What is Gross Domestic Product or GDP? How does it affect currency exchange rates?

03.04.18
8 minute read
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You might have heard TV panels full of economists and policy experts talking about the size of an economy. Germany, for instance, is considered one of the largest economies in Europe. But what does this mean? How is an economy large or small? In terms of what measurement?

Most of the time, experts are referring to the most important indicator of economic growth and size: Gross Domestic Product. For short, it’s called GDP.

But why should you care about GDP? Does it even affect your day to day finances? The short answer is yes.

Because GDP is such a mainstream measurement, a lot of important decisions that affect everyday people are made based upon GDP. Your job opportunities, your investment statuses, and your currency exchange rates - they are all affected.

This article will specifically cover how GDP affects the value of your money. And, if you deal with different currencies or make international money transfers, GDP is affecting the exchange rate you get. But, before we get into the nitty gritty of what that means, let’s dive into what GDP is and how it’s calculated.

What is Gross Domestic Product (GDP)? How is it calculated?

Almost everything that happens in a country’s economy is captured by GDP and is translated into a number. To understand how that happens, we’ll need to split GDP into its parts.

Generally, GDP is noted by the following components:

  1. Personal consumption expenditure (C)
  2. Business investment (I)
  3. Government spending (G)
  4. Exports (X-M)

Once you know the segments, it's easy to calculate a country's GDP using this standard formula:

Personal Consumption Expenditures + Business Investment + Government Spending plus (Exports - Imports).

Or, as a formula, it can be written like this:

C + I + G + (X-M).

Exports play an especially important rollin factoring a country’s GDP. GDP rises when the value of a country’s foreign exports exceed the value of their foreign imports. In essence, if a country is selling more to foreign nations than their regular consumers are buying products that originated from abroad, a country’s GDP will get higher.

A heads up before we go on. Apart from the calculation we just used, there are other ways of measuring GDP like the production approach or the income-based approach. Despite having different formulas to calculate GDP, if the economic data of a country is sound, each method should get you to the same GDP number.

Why is GDP an important economic indicator?

If a country has a high GDP number, then it’s generally accepted that the nation has a healthy economy and a decent standard of living. Since it’s measured essentially the same in every nation, it’s one of the easiest ways to compare economic health and progress between several countries.

Let’s dive into an example to show why GDP is such a popular way of measuring economic health and activity.

Let’s start with a car made in a country. Let’s say it’s a Ford Fiesta. When the Fiesta is made, GDP doesn’t merely measure its end price tag. GDP also takes into account the origin of the materials used to make the car in addition to their value.

Let’s say, for the sake of the example, that the foreign and domestic materials and processes used to make the Fiesta cost more than the car itself. Which would mean that even if the car itself is worth a lot, the GDP would denote negative growth. That is, it took a lot of resources to produce something whose value was less than the cost of these resources.

The car example shows the basics of why GDP is often touted as a good standard of economic activity - because it gives an idea about the success and failure of economic activity rather than simply the final value.

Though, as usual, it isn’t quite so clear cut. There are still many theorists who believe GDP doesn't really capture everything important. Economic growth, for instance, isn’t always a reliable indicator of the well-being of people living in that country. All that considered, though, GDP remains the standard measurement for economic growth in mainstream economics, politics and public imagination.

And that's also why it’s a very important number.

What is the difference between nominal and real GDP? Which one is better?

Because GDP is based how much money an economy’s output is worth, it’s subject to inflation. Or, to put it another way, GDP fluctuates when the value of a currency changes. It’s normal for the cost of goods and services in a country to go up over time. And those gradual cost increases are reflected in the nation’s GDP. But how can we know whether a GDP lift is due to a stronger economy or if it’s merely due to inflation? That’s where Real GDP comes in.

Real GDP adjusts calculations for inflation before coming to a final figure.

Nominal GDP, however, ignores both inflation and deflation.

