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Lesson 11: Components of GDP & Real vs Nominal GDP

Module 1: Macro Fundamental Analysis

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Video Transcript

In this module we’re going to look at gross domestic products so GDP and this is probably the most important at least arguably the most important out of the major macroeconomic objectives of central banks and governments so the four looking at gross domestic product inflation unemployment and trade those were the four we looked at in the previous spreadsheets these four key macroeconomic objectives of central banks and governments and remember it’s the management of these four key objectives of central banks and governments which move the markets and out of those GDP pretty much sits on the top of the pile being able to understand whether GDP is going to be expanding or contracting will give us an understanding of where multiple markets will be heading

so as you can see GDP is going to be considered a high impact piece of economic data on any economic calendar and this is because GDP is arguably perhaps alongside inflation the most important metric in an economy as it is the principal measure of the business cycle or the economic cycle

GDP is a measure of production so it’s measuring the output in an economy and it reflects the total value of goods and services produced within an economy so it’s a measure of the output of that economy so whatever economy it is that you’re looking at and it is measured in monetary terms so it will be a value a monetary value so 100 billion dollars of goods and services sold within a year as an example

central banks and governments will enact monetary and fiscal policy measures in order to shift the aggregate demand curve so we looked at this in the previous module one way or another so to the left or to the right so central banks monetary policy government’s fiscal policy and they will do that in order to manage GDP and inflation as we have seen so as the ad curves shift left and right and on the y axis you have your general level of prices of goods and services so changes to that inflationary and deflationary and then on the x-axis we looked at real GDP and as the ad curve shifted left and right this increased and decreased inflation and that would be depending on where we were in the business cycle if we were at the top of the business cycle and inflation was getting out of hand they may actually want to decrease aggregate demand shift the curve to the left to cool down the economy so inflation doesn’t spiral out of control and of course GDP will contract slightly or slow down in that situation and conversely if there was a recession and GDP had already contracted and there were deflationary conditions either in place or on the horizon then central banks may want to step in and governments in order to stimulate growth and increase inflation at the bottom of the business cycle so top of the business cycle shifting the aggregate demand curve to the left so reducing aggregate demand to control inflation bottom of the business cycle increasing aggregate demand taking monetary and fiscal policy measures to stimulate growth and stimulate inflation

Aggregate demand is defined as the total demand for a country’s goods and services at a given price level at any given point in time so that’s a definition you need to remember the aggregate demand curve itself represents total expenditure because we’re always looking in terms of expenditure or revenue so monetary values so total expenditure on goods and services in an economy so when you think about it in a floating exchange rate system so in a free market economy total expenditure on goods and services in that economy is also going to represent the revenue generated or the output of that economy so aggregate demand actually equals GDP one person’s expenditure is another person’s income

So gross domestic product is defined as the market value of all final goods and services produced within an economy over a given period of time and because supply will always tend to meet demand in an economy GDP will be equal to aggregate demand so the amount produced within an economy will be equal to the amount demanded

So the market value of a country’s GDP in monetary terms can be thought of as similar to so not exactly the same but similar to a company’s total revenue but on a macro level so think as of a country just as being a business so USA corporation or UK plc and the total value of goods and services produced within an economy over a given period of time in monetary terms is like that country’s revenue and that would be on a nominal basis of course because this doesn’t account for inflation so if you’re thinking about it just in terms of revenue so a country’s revenue you’re looking at it without taking into account inflation so that would be your nominal GDP and then to get real gdp you would take into account changes to the prices of those goods and services to actually be able to assess whether more goods and services have actually been produced or less or really the same amounts have been produced but just at higher or lower prices that’s where you would get your real GDP

So in the formula for gross domestic product we attribute the letter y to represent GDP so if you see the letter y this just simply means GDP

So the GDP formula is y equals c plus i plus g plus nx or just a simple way of putting that GDP y equals consumption plus investment plus government spending plus net exports and what this is really showing you is really what we’ve just been discussing which is that GDP so the total output of an economy is equal to c plus i plus g plus nx this is aggregate demand so c plus i plus g plus nx is representative of aggregates demand within the economy so GDP equals aggregate demand that’s really what that’s telling you and this also takes us back to the three pillars we looked at within an economy of government consumer and business so GDP the total output of an economy is equal to demand from the consumer demand from businesses and demand from government and that would be in a closed economy plus net exports so demand from other countries and that’s when you get to your open economy so total output within an economy is from consumption investment and government spending which is within the domestic economy and then you also have demand coming in from the outside so demand from the three pillars plus demand from external economies is equal to the total output of an economy

