GDP

Gross Domestic Product (GDP) and Gross National Product (GNP) are the two most common means of measuring the size of a country’s economy. By comparing results from previous reporting periods, it is possible to determine if the overall economy is growing or shrinking.

Because these two leading indicators are very similar, they have been combined here for ease of study, but note that there are significant differences which are outlined later in this chapter. Many of the world’s major economies have adopted GDP as the preferred method of evaluating economic output, including the United States which ceased reporting GNP in favor of GDP in December of 1991.

What is GDP?

Gross Domestic Product can be thought of as the total value of all goods and services produced within the borders of a particular country for a given time period (usually one year). Everything produced in the country is counted without regard to the nationality of the workers involved or the ownership of the firms producing the goods – in short, if it is produced within the country’s borders, it is counted as part of the GDP.

Generally speaking, an increase in GDP in the current year when compared to the previous year is seen as a positive indicator. It naturally follows that if the value of a country’s production has increased, then a corresponding increase in the workforce likely results which suggests greater employment and higher incomes.

There are shortcomings in this assumption however, as volunteer work is not included in the basic GDP calculation; nor is work performed "under the table" or in exchange for other goods or services. This means that a significant amount of production is not routinely captured when determining GDP results.

Real GDP Versus Nominal GDP

When the value of goods and services from one time period is compared to another, changes in the inflation rate can account for some of the difference between multiple GDP results. In order to make it clear whether or not inflation has been factored in, economists use the term Real GDP to indicate GDP results that have been adjusted for inflation. This is the value that best enables economists to determine if the economy has increased or contracted in the time period.

GDP figures that have not been adjusted are usually referred to as Nominal or Current Dollar GDP amounts.

How is GDP Calculated?

The following formula is used to calculate GDP:

GDP = C + I + G + (X – I)

Where:

• C = Consumption

Consumption exists as private or personal consumption and includes most personal expenditures typical of any household. Items such as food and housing (but not new housing) are considered consumption for the purposes of calculating GDP. Consumption is further categorized into one of the three following classifications:

• Durable goods – items such as automobiles and furniture which when purchased, are expected to last several years before they must be replaced
• Non-durable goods – items with a much shorter lifespan and require frequent replacing. This includes things like clothing and food.
• Services – these are non-tangibles items such as tickets for sporting events and concerts, and recreational travel.

• I = Investment

In this case, I represents business investment specifically and includes investment expenditures such as obtaining equipment for a factory or the purchase of new computer software required to operate a business. While typical household spending is not included, spending by households on new houses is included in this category.

Also note that money invested in financial instruments such as a savings bond or the purchase of capital stock is not included in this calculation. For GDP calculations, investment refers specifically to the purchase of goods or services to be used to operate or expand a business and does not refer to the purchase of financial investment instruments.

• G = Government Spending

Government spending falls into two broad categories:

1. Provision of Public Services – includes items such as public healthcare and public education

2. Expenditures for capital items with a measurable life span such as the building of highways and museums. Note that this category does not include direct transfer payments such as welfare and unemployment benefits.

• X = Total Gross Exports

When calculating GDP, it is necessary to account for all goods and services produced by a country. This also includes goods and service destined for export to other countries.

• I = Total Gross Imports

Consumption items – particularly private consumption (C) and government spending (G) – includes goods and services that may have been imported from other countries; therefore, all goods and services imported into the country must be subtracted from the expenditure totals. Subtracting total imports from total exports results in the net of all exports and this is the figure used in the GDP calculation.

Double-Counting Issues

Because many products may have multiple stages where value is added before being re-sold, economic statisticians are careful to only include the final value added stage for a given product. For example, milk produced on a dairy farm is sold by the producer to a processing plant that makes various dairy products such as cheese and yogurt. These products are then sold by the processing plant to retail grocery stores where, after being sold to consumers, they finally make their way to individual households and are actually consumed.

In this example, the milk was sold at three different stages where it was modified (value added) in some way and then re-sold. Therefore, it is only at the final stage when the product was sold to the consumer that the value of the product is included in the GDP calculation.

GDP Variants

The Gross Domestic Product for a country can be expressed in several ways. The most common method is to determine the total output of all goods and services, but it is also possible to determine total income derived from GDP as well as the total expenditures for the goods and services for the economy.

