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What is GDP?

GDP, inflation, interest rates, economy, money, investments

You’ve probably heard of gross domestic product, or GDP as it’s mentioned in the news. It measures the health of a country’s economy, and is an indication of a population’s standard of living. But how does it impact you and your money?

UK GDP reflects the size of the UK economy by measuring the total value of everything produced by the people, businesses and government within it.

When GDP increases, the economy is rising; when GDP falls, the economy is contracting. It’s only after two consecutive quarterly falls in the GDP measure, when the economy officially enters a recession.

Calculating GDP

GDP is calculated by adding together consumer spending, business investment, government spending and the difference between imports and exports.

There are three ways you can calculate GDP, each of which should result in the same number. You can add up what everyone earns – the income approach; calculate what everyone has spent – the expenditure approach; or measure the value of the output from all the goods and services.

The raw aggregate calculation is called the nominal GDP, however it’s difficult to compare GDP over time as it doesn’t factor in the impact of inflation.

That’s why the number crunchers at the Office for National Statistics adjust the numbers to account for inflation; this is known as real GDP. This figure is then used to calculate GDP growth between quarters and years.

To compare GDP reliably between countries, analysts divide the aggregate figure by the number of people in the economy to get GDP per capita. Otherwise, a nation with more people in it may produce a larger GDP just because it has more consumers to spend money.

Whilst GDP is one of the broadest measures of economic growth, it’s not very timely and later revisions to estimates can alter historical data.

Why is economic growth important?

The economy plays a pivotal role in our standard of living.

If an economy is growing, consumers spend their money on goods and services, businesses reinvest the profits and creates more jobs, and the government spends more money on new initiatives.

In a healthy economy unemployment is low and wages are rising, whereas in a bad economy earnings are lower and unemployment is higher.

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If one of these economic inputs falls and no other parts of the chain can cover the decline, GDP will decrease, which will impact the standard of living of the population.  

Monetary policy

Governments and central banks use GDP to decide monetary policy and government initiatives.

For example, the Bank of England or Federal Reserve may decide to to stimulate a stagnant economy with loose monetary policy – expand money supply to encourage spending. This might include lowering interest rates and introducing quantitative easing (QE) – where new money is created to buy investments like government bonds.

This would be bad news for savers as the returns on their savings accounts will reduce, although borrowers will enjoy access to cheap money.

An economy that’s overheating may need slowing down by hiking interest rates or scaling back QE – slowly reducing the amount of money being created to nothing. Whilst savers will be relieved to earn more from their cash savings, unprepared borrowers may encounter some trouble keeping up with repayments.

It’s important to remember that GDP is calculated by compiling aggregate numbers, the effects of positive GDP growth isn’t split equally to everyone. Whilst some enjoy the fruits of a healthy economy, others will struggle.  

How does GDP impact investments?

Economic growth acts as a good springboard for investments on the stock market. When consumers and governments spend more, company profits will rise. These profits will be reinvested in a bid to drive profits higher over time. Higher earnings mean better equity valuations.

Although there’s a correlation between GDP and stock market performance, the theory is by no means infallible.

Gone are the days when companies operated in just one country. Today, a corporation will have businesses across the globe, so its  value will be influenced by all of the economies it works in.

Investors should use GDP growth rates, both historical and predictions, to influence the asset allocation within their portfolio. However, just because an economy has performed well doesn’t mean it will forever.

Diversifying your investments across geographies will help reduce your exposure to one economy; if one economy is in trouble you can hope to benefit from growth elsewhere.

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