So nominal versus real GDP what’s the difference we mentioned this a couple of slides back when we talk about nominal GDP we’re talking about the total market value of all final goods and services produced within an economy over a given period of time when we talk about real GDP we’re talking about the total market value of all final goods and services produced within an economy over a given period of time so exactly the same definition as nominal GDP but adjusted for inflation so it takes into account changes to the price levels within the economy now the reason for this is because GDP is a measurement of output of an economy so if you imagine an economy has in year one ten goods and services so five goods five services which are produced and they’re all one dollars each and it has a GDP value of 10. well the second year if that economy produced five goods and five services exactly the same as the year previous but the value of those goods and services had risen from one dollars to two dollars instead of a GDP value of 10 it would be 20. and if you were to look at that you would on the surface maybe think that the output of that economy has increased but it hasn’t the output has actually remained exactly the same it’s just that the prices of the goods and services have gone up so it’s not a true value of output because total GDP increase in nominal GDP increasing may actually just be a result of higher prices not additional output from that economy so when you look at real GDP and when people mention GDP they are generally speaking talking about real GDP it is stripping out the price factor within the GDP to get a much more accurate assessment of real output within that economy so you can also have nominal and real interest rates for example it’s not just GDP so nominal interest rates interest rates not adjusted for inflation and real interest rates interest rates adjusted for inflation so whenever you see the terms nominal and real it just simply means not adjusted for inflation so nominal and adjusted for inflation real so because GDP so total value can be increased by either an increase in production or an increase in prices real GDP strips out the price component and attempts to provide a more accurate measure of the real underlying productivity within that economy real GDP is what is usually meant when the term GDP is used and this is the data that traders and investors are focused on predicting in order to understand where markets are heading on a fundamental basis

Real GDP is released quarterly as an annualized number and this means that it’s compared to the same quarter the year before to remove any seasonality factors which could distort the final number so for example if you have an economy which relies heavily on tourism in the summer of course GDP is going to decrease significantly in the winter than to the summer so q3 could be much much higher in terms of GDP than q1 because that’s when all the tourists go in the summer so trying to measure the output of that economy whether it’s becoming more or less productive from the summer quarter to the winter quarter wouldn’t make much sense whereas if you took the GDP numbers from q3 of 2020 say to q3 of 2019 that would give you a much more accurate depiction of whether that economy is becoming more or less productive please download the attached spreadsheet for gross domestic product and we’re going to jump over to the spreadsheets now and look at this in much more detail so if we open up the gross domestic product spreadsheet here you can see on the first tab we have us GDP composition so what we’re looking at here is a table and it’s a recent one you can see last revised on may the 28th 2020 so it’s a recent example a table of a recent example of the breakdown of GDP in the us so we’re looking at this in terms of percentage share so as a composition what components comprise what’s percentage of overall GDP and we can see here on the right hand side we have c so consumption which makes up 67.7 percent we have investment which breaks down into fixed investments non-residential structures equipment intellectual property products residential changing private inventories you can see breaks down to 16.8 percent of GDP we have net exports which is minus 2.4 so this shows us that america is a net importer of all goods and services and this actually has a slight negative effect on GDP and we can see government spending in the us accounts for 17.9 of GDP and if we add consumption investment net exports and government spending so total demand

Within the economy c i g including also net export so total demand from outside the economy as well you can see we come to 100 of GDP so aggregates demand total demand in the economy consumption investment net exports and government spending comes to 100 which is gross domestic product so the output of the us economy the other thing to note here is that consumption makes up 67.7 of us GDP so in terms of economic performance in the us and this is not just the us this is the same in the UK and many other economies around the world the consumer is a very very significant part of an economy’s performance if the consumer is bullish and they are going out and they are spending money the economy is going to perform better if the consumer is bearish or they are fearful or they are worried about the future they will go and spend less money and as they tighten their belts the economy will also contract so as we go through the course and we start to look at some of the leading economic indicators to predict GDP and economic performance just remember that consumption consumer confidence is very very important to an economy’s performance and therefore also the direction of the underlying currency and markets in general so if you want to dig around into u.s economic data you can see the source for this is the u.s bureau of economic analysis all you have to simply do is click this link in the spreadsheet and it will take you straight to the place where we got this data from and you can look at other similar data if you so wish