GDP From Output

GDP from Output – GDP(O) – measures the total of the added value resulting from the production of goods and services for an economy. This is the most common means of estimating a country’s GDP and evaluates the contribution of various industries and sectors towards the overall economy.

GDP From Income

GDP from Income – GDP(I) – calculates the total income generated from the production of goods and services. This approach can be used to determine the income earned by sectors, by corporations, and by workers.

GDP From Expenditures

GDP from Expenditures – GDP(E) – measures the total expenditures used in the production of the finished goods and services for the economy.

Gross National Product (GNP)

GDP measures the value of all goods and services produced by a country with no regard to the ownership of the firms or the nationality of the workers producing the goods. GNP also measures the value of goods and services produced in the country, but ownership and employee location are considered when determining final value.

GNP includes goods and services for all domestically-owned firms, as well as goods and services produced in foreign countries by domestic companies. In return, goods and services produced in the country by companies that are foreign-owned are not included in GNP – these are the major differences between GDP and GNP calculations.

An easy way to illustrate the differences between GDP and GNP is to consider the following. BMW manufactures automobiles in Germany and the U.S., but it is incorporated in Germany. Therefore, everything BMW produces in their U.S. facility – even if there are several German nationals working there as engineers – is counted towards the U.S. GDP.

Now, consider SAAB which is actually a division of American-owned General Motors. SAAB produces automobiles in Sweden but does not currently build cars in America. For GDP calculations, SAAB’s totals are not included when calculating U.S. GDP because SAAB does not manufacture cars in the U.S. – these totals do however, factor in determining GNP as SAAB is wholly-owned by General Motors.

The following formula is used to calculate GNP:

GNP = C + I + G + (X – I) + NFP

Notice that this is practically identical to the GDP formula except for the addition of the NFP element. NFP represents the net factor payment which is defined as the total paid to foreign workers working in the country, minus the value of the goods produced by foreign workers.

System of National Accounts

Originally created by the U.S. Department of Commerce in 1930, the System of National Accounts (SNA) defines five primary, mutually-exclusive sectors for the U.S. economy; each of the five sectors can be broken down to further levels of granularity. The first set of National Accounts was prepared by Simon Kuznets and consisted of the following sectors:

• Non-financial corporations

Consists of corporations that are owned by the government or private shareholders which produce goods and services of a non-financial nature

• Financial corporations

All corporations providing financial services – can be owned by government or by private shareholders.

• General government

Entities with legislative, judicial, or executive authority which provides a collective service to the taxpayer usually at no extra charge or for a nominal fee. Public education is one example of this sector.

• Households

Defined as a group of people, sharing accommodations and pooling income to provide goods and services for the entire group. Most of this consumption is in the form of food and housing.

• Non-profit institutions serving households

The Non-Profit sector consists of organizations that provide goods and services to other institutions (primarily households) but owing to their non-profit status, are not permitted to create income or financial gain for individuals creating the goods and services.

Today, the SNA has been adopted by many other countries and is used as the basis for measuring the value of a market economy . Having a consistent, internationally-accepted series of accounts makes it possible to produce GDP results of comparable detail that can be accurately compared with other countries and economies. The 1993 System of National Accounts (1993 SNA) includes revisions to the earlier 1953 and 1968 versions that takes into account technological and global economic factors that have continued to evolve in the past fifty years since the SNA was first introduced.

The System of National Accounts is administered and published by a coalition that includes representation from the European Union, the United Nations, the World Bank, the Organization for Economic Co-operation and Development, and the International Monetary Fund.

How GDP / GNP News Affects Markets

FX Market

Strong GDP results indicate a healthy economy, suggesting that the currency may increase in value compared to currencies for countries with weaker economies. This could lead to an increase in demand for the currency.

Bond Market

When GDP numbers are weak, investors may find that fixed income instruments offer better returns than either equities or foreign exchange. Conversely, when the economy is growing, investors may reduce their bond holdings in favor of foreign exchange or equities.

Stock Market

When the economy is expanding as evidenced by consecutive GDP reports, investors have more confidence in the ability of companies to flourish. For this reason, favorable GDP figures can boost activity in the stock market resulting in a bull market.

Market Relevance

Very High – GDP is considered one of the most accurate indicators of the nation’s economic health and is eagerly anticipated by market watchers.

Publication Frequency

GDP statistics are updated monthly but released each quarter.

Influence on the Markets

GDP is regarded as having a moderate to high influence on the markets.