Understanding the economic cycle is crucial, as it significantly influences the pricing of financial instruments.

So how do investors discern the current stage of the business cycle and the overall health of the economy? And of course, this insight is vital not just for investors and issuers, but also for governments shaping fiscal policy and central banks setting monetary policy.

We'll delve deeper into this shortly.

A fundamental question we should ask is, what's the state of economic growth? Is our economy expanding or contracting? Typically, we turn to the gross domestic product or GDP for answers.

GDP is a widely recognized measure of an economy's size.

It calculates the market value of all final goods and services produced within a country during a specific timeframe.

The rationale is that a country's output, rather than the amount of money circulating drives prosperity.

After all, printing more currency doesn't equate to increased national wealth, though GDP is a production measure, it's commonly computed using the expenditure approach to sidestep the over counting dilemma.

This problem arises when the same output is repeatedly counted.

For example, a steel company produces stainless steel and sells it to a manufacturer of cutlery for let's say, $100,000.

The manufacturer turns the steel into quality cutlery and sells it to a retailer for let's say, $200,000.

The retailer then sells the cutlery to customers for, let's say, in total $250,000.

If all three steps were counted, this would lead to a total output of $550,000.

But this would include the value of the steel three times.

By focusing on final sales, the expenditure approach ensures that only end products are accounted for, so consequently, there is no over counting, and the GDP numbers are a true reflection of economic activity.

The equation to calculate GDP using this method is as follows, GDP equals C plus I plus G plus X minus M.

Here's what each component represents.

The C is for consumption, which encompasses household purchases of goods and services Like groceries, housing, rent, and medical care.

It doesn't include buying new homes, but is generally the most substantial part of GDP in many countries.

The I is for investment, and this does not refer to stock and bond markets in this case, but to business capital expenditures such as machinery purchases, new construction, and it includes residential housing.

It also accounts for inventory changes, including unsold goods.

The G is for government expenditure, which covers government spending on goods and services from roads to defense, but not transfer payments like pensions or unemployment benefits as they're not payments for goods or services.

Lastly, the X minus M or exports minus imports captures the impact of foreign trade. In an entirely self-sufficient economy, production and consumption within the economy would match, in practice however, every economy imports and exports goods and services and the GDP should be adjusted accordingly.

A trade surplus, exports exceeding imports, boosts GDP as more goods have been produced than have been accounted for in the first three components.

Exported goods will neither appear in C, I, or G, but they have been produced and therefore should be included in the GDP as we defined the GDP as the market value of all final goods and services produced within a country during a specific timeframe.

Consequently, a trade deficit imports exceeding exports reduces GDP.