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What is GDP, and how is it calculated?

Welcome again everyone to episode 3 of our FX 101 series of podcast episodes! In these episodes, we aim to provide you with bite-sized educational and informative content on a range of topics related to financial markets, FX, economics and more.

On the last episode of FX 101, we talked all about inflation: How is it measured, and why is it important for central banks, governments and financial markets? If you’ve not yet had a chance to listen, be sure to go back and do so, and of course if you would like to, subscribe to the podcast, and you’ll get notifications when our next episodes become available.

In this week’s episode, we’re going to talk about GDP, or Gross Domestic Product. I’m going to cover, what is GDP? How is it calculated? And give a few examples of some of the many different economic indicators that we look at in our analysis when gauging the strength of an economy, which of course is one of the main drivers of currencies and exchange rates.

What is GDP?

As mentioned, GDP stands for Gross Domestic Product. This is the widely accepted primary indicator of macroeconomic performance, and refers to the market value of all the finished goods and services produced within a country’s borders in a specific time period. I.e. it provides an economic snapshot of a country, used to estimate the size of the economy, its growth rate and its overall health.

How is GDP calculated? Well, Gross Domestic Product is calculated using three widely accepted methods: the Production (or value added) Approach, the Income Approach and the Expenditure Approach.

The Production (or value added) Approach

This is estimated by calculating the total value of all economic output, and deducting the cost of intermediate goods and services that were used in generating that output. In other words, it calculates the sum of the value added across all industries of an economy.

The Income Approach

This calculates the income earned by all factors of production in an economy. I.e. a sum of all wages paid, rent earned, return on capital and corporate profits.

Finally, we then have the most common and recognised of the three methods that is used to calculate the official GDP figures, and that is: the Expenditure Approach.

The Expenditure Approach

The Expenditure Approach is based on the money spent by various groups within an economy. Those of you that have studied economics at any level will be very familiar with the formula: C + I + G + NX (or X-M).

But, what do these letters stand for?

Well first of; we have ‘C’, or ‘Consumption’. This refers to consumer, or household spending, on goods, such as your weekly trip to the supermarket, and services, such as a haircut. For developed economies, consumption accounts for the bulk of GDP (in the UK and the US at least, around two-thirds of overall economic activity is made up of consumer spending).

‘I’ refers to Investment. This is a measure of how much businesses spend (or invest) on things such as buildings, land and equipment, while also accounting for major consumer investment on things such as: buying a house.

Government Spending, or ‘G’ in our formula, represents the amount of money spent by the government on things such as healthcare, education, infrastructure and defence.

And finally, we have Net Exports (or Exports – Imports). This can either add value to GDP, if the value of a country’s exports is larger than that of imports. Or, it can lower a country’s GDP, if the value of imports is larger than the value of exports. For emerging market countries that are more dependent on trade, net export data tends to take on greater importance than the majors that are typically more dependent on domestic demand.

Now of course, we are not simply just interested in the overall size of an economy, but the growth rate in that economy, over time. GDP growth data is released on a quarterly basis in the major nations, although some (including the UK) release monthly data. These growth rates are shown as both quarter-on-quarter, and year-on-year. And as we know, growth can be negative, and if an economy experiences two consecutive quarters of negative economic growth, that denotes a technical recession.

As far as the foreign exchange market is concerned: a robust economy is seen as conducive to an appreciation in the domestic currency, so a stronger than expected GDP growth number is typically bullish, whereas a weaker number is bearish.

A problem with these GDP growth rates is that they run on somewhat of a lag. In the UK, we generally receive the initial estimate of the quarterly GDP figures around 6 weeks or so after the end of that quarter, with revised data out about another 6 weeks after that.

Investors will therefore look to other, more timely, indicators of economic activity to gauge the strength of an economy. But, which ones are the most important for market participants, and currencies in particular?

Well first up, we have the Purchasing Managers Indices, or PMIs, as they are known for short. These are closely watched monthly surveys of business owners and senior executives of private firms that provide information on how they expect their companies to perform relative to the previous month with regards to new orders, output, employment and prices. This information is then congregated to create an index. Any level in the index above the level of 50 suggests expansion relative to the previous month, below 50, contraction, and exactly 50…is flat growth. These surveys are generally conducted for both the services and manufacturing sectors, providing two separate PMI numbers, which are then aggregated to form what is known as the composite PMI.

The key advantage of these PMI numbers: they are incredibly timely, with the preliminary estimate for the month generally released on the fourth week of that same month. The PMIs are an example of what are known as ‘soft’ indicators of economic activity, similar to business and consumer sentiment indices, which provide a guide or estimate as to levels of current or future economic activity.

Aside from these sentiment indicators, investors will also look at ‘hard’ data, which represents measures of real activity that directly impacts GDP. These hard indicators include data such as retail sales, a decent gauge as to the overall strength of consumer spending (that as mentioned, makes up the bulk of GDP in the developed nations). We also have the likes of industrial production and durable goods orders.

Data that measures the health of a country’s labour market is also crucial for investors, as a strong labour market tends to indicate stronger future GDP growth, higher inflation and, therefore, higher interest rates. Here, markets pay close attention to data on unemployment, jobless benefit claims, earnings growth and job creation, among others. Undoubtedly the most important labour market data on the monthly economic calendar is the US Nonfarm Payrolls report, released on the first Friday of every month. Here, market participants pay very close attention, in particular, to the monthly nonfarm payrolls number (which represents the net change in the number of people employed in the previous month, excluding certain sectors, most notably: farming). This NFP report tends to elicit a high degree of volatility in currencies, both surrounding and following its release.

So hopefully this episode has given you a better understanding as to what GDP is, how it is measured and why it is important for the FX market. As mentioned, if you’ve not yet had a chance to listen to our previous FX 101 episodes, please have a scroll back and check those out… and be sure to look out for further episodes in the future.

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