To calculate Real GDP, economists first work out something called a GDP deflator. A GDP deflator is the difference between prices in the current year and the growth that has occurred since the base year. The base year is merely the year taken as standard for the measurement.

To arrive at the Real GDP, take the country’s Nominal GDP and divide it by the calculated GDP deflator.

As you must have guessed, in most cases, Real GDP is a more reliable indicator of a country’s growth than Nominal GDP. In addition, it’s easier to compare the growth difference between 2 countries. Because inflation is usually above zero, that means that the Nominal GDP is higher than Real GDP more often than not. As you might expect, a big gap between real and nominal GDP figures means an economy is experiencing a lot of inflation pressure - a signal for policymakers to take necessary steps to curb inflation.

What is GDP Per Capita?

As you know, different countries have different populations, economic output, and geographical size. Their growth rate would then depend on all these factors.

How could it be fair then, to compare the GDP rate of a massive country like China with that of a tiny country like Estonia? One country has more than a billion people and the other just a million. Some countries have a large amount of economic activity simply due to a large population.

To level this playing field to some extent, there’s a concept called Per Capita GDP.

Per Capita GDP is one of the best ways to compare growth between 2 or more countries because it divides the GDP of a country by its population. This gives a more accurate picture of growth because it measures GDP according to how it’s distributed, on average, across the people who live there.

For example, the 2016 US Per Capita GDP was $57,300 - this means that the entire GDP of the United States, when divided by the number of all US residents, gives us that figure per person.

Usually, the most efficient and accurate way of measuring GDP would combine real GDP and Per Capita GD - to get Real Per Capita GDP. It gives growth adjusted for inflation in addition to taking into account population differences.

How does GDP affect currency exchange rates?

If you have any international money dealings, then you probably know that currency exchange rates play an important role in your choices and their timing. Exchange rates, in turn, are constantly influenced by a country’s GDP data. While the relationship isn’t direct, it is quite strong.

Broadly speaking, GDP can affect currency exchange rates in three main ways.

Firstly, when a country’s GDP rises, its currency’s worth also rises. It works the same way in the other direction, too. When a country’s GDP falls, its currency also weakens.

When a country’s GDP dips, it means the nation’s economic growth is slowing down or stabilizing. However, when a country’s GDP drops to negative numbers, that's bad news. It means the economy is actually shrinking - there's loss of productivity and purchasing and, as a result, a loss of jobs. In other words, it likely means the nation is experiencing a recession. As a result, there’s usually a fairly large incentive to keep a country’s GDP on a positive growth trajectory.

GDP fluctuations aren’t the only way GDP can influence a currency’s worth and its subsequent exchange rates.

Secondly, investors and international corporations use GDP to inform many of their investment decisions.

Investors usually prefer putting their money in countries that indicate high GDP growth rates. Because investment usually strengthens the currency of that country, GDP has an indirect influence over it through affecting investment decisions.

Thirdly, most national central banks, including the US Federal Reserve, also take GDP growth rates into consideration when deciding whether or not they should change interest rates.

GDP growth rate can sometimes be an indicator of inflationary activity in the country, and most central banks use interest rates to manage inflation. Inflation, on the other hand, has a very large impact on a currency’s value.

For instance, imagine a nation’s Nominal GDP is trending upwards at an unusual pace. This isn’t always a good sign, and it may mean that something isn’t going as expected with the production dynamics of that country.

Skyrocketing GDP could mean a number of things:

  1. more goods are being produced at the same prices as before
  2. the same amount of goods are being produced, but at higher prices
  3. more goods are being produced and the prices are higher at the same time

Each of the above scenarios results in central banks making different decisions. For example, in the second scenario when the same amount of goods were being produced but at higher prices. Meaning that while economic activity may be stagnating, consumers would still be strapped with higher prices. Usually, in such cases, central banks like the Federal Reserve intervene by changing interest rates. Higher or lower interest rates often, in turn, affect the country’s currency value and cause investors to either pour more money into the nation, or take money out of investments there.

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