Gross Domestic Product (GDP) is an important economic indicator closely watched by policymakers, traders and investors alike. Even as a consumer, it’s important to have a clear grasp of what GDP is, how it’s measured and what kind of information it provides. Before we dive in, here are a few general points to note.
An economic indicator is simply any statistic that reflects the current or future state of the economy. Economic indicators can be classed into three broad categories: leading, lagged and coincident.
Leading: indicators that change before the economy changes (e.g. stock market returns tend to decline before a decline in the economy is seen). These indicators are the most important for investors.
Lagged: indicators that reflect changes that have already taken place in the economy (e.g. CPI).
Coincident: indicators that change at the same time the economy does (e.g. GDP). Many different institutions publish reports on economic indicators. However, because the United States is the world’s leading economy, the financial data published by the U.S. Bureau of Economic Analysis (BEA; a government agency) is particularly important.
GDP: basic definition
In simple terms, GDP represents the total market value of all finished goods and services produced within a region’s borders in a specified time period. The term ‘finished goods’ refers to those that have gone through all stages of production and are being held for sale.
Because GDP gives a broad overview of domestic production, it’s seen as a marker of a region’s overall economic health and growth rate. Most countries publish GDP data on a monthly, quarterly and yearly basis. In the U.S., the BEA publishes an advance release of quarterly GDP four weeks after the quarter ends and a final release three months after the quarter ends. More information can be found here.
Types of GDP
Nominal GDP
Nominal GDP values goods and services at their current market price, meaning that it does not adjust for inflation/the pace of rising prices. Nominal GDP is generally used when comparing the output of different financial quarters within the same year.
Real GDP
Real GDP measures the number of goods and services produced while controlling for price inflation. With Real GDP, the prices of goods and services are adjusted to the price levels of a reference year, known as the base year. This allows economists to get a better idea of whether changes in GDP are a result of economic expansion/contraction or just changes in price. If there is a big difference between the real GDP and nominal GDP, it may be a sign that there is inflation or deflation in the economy.
GDP per capita
GDP per capita is a measurement of how much economic production output can be attributed to each individual citizen. It’s often viewed as an indicator of the average productivity levels, living standards and the overall wealth or prosperity of a region. For example, if a country is seen to have a high GDP per capita but a small population, this may reflect a strong and relatively self-sufficient economy.
How to Calculate
There are three primary methods used to calculate GDP: the expenditure approach, the Output Approach and the Income Approach. The Expenditure Approach is the primary method used to calculate the GDP in the U.S., so let’s go through it briefly.
Consumption is the biggest component of GDP as it accounts for all consumer spending.
Government spending includes government consumption expenditure and gross investment (e.g. payroll, infrastructure and equipment).
Investment represents all private domestic investment and capital expenditures (e.g. a business buying machinery or software).
Net exports subtracts total exports (exported goods and services that an economy makes) from total imports (imported goods and services purchased by domestic consumers) (i.e. NX = exports – imports). All expenditures by companies located in a given country, even if they are foreign companies, are included in this calculation.
Note: Real GDP is calculated using a ‘price deflator’, which takes into account the difference in prices between the base year and the current year. For example, if prices rose by 7% since the base year, the deflator value would be 1.07. Real GDP is then calculated by dividing the nominal GDP by the deflator. GDP per capita is simply calculated by dividing the real GDP figure by the region’s population.
GDP Growth Rate
GDP growth rate is a comparison of the year-on-year (or quarterly) change in a region’s economic output. Growth rate is typically expressed as a percentage and is viewed as an indicator of how fast an economy is expanding or contracting.
Why it’s important
To recap, GDP provides a snapshot of a region’s economic size and health. Generally speaking, countries with larger GDPs will have a greater amount of goods and services generated within them (i.e. more value being produced), along with greater market activity and a higher standard of living compared to countries with lower GDPs. This being said, a criticism of GDP is that it does not account for economic inequality, and so a high GDP isn’t necessarily a sure sign of a healthy economy. For example, two regions could have similar GDPs, but the GDP of one region could be the result of a healthy economy where each individual earns a decent income whereas the other could be a result of an economy fuelled by a handful of extremely wealthy individuals while the rest live in poverty. As already mentioned, GDP Growth Rate is an indicator of how fast an economy is expanding or contracting. This metric is particularly important for government entities/central banks, as it helps to inform changes to monetary policies. For example, a large positive growth rate may signal that the economy is overheating, which may call for the implementation of strategies that will help to cool down or ward off inflation (e.g. raising interest rates). On the other hand, a declining or negative growth rate may require banks to lower interest rates or engage in other expansionary measures to avoid a potential recession. We’ll go into all of this in more detail in our upcoming guides on monetary and fiscal policies so keep an eye out! As regards crypto trading and investing, the latest GDP figures can have a considerable influence on market sentiment. Stronger economic growth tends to translate into higher profits and investor risk appetite. In other words, there is more money in the economy and people are more willing to invest in ‘risk-on’ assets (assets considered to be riskier investments) like crypto. The opposite is true during times of economic downturn, where people either conserve their wealth for more immediate consumption or are more willing to invest in assets that are ‘risk-off’ (considered to be a safer bet during times of economic uncertainty, e.g. gold).
