Gross Domestic Product (GDP) measures the market value of all final goods and services produced over a given time period. It is its broad scope that makes it a summary indicator of the state of an economy.

GDP growth rates are often the basis for monetary and fiscal decisions. For these reasons, it is observed with particular interest by the entire investment community.

There are three main methods of calculating GDP, leading to the same results – income, production and expenditure (which is the above definition).

The income method sums up what households and businesses earn during the period under consideration. These are wages for workers, corporate profits, land rents, interest payments, etc.

The production method sums up the net value added from each stage in the creation of a product or service.  

The most popular and intuitive method for calculating GDP is the expenditure approach. It reflects the expenditure that different economic groups make on final goods and services. It is calculated as follows:

GDP = C+I+G+(X-M)

GDP – Gross Domestic Product

C – Consumption – consumption is the largest part of GDP. It reflects the value of goods and services purchased by households. These are, for example, food, clothing, gasoline, etc.

I – Investment – this is the investment a business makes in carrying out its activities. This can be expenditure on purchasing machinery, software, employee training, offices, etc.

G – Government spending – these are the expenditures that the government makes – salaries for government employees, purchase of military equipment, etc.

X-M – Export-Import (net export) – reflects the difference between exports and imports.

 

Nominal and real GDP

Let us hypothetically assume that a country produces only jeans.

Production 2020: 100,000 pieces of jeans

Price per piece of jeans 2020: 10 dollars

Nominal GDP = USD 1,000,000 (current production at current price).

 

Production 2021: 100,000 pieces of jeans

Price per piece of jeans 2021: 11 dollars

Nominal GDP = USD 1,100,000 (current production at current price).

In the above example, we see that nominal GDP grows by 10% in one year. However, this is due to the change in the price of jeans, not increased productivity.

Real GDP seeks to eliminate the effects of inflation/deflation by using base year prices.

If the base year is 2020, then the real GDP for 2021 would be USD 1,000,000 (100,000 x 10). Thus, there is virtually no real growth over the period.

GDP growth rate

The GDP growth rate is considered with particular interest. High growth implies increased economic activity. A slowdown in the growth rate indicates a deteriorating economic environment and a possible future recession.

The growth rate can be viewed in nominal or real terms. Real growth takes into account the effect of inflation and facilitates comparison between similar economies.

To a large extent, fiscal and monetary policy depend on GDP growth. Additional incentives may be needed if the economy slows down. When growth is strong, high inflation is often generated, necessitating a cooling of the economy.

GDP as a welfare indicator

It is pointless to compare the GDP of two countries as an absolute value. Obviously, a country like the United States, with a population of over 300 million, would have a larger GDP than, for example, Luxembourg, with a population of approximately 630 thousand.

In order to compare the standard of living between one country and another, the GDP per capita indicator is most often used. It simply divides the GDP by the population. Although the GDP of the USA is many times higher than that of Luxembourg, on the basis of GDP per capita it turns out that the European country has a higher standard.

The purchasing power parity is often used to compare standard of living. This indicator determines the amount of goods and services that can be purchased with GDP per capita in different countries.

GDP and GNI

In contrast to GDP, which is territorially focused within a country, Gross National Income (GNI) measures what is produced by the country’s citizens and businesses not only within its borders, but around the world. Respectively, the income earned by foreign residents and businesses in its territory is not part of its GNI.

Depending on the economic characteristics of the particular country, one or the other indicator may be more indicative of its situation. For example, a country in which foreign business is highly active should be explored through GNI as a priority.

Criticism of GDP

GDP is undoubtedly among the most recognizable economic indicators. At the same time, it suffers from some shortcomings. One major criticism is that it does not take into account economic activities that are not directly paid for with money – housework or barter transactions.

It should be noted here that the informal economy also remains outside the scope of GDP, and for some countries it is significant.

Another criticism concerns the indirect effects of economic activity. A country may be experiencing strong GDP growth, but at the same time this growth may be at the cost of environmental pollution, resulting in deteriorating population health and rising healthcare costs.

Activities that do not bring much economic benefit to the population, such as expensive infrastructure projects in uninhabited areas, are included in the GDP calculation as well. So, while GDP may appear to be growing, the reality is that the welfare of the population is not improving.

Sometimes high GDP can be misleading. For example, GDP per capita may suggest a high standard of living, but a more detailed reading would show a small number of high-income residents and enormous poverty among the rest of the population.

There are other shortcomings and limitations that are good to know when analyzing an economy through GDP. Nevertheless, this is one of the most significant indicators in macroeconomics.

How do investors interpret GDP data?

Rarely does the release of GDP data trigger a meaningful market reaction because this indicator is lagging and data on the actions of individual economic entities (households, businesses, government) are already available in the market. However, when considered in the longer term, it highlights major economic trends. Data on previous periods and future projections can be found in reports by reputable financial institutions such as the World Bank and the International Monetary Fund.

Expectations of sustainable global GDP growth imply a favorable trade and investment environment. During these periods, almost all sectors grow and, in parallel, people’s welfare should increase and they should consume more goods and services.

When the attitude of market participants is optimistic, high-risk assets perform better. Currencies from emerging markets, carry trade pairs such as AUD/JPY, or currencies of countries exporting key manufacturing commodities will rise in value. Traditional safe-haven currencies such as the US dollar, Japanese yen and Swiss franc should lose ground. The same logic will apply to other asset classes – for example, equities should perform well in an upward economic cycle.

The reverse logic is also true – when an economic slowdown is expected, investors will prefer lower returns and more security, redirecting their capital towards such assets. This trend is most evident during a recession. By definition, a recession occurs when GDP falls in two consecutive quarters. Informally, however, most analysts’ perception of a recession involves a drastic slowdown in the economy.

In such a picture, investors would seek security – the so-called “safe-haven” currencies such as the US dollar, Japanese yen and Swiss franc, which should appreciate.

Of course, not everything is as clear and unambiguous as in the above examples, but that is the general financial logic.

Excessive GDP growth often leads to rising inflation. This combination creates the risk of an overheating economy. It can be expected that the central bank will take preventive action, including raising interest rates. High interest rates make investment in domestic bonds attractive. Hence, there will be an increased demand for local currency, which may lead to its appreciation.

The opposite is also valid – a decline in growth rates and deflationary risk may provoke a reduction in interest rates by the central bank, resulting in capital outflows from the debt market and a depreciation of the local currency.

Which factors could have an impact on GDP in the long term?

In the short term, a number of factors – wages, taxes, consumer sentiment, exchange rates, etc. – have an impact on supply and demand and, consequently, on GDP.

Long-term economic development is mostly determined by factors such as labour, capital and technological progress. To a large extent, the faster growth rates in emerging markets are due to a demographic factor – a young working-age population that is accessing quality education more easily. In other words, the workforce is gaining skills in addition to numbers. The rapid uptake of technological advances is a key factor driving growth in these economies. This market conjuncture is a pulling force for foreign capital seeking cheap labor and low costs for its business plans.

For developing countries, a growth rate in the order of 5-10 percent per year is not unaffordable. China’s economy, for example, has been growing at an average rate of about 10 per cent a year for the past 30 years or so, which has propelled it to the world’s second-largest economy by GDP and it seems only a matter of time before it tops the rankings. The closer it gets in terms of characteristics to a developed market, the more its growth rate slows down.

Developed markets, on the other hand, often suffer from a demographic problem – a declining and ageing population. The potential for growth is more limited and is largely the result of technical innovation. For such countries, GDP growth of 2-3 percent per year is the norm within an upward economic cycle.

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