Understanding Gross Domestic Product (GDP)

Learn About GDP

Gross domestic product (GDP) is the sum of the gross value added of domestic production of goods and services during one fiscal year. Many investors look at this economic indicator as it measures the economic performance of a country. To put it in a simple way, GDP measures the value of products produced by all the people in a country.

When the GDP is growing, it shows that lots of goods and services are produced in the country, which implies that business is prospering and there is an increase in the flow of money. This indicates that the economy of the country is growing.

In order to make it easier to understand, let us take a look at the following example. Here, we use bread as an example.

A wholesaler purchased wheat flour from a wheat flour milling plant and it cost $1.
(The wheat flour milling plant made a profit and earned $1. ⇒ $1 adds to the GDP.)

A grocery store purchased wheat flour from the wholesaler and it cost $2.
(The wholesaler purchased wheat flour from the wheat flour milling plant for $1 and it earned $2-$1=$1. ⇒ $1 adds to the GDP.)

A local bakery purchased wheat flour from the grocery store and it cost $3.
(The grocery store purchased wheat flour from the wholesaler for $2 and it earned $3-$2=$1. ⇒ $1 adds to the GDP.)

A consumer bought a loaf of bread from the local bakery and it cost $4.
(The local bakery purchased wheat flour from the grocery store for $3 and it earned $4-$3=$1. ⇒ $1 adds to the GDP.)

When a consumer bought a loaf of bread, many companies will make a profit, which will be added to the GDP. So, the profits ($4) made by the wheat flour milling plant, the wholesaler, the grocery store and the local bakery will contribute to the GDP.

GDP measures the value of final products produced by all the people in the country regardless of nationality. For example, the income of a person, who is a foreign national and works in the United States, will be included in the GDP of the United States. If a U.S. citizen works in the United Kingdom, it will be included in the UK GDP instead of US GDP.

Nominal GDP vs. Real GDP

Now that we have a basic understanding of what GDP is, let’s take a look at what nominal GDP and real GDP are.

Nominal GDP
It includes quantities of goods and price changes.

Real GDP
It is adjusted for price changes.

Basically, the nominal GDP measures the values of all goods and services at current price levels, while real GDP takes into consideration of price changes or inflation. It may be difficult to understand the definitions. Therefore, let us take a look at the following examples.

Nominal GDP

Last year, 1 million cakes were sold at $3 and the amount of production was 3 million dollars.
This year, 1.2 million cakes were sold at $4 and the amount of production was 4.8 million dollars.

In this case, there is an increase of 1.8 million dollars compared with the amount of production in the previous year and there is a 1.6% increase in GDP. In nominal GDP, the amount of production in the current year is simply compared with that of previous year. Even though the quantities and prices are different, the nominal GDP shows the changes in prices.

Real GDP

Last year, 1 million cakes were sold at $3 and the amount of production was 3 million dollars.
This year, 1.2 million cakes were sold at $4 and the amount of production was 4.8 million dollars.
However, if 1.2 million cakes were sold at $3, which is the same as last year, the amount of production would be 3.6 million dollars.

If the prices of goods were not changed, there will be an increase of 0.6 million dollars compared with the last year and the GDP will rise by %1.2. The real GDP is calculated without considering the changes in prices. While the nominal GDP does not take into consideration of differences in price levels, the real GDP is adjusted for price changes.

Since the price of goods constantly changes, there will be a difference in calculation. The real GDP is calculated by taking into consideration of changes in price levels.

When you hear the media reporting on GDP or read it in the newspaper, it usually refers to the real GDP.

Release Date of GDP and Time for Trade

GDP is one of the most important economic indicators that draw the attention of investors and it is released on a quarterly basis. The exchange rate is likely to fluctuate soon after the indicator is released. If the released indicator is very different from expectations, large movements in exchange rates tend to happen. Therefore, it is essential for an investor to pay attention to the GDP when it is released.

In particular, the US GDP draws the attention of investors from all over the world because it has an impact on other currencies. The GDP includes personal consumption expenditures, capital investment, housing investment, inventory investment, government expenditure, and net exports. By looking at GDP, it is possible to know the economic performance of the United States and market movements.

In order to forecast the market movements, it is necessary for an investor to look at the GDP when it is released. Basically, when the GDP rises, it indicates that the economy of a country is growing and the value of its currency is likely to increase. When the economy of a country grows, there will be more chances for investments and more money is expected to flow in from overseas. The value of the currency is thus likely to rise.

It is also necessary to consider the situation from another perspective. When the economy of a country is growing and it has a high growth rate of GDP, there will be an increase in imports of goods, which would make the deficit in balance of trade to rise. In this case, the credit risk is likely to rise and the currency of the country would be sold.

In summary, as most of investors know, the movements in exchange markets are closely correlated with GDP. It is critical for investors to pay attention to GDP when they analyze and predict the movements in exchange markets.

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