Understanding GDP and Its Different Types

13 November 2023

The basic definition of GDP is as follows: The Gross Domestic Product (GDP) measures the value of all goods and services which are produced in a given country during a specific quarter or year. This is also known as the Nominal GDP.

The formula of the Gross Domestic Product has four components: Consumption, Investment, Government Spending, and Net Exports.

There are also other measurements. GDP growth rate shows the increase or decrease of Gross domestic product, compared to the previous year. This helps to get a picture of the strength of the economy.

Real GDP is measured similarly to the Nominal one, however, one difference is that it takes inflation into account.

Finally, GDP per capita measures GDP per individual. This can be very helpful when comparing the economic strength of two different countries with different population levels.

The latest release of GDP numbers can have a major impact on the currency movements. Notable expansion of the Gross Domestic Product is one of the signs of strong economic performance. Therefore this can help the currency to appreciate against its peers.

On the other hand, the recession is defined as negative GDP growth for two or more consecutive quarters. This can be very damaging to the economy and could potentially force the central bank to cut interest rates considerably, usually leading to currency depreciation.

GDP Explained

The official GDP formula is as follows: Y = C + I + G + NX. The symbols used here stand for:

Y - Gross Domestic Product
C - Consumption
I - Investment
G - Government Spending
NX - Net Exports

To get a better idea of how GDP is calculated, let us go through the list of its components in more detail.

Consumption

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.

Investment

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.

Government Spending

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.

Net Exports

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.

Using GDP Data - Key Takeaways

Any change in the four components of GDP can have a major impact on the economic growth of the country and by extension, its currency.
Central Banks across the globe do not officially target any specific GDP growth level, however, they do still take into account the latest developments in Gross Domestic Product indicators.
Currencies with consistent trade surpluses can be well-positioned for long term appreciation, considering that the net exports is one of the components of GDP. At the same time, the persistent trade deficit can have a significant negative impact on economic growth.

FAQ: The Basics of GDP

What are the latest dynamics of GDP in the US?

Taking a look at the indicators, provided by the US Bureau of Economic Analysis, by the last quarter of 2017, the US Gross Domestic Product stood at $19.919 trillion. It surpassed the $20T mark during the first quarter of the following year. The latest report, published for Q4 of 2019, puts GDP at $21,729 trillion.

During the same 3 year period, 2017, 2018, and 2019 the actual growth rate of Real Gross Domestic Product has fluctuated from 1.1% to 3.5%. The average of the last 12 quarters is 2.54%.

Which are the top 5 countries with the largest GDP in the world?

By the latest 2019 data for Gross Domestic Product, the US still represents the largest economy in the world, with its GDP standing at $21.427 trillion. In real terms, it expanded by 2.3% compared to 2018.

China has the second-largest economy, with a GDP $14.140 trillion, according to the Chinese authorities this puts an annual growth rate at 6.1%

Japan holds 3rd position, its GDP reaching $5.154 trillion, representing only 0.9% expansion over the 2018 numbers.

Next comes Germany, with the Gross Domestic Product at $3.863 trillion, however the economic growth has slowed significantly, standing only at 0.6%.
India represents the fifth largest economy in the world, with GDP running at $3.202 trillion, with economic growth near 5%.

How does the Chinese GDP composition differ from the US counterpart?

The first most obvious difference which comes up when comparing those two economies is that the portion of consumption in China is much smaller than in the USA. In fact, it is not even the largest part of GDP, only making up 39.1%.

In China Investment is the most important component with its share of 44.4%, more than 2.5 times bigger than in the USA. One similarity between the two countries is that Government Spending has similar portions in relation to GDP, in Chinese case making up 14.5%.

Unlike the US, China is running a trade surplus. Net exports are contributing 2% of GDP. In summary, this Asian country has a less consumer-oriented economy, more focusing on Investment and exports.

Can the long term appreciation of currency hurt its GDP growth?

According to one economic theory, the strengthening currency can be hurtful for the economy. The reasoning goes as follows: the appreciation of currency makes exports more expensive, with foreigners needing more money to purchase goods and services from this country. At the same time for the local residents, the imports become cheaper and affordable. The trade balance formula is very simple: Exports - Imports and strong currency undermine it from both sides of the equation.

As one of four essential components of GDP, If Net Exports turn negative, then it drags down the Gross Domestic Product and consequently reduces economic growth.

This sounds quite logical, but it can be helpful to check the validity of this theory against some real-life examples. The major currency pairs always fluctuate considerably and sometimes it is difficult to find one currency who has consistently has appreciated against its peers.

However, the example of Swiss Franc might be useful here. At the beginning of 2000, USD/CHF traded at 1.60 and EUR/CHF near 1.61, with GBP/CHF standing at 2.58. Let us take a look at how things changed after more than 20 years.

The Swiss currency surpassed parity with USD in 2010, nowadays, at the beginning of April 2020, one Franc is worth around $1.03. We see a similar picture with EUR/CHF, which fell significantly over the years, eventually trading at 1.05. It has already pierced the parity level back in 2015, so it might happen again. The appreciation of Swiss Currency is even more dramatic against the pound, with GBP/CHF falling from 2.58 in 2000 to all the way down to 1.20.

Now, small periods of currency strength may not have much impact, but according to the economic theory mentioned above, the 20-year history of CHF appreciation must have been a devastating blow to the country's exports. By now the Swiss government should be faced with a massively expanding trade deficit. Is this not the current state of affairs?

Surprisingly, Swiss exports are doing quite well. The last time the country had an annual trade deficit was back in 1983. Despite the significant long term appreciation of CHF, the trade surplus has expanded from 6.13% of GDP in 2000 to 12.23% in 2018. So the exports not only held their ground under stronger Franc, but it has expanded considerably during the last two decades.

So what can be the reason behind this unexpected outcome? Many goods require the import of raw materials from abroad, the strengthening currency obviously, makes them cheaper. Therefore the lower input costs can potentially offset some of the price gains due to CHF appreciations. Other factors such as quality and brand loyalty can also play an important role in the rising number of Swiss exports.

On the other end of the spectrum, we can take an example of the US from 2002 to 2006. During this period USD depreciated significantly against its peers. Theoretically, this should have helped with exports; however, the trade deficit still expanded massively, surpassing $700 billion by 2006.

Therefore, currency appreciation does not always lead to an increasing trade deficit and also devaluations do not guarantee an improvement in the Net Export category.

Did the US always have a trade deficit?

The US did run a trade surplus some years in the past. The last time it happened was back in 1975 when the country’s exports exceeded imports by approximately $16 billion. Despite going negative, until 1996 the Net Exports stayed more or less close to balance.

This changed after 1997 when with the strengthening of USD, the trade deficit started to expand massively. Interestingly enough, the weakening of the dollar since 2002 did not improve the picture. By 2006 it reached an all-time high of $771 billion.

After the Great Recession of 2008, the demands for exports moderated somewhat, and by 2009 reducing the trade deficit to $396 billion. However, as the economy started to recover the number of imports increased substantially, eventually pushing Net Exports to minus $617 billion.