Gross Domestic Product (GDP)

What Is GDP
GDP is the total monetary value of all goods and services produced in a country
during a specific period. GDP growth is the rate of change of GDP when compared
from one period to another.

It’s the most “commonly used measure of economic activity“. GDP is used as a gauge
by central banks to track a country’s economic health.

There are three ways in which GDP can be calculated. The most widely used method is
called the “Expenditure Method“.

This method combines total consumer spending, government spending, business

investment and net exports.

The above image better illustrates how GDP is calculated using the Expenditure
method.

Nominal GDP numbers can be artificially inflated due to things like inflation. If
inflation was 10% in one year and 2% in another the change in prices will skew GDP
numbers.

Higher general price levels in one year means it would cost more to produce goods
and services. Compared to a year where lower price levels means goods and services
cost less to produce.

The cost to produce goods and services can thus inflate or deflate the end-product
prices.

That is why Real GDP is so important. Real GDP is a much more accurate measure as
it is GDP adjusted with inflation.

Real GDP compares economic growth at constant general price levels. This strips out
inflated or deflated general prices from one year to another.

For this reason, most central banks prefer using real GDP as their gauge of
economic growth.

Why Central Banks Care About GDP

Stable and sustainable economic growth is very important to central bankers. Some
scholars believe that the ideal GDP growth rate is between 2% and 3%.

The average GDP for the world economy in 2017 was 3.15%. From 1961 to 2017 the GDP
for the world economy averaged 3.52%.

GDP growth can differ drastically from one economy to another. In 2017 Lybia had
GDP growth of 26.68% compared to Congo that had negative GDP growth of -4.59% in
the same year.

Much like inflation, GDP growth should be stable for the best outcome of an
economy. Too low or too high growth rates can both have detrimental effects on an
economy.

There are a number of benefits to keep GDP stable and sustainable namely:

Increase in living standards

Decrease in unemployment
Lowers government borrowing
Increase in business investment
The opposite of this is also true. When GDP growth is too low or too high it can
have the opposite affects.

GDP And Monetary Policy

GDP growth can be a tricky thing to manage for central banks. Monetary policy needs
to be able to support both expansionary and contractionary requirements.

Supply and demand economics help us to understand this a lot better.

Low economic growth means reduced economic activity. With low economic activity
companies require less workers to meet production demand.

This leads to higher unemployment. Less employment mean less people have money to
spend.

In turn this drives down the demand for goods which reduces prices (inflation). In
such a case the economy will require expansionary monetary policy.

What about an economy where growth is high? Isn’t growth a good thing?

It’s only good when it’s sustainable. High economic expansion leads to increased
business activity.

This means more companies require workers to meet the increasing demand for goods.
The impact of this is lower unemployment as more people enter the job market.

The higher employment means more people have money to spend. This drives up the
demand for goods and services even more.

As demand for goods and services increase prices start to go up. If this escalates
an economy can overheat causing inflation to soar.

Relationship between GDP and Interest Rates

GDP growth is considered as a procyclical indicator. Procyclical means it moves in
tandem with the economy.

If the economy is doing well, GDP growth should be good as well. On the other hand,
if the economy is doing bad, the growth number should be bad.

How does all of this relate to Interest Rates? This brings us back to the business
cycle. Every business cycle will require different interest rate policies.

High or low interest rates means higher or lower borrowing costs. When borrowing
costs are too high, businesses don’t borrow money to invest and expand.

This leads to less people employed in the work force. Reduced employment means
reduced private consumption.

Contrastingly, when the cost of money is cheap businesses take advantage to invest.
This leads to more work and more private consumption.

Why exactly is business investment and private consumption so important to GDP?

According to The World Bank, about 60% of total GDP comes from private consumption
alone. The numbers differ from country to country.

For example, in the US private consumption forms 70% of GDP. Whereas in the EU it
only makes up about 57%.

The important point here is that consumer spending forms a massive part of a
nation’s GDP. If interest rates cause businesses to cut back it directly affects
consumption.

Slowing economies normally require interest rate cuts to stimulate growth.

Overheating economies normally require interest rate hikes to cool down growth.

If growth rises too fast, central banks might combat it by raising interest rates.
When GDP drops significantly, they might lower interest rates to boost growth.

Moves in GDP directly effects interest rate expectations. Thus, by tracking GDP,
traders can anticipate possible interest rate adjustments.