The official GDP formula is as follows: Y = C + I + G + NX. The symbols used here stand for:
To get a better idea of how GDP is calculated, let us go through the list of its components in more detail.
This category includes all personal consumption expenditures, including goods such as cars, food, clothing, appliances, furniture, and services such as healthcare, education, and other items.
This is usually the largest component of the Gross Domestic Product. According to the US Bureau of Economic Analysis website, for 2019 the Consumption has contributed $14.795 trillion to US GDP. This makes up more than 68% of the entire gross domestic product of the country.
Therefore in cases of the US and any other countries, any change in the household expenditure has a large impact on economic growth, than in the other categories of GDP.
The second component of GDP includes Business Investment. Nearly all businesses invest to expand their activities, such as buying equipment or machinery. This has a significant impact on two essential economic factors.
Firstly, increasing capital expenditure can lead to better productivity levels. Also, expanding businesses can create more jobs and further reduce unemployment.
According to the latest numbers from the US Bureau of Economic Analysis (BEA), in 2019 the Investment category contributed $3.698 trillion to the GDP.
This is another essential component for Calculating GDP. It includes all government expenditures, including military, infrastructure, healthcare programs, salaries for the public sector employees.
Since this is the only component, which is directly controlled by the government, in times of recession and economic downturn, expanding public spending can be one direct way to address those concerns.
If the household spending falls and businesses reduce their investments, then the government can step in to offset at least some of the losses for the country’s GDP.
However, it might be worth noting that this has its limits. If the public spending gets out of control this can lead to at least one of the two major problems. This depends upon the source of those extra funds.
If the government massively expands borrowing to cover those costs, then this could eventually lead to higher bond yields and in some cases to the sovereign debt crisis, as it happened in several Eurozone countries.
If on the other hand, the government monetizes debt with money printing, then this could lead to higher inflation and eventually to significant currency depreciation.
According to the BEA, government spending is the second-largest contributor to the Gross Domestic Product. In 2019 it contributed $3.814 trillion to GDP.
This is calculated by subtracting total imports from total exports. Therefore the Current Account Surplus can help to boost the Gross Domestic Product of the country. On the other hand, if the imports are higher than exports, then the difference is subtracted from GDP.
Other types of GDP Measurements
For a better understanding of GDP, it is worthwhile to mention that looking only at the Nominal GDP figures might not provide us with a full picture of economic growth. Year after year the buying power of each currency pair
changes. For example, according to the US Bureau of Labor and Statistics, in February 2020, $153.25 had the same purchasing power as $100 in January 2000.
Therefore comparing the nominal GDP figures from different years can be very misleading. The Real GDP addresses this issue, by using the so-called ‘deflator’, taking into account the loss of purchasing power due to inflation and calculating the Gross Domestic Product in constant dollars.
For example, suppose that the country’s Nominal GDP in 2020 was at $20 trillion and $21 trillion next year, with the inflation rate running at 3%. In this case, the Real GDP in constant 2020 dollars would be $20.388 trillion. This puts the annual growth rate of Real Gross Domestic Product at 1.94%.
Another common problem with working with Nominal GDP numbers is the comparison with two different countries. Obviously, nations with larger populations are more likely to have bigger GDP, however, this does not mean that the quality of life will always be better compared to smaller ones.
GDP per capita is used to address this issue, by dividing the GDP by the population. This can be helpful for comparing the economic performance of two different countries. This indicator can also be very helpful for analyzing the standard of living in a given nation. Some countries might have a large GDP, but because of the very large population GDP per capita could still be lower than in many other regions.
How does GDP numbers affect currency pairs?
Currently, there are no Major central banks who are openly targeting some specific level of Economic growth. However, it can be helpful to keep in mind that the GDP growth rate can have a significant impact on other indicators like unemployment and inflation. Therefore, central bankers do pay attention to the latest developments and sometimes might base their decisions on this type of economic data.
So why is this the case? If the GDP growth rate is negative, then the economy is contracting, meaning the actual total value of goods and services produced within the country is in a decline. Many businesses, taking note of weakening demand might consider cutting back, including reducing the number of employees. With more people losing their jobs, the unemployment rate increases.
Then how can this affect CPI
? The market value of any good or service basically is a function of demand and supply. If there is a significant decline in the above mentioned first category, then the prices begin to fall putting serious pressure on the Consumer Price Index. Since this is where most central banks are concerned, they do take the latest GDP developments into account in order to prevent this type of scenario from happening.
The opposite can also be true if the country has a strong rate of GDP growth, which means the total value of goods and services are expanding significantly. In this environment, businesses are more inclined to increase their advertising, investment, and usually also hire more people. With more employment opportunities and rising income, consumers tend to spend more. Rising demand then leads to price pressures. As a result, the CPI can easily surpass the 2% inflation target and eventually can even get at 3% or higher.
Here again, before this comes into fruition and the central bank is forced to consider hike rates, it tries to analyze these situations from the latest GDP numbers, to identify such scenarios earlier, and consequently act in a more timely manner.