of expenditures for personal consumption, gross private domestic investment, net export of goods and services and government consumption. GDP tracks the size and direction of the economy.

Business managers, economists and policymakers monitor the GDP to make decisions about investments and legislation.

GDP is a lagging indicator. The BEA publishes the GDP quarterly four to eight weeks after the reporting period; it is subject to later revisions. Because of this late reporting, GDP is not much use as a predictor of future stock market performance or economic activity.

However, a decline for two quarters in a row is considered a signal that a recession is coming.

How Does GDP Affect Interest Rates?

The strength and direction of GDP growth or decline can affect interest rates. The Federal Reserve Bank, also known as the Fed, monitors the GDP to make decisions on setting interest rates in an attempt to control the direction of the GDP.

If the Fed believes the economy is getting stronger and that the rate of inflation may increase, it will raise interest rates to slow down an overheated economy. Higher interest costs will reduce borrowings by small business owners and reduce the expansion of their companies. Businesses would be wise to lock in fixed-rate loans during a rising economy rather than accepting loans that are based on fluctuating rates above the prime rate because of the possibility that the Fed could raise rates.

On the other hand, the Fed might drop interest rates or expand the money supply in a slow economy to stimulate growth. This would be a good time for businesses to take advantage of lower interest costs to purchase buildings and equipment.

What Happens to Employment?

Growth in the GDP means that the economy is getting stronger and businesses will be looking to hire more employees. The unemployment rate could go down as wages go up.

If the economy is especially strong, it could become more difficult for businesses to find and hire employees. Paying higher wages can cause a company to raise prices to its customers.

A more detailed analysis of changes in GDP could reveal sectors that are growing faster than others, healthcare for example. Identifying these high-growth sectors could represent training opportunities and businesses to start.

The Effect of GDP on Business Expansion or Investment

Stronger economies will encourage businesses to expand by purchasing more equipment and hiring additional employees.

Banks are more likely to make loans in a strong economy because they see less risk that a business will fail and default on its debts. As the saying goes, "a rising tide lifts all ships."

If GDP is growing, investors are more willing to finance start-up businesses or provide fresh capital for companies to expand their operations. The stock market will go up in reaction to strong GDP reports, and companies can get higher prices for any new stock offerings.

While the GDP is a lagging indicator and reports past results, small business owners can use the advantages of GDP reports and monitor the actions of the Federal Reserve Bank to get some idea of where they believe the economy will be going in the future. If the Fed directors think the economy is growing too slowly, they may stimulate it by lowering interest rates or increasing the money supply. Business managers can interpret the Fed's actions and make the appropriate decisions for their own companies.