GDP – You might have heard politicians, business people, economists, traders and the common man (here and there) talking about it often times. If you’re confused about what it is and how it affects or say dominates, these many paradigms, you can have your answer here.
What is GDP?
Gross Domestic Product, as the name indicates, is the total monetary value of all the goods and services produced within the country in a certain period, usually a year or a quarter.
- A company has its headquarters in country A, but produces its goods in country B, then country A doesn’t take the company’s output into its GDP account.
- GDP excludes unpaid work like social service, voluntary work at youth centers and black economy.
- GDP only takes finished products for calculation, to avoid double counting.
So, practically, the goods you consume, your work (pat yourself), everything contributes to the nation’s GDP.
In hindsight, it paints the economic well being of a country. And that’s why all these buzzes about GDP across sectors.
For a politician, it acts as a report card and for an economist it earns the bread and butter. The business community and investing fraternity use it as a parameter to make their investment decision.
Traders: What to play?
GDP is an indicator of growth and development. So a good reading of the number tends to have a positive impact on all asset classes- forex, stocks and commodities (especially on energy and industrial metals).
As GDP rises, inflation tags along with it. Hence, the central banks raise the interest rate to keep the inflation in check. And the currency market is set to stay on the bullish trajectory for a more extended period.
On the flip side when it contracts or falls short of expectation, it could send the market spiraling downwards.
Why inflation rises with GDP?
As GDP increase, the employment opportunities, wages and working hours follow it up.
These effects subsequently increase the spending capacity which adds up to the demand in the economy.
Like the recession, surplus growth is also not good for the economy since it can spike up prices of essential commodities.
Traders: Numbers that matter
The preliminary forecast for the GDP is important since the markets are always forward-looking.
The balance of trade- the difference between the exports and imports is a mighty constituent of the GDP measurement.
Also, the balance of trade has a direct impact on the exchange rate of the currency too.
Investor sentiment surveys which dictate private spending is another data to look out.
Employment data and GDP have a direct correlation. One follows the other, be it to heaven or hell. So one needs to keep a tab on it for an ambush.
Who measures GDP?
GDP comprises of a vast amount of data and statistics. Each country deploys its national statistical agency to collect and measure GDP.
In the United States, the Bureau of Economic Analysis collects data and measures GDP.
GDP compromises personal spending, government consumption as well as imports and exports, capturing the width and breadth (whole size) of the economy.
How to determine GDP?
There are three methods to determine GDP. In spirit, all the approaches should deliver the same result. However, nations use different methods for their convenience in collecting data.
It is one of the primary approaches to read economic growth.
The spendings of the private sector (individuals as well as entities) and the public sector are aggregated together to ascertain the GDP.
It has four components namely – Consumer spending, government spending, business investment and exports. The expenditure incurred on all these four fronts are accumulated and aggregated.
Consumer spending is tracked by the purchase of durable goods and nondurable goods. Hence, these numbers are of pivotal importance to a trader.
Likewise, government spending can be tracked through the fiscal budget.
Investment by entities is a critical figure and is subject to change year on year. The value comprises of companies’ expenditure in infrastructure development and procuring raw materials. It is an indicative figure of investor sentiment. During expansion, it soars whereas in a recession it dives.
This is likely an indirect approach to the Spending or Expenditure method.
This methodology calculates the total output of the economy and the consumption at intermediary stages separately.
Then, it derives the net output by taking out intermediate consumption from the gross (total) output.
What one spends, is income for the other. So one can measure the GDP at the revenue counter also. It is the exact opposite of the spending method.
Hence, this approach sums up the income of all entities and individuals together to calculate the GDP.
Although it is an exact opposite method of expenditure, it differs in certain aspects.
For one, it takes into account the sales and property taxes. Next, it assimilates the depreciation of assets as national income. So, the wear and tear of the machinery during production receives its due credit.
However, the expenditure approach disregards these factors in its entirety.
GDP growth rate
GDP is supposed to increase year on year (or quarter on quarter). Also, it is the incremental value that is of priority rather than the absolute number. Hence it is commonly denoted in percentile, which is the growth rate. And people commonly refer to the growth rate as the GDP in many instances.
If it increases compared to the previous quarter or year, the economy is in an expansion phase.
Supposedly, if it decreases, then the economy is in a contraction phase.
If the contraction phase sustains, then the subsequent turbulent stages ensue – recession then depression.
Why Real over Nominal GDP?
Nominal GDP is the raw measurement of output in the current year’s price. But it doesn’t portray the real picture.
For instance, during an economic slowdown, the growth tends to be slow or even be negative. However, owing to inflation, the numbers might portray an upbeat picture.
Hence, to nullify (considerably) the effect of inflation, economists opt for the concept of the base year.
Since the growth rate is always a comparative figure, it compares a year’s numbers with the preceding years.
A base year is the first year (conventionally) among the series of years for which the growth rate or inflation is to be ascertained. Say, to find the growth rate or inflation for the period of 2014-19, 2014 is the base year.
Real GDP is calculated by taking the prices of a previous year – base year – and multiplying it with the units produced on the current year.
The ratio of nominal to real GDP is the ‘price deflator’ since it negates the effect of inflation. The ratio also renders the impact of price increase over the course of years.
GDP vs. GNP
Gross Domestic Product measures the output of all goods and services produced domestically whereas Gross National Product takes into account all goods and services produced by the country’s nationals without any boundary constraints.
GNP is calculated from the income generated by nationals and hence it’s common name is Gross National Income (GNI).
GNI takes only the difference of outward (local to foreign) and inward remittance (foreign to local). Hence the difference between GDP and GNI is insignificant theoretically.
However, post-globalization, many consider GNI as an optimal evaluation metric. The reason being Multi-National Companies either opt for production offshore or tend to withdraw their profits during the end of the year from their subsidiaries. The former projects an upbeat GDP while the latter dents it.
Why do nations fear recession and depression?
When the negative growth (contraction) sustains for a longer duration, it is an indication that companies are also posting losses or in a declining phase. Hence it naturally results in mass layoffs, companies shutting down and the state revenue plunge too. At times, it unleashes a vicious chain of events like protests, riots, when the unemployment rate soars.
GDP per capita
Take the GDP, divide it by the number of residents in the country and you arrive at the GDP per capita.
It ambits to measure the impact of growth in the overall economy, its effect on the nation’s citizens and more importantly, to compare it with other countries.
To suppress the effect of inflation and exchange rate between countries, one can opt for real GDP per capita.
Although there are multiple variants and methods to calculate GDP, it still couldn’t assess the economic conditions in the right spirit.
Exclusion of Black economy
In most nations, the black economy or underground economy generate employment and wealth. However, GDP depends on official data and henceforth, these figures don’t find a way in.
Impact on the Environment
The effect of growth always takes a toll on the environment. Excretions from factories and pollution will have its say in the future. However, statisticians ignore these costs.
Though voluntary work, social services are pro-bono, they have a positive impact on building the future of the economy. Socially, these are investments, made into the future and the economy is bound to reap its benefits sooner or later. It is not set to find a trail in the GDP figures too.
There are economies, say Scandinavian countries, in which citizens pay higher taxes to their regime. In return, they get to enjoy the free package of education, health-care and other social benefits. Some economies provide social benefits through subsidies. On paper, these economies portray a gloomy picture whereas the reality is the exact opposite.
GDP is a barometer of growth rate in the economy. It gives you an eagle eye view of the economy. One has to remember that its an accumulation of series of number. Micro-analyzation of numbers presents the real deal at the ground level and at times contrary to the eagle eye view. So, simplifying it to a single number won’t do the trick – it may work for the politicians and economists to get their approval rating but not for the economy or the people.