In forex economics I explained GDP with luxury of humor and detail. If you missed it, click the link, you won’t regret it.
I can’t leave the GDP page without a definition now, can I?
GDP or Gross Domestic Product is the value of all final goods and services produced by an economy in a given period of time.
Ok, so… what about it?
Well let’s go back in time 300 years.
We are now in the 1700’s.
Assuming you’re lucky, and were born into royalty you had all the comforts money could afford… at that point in time.
Why emphasis on that last phrase?
Well, for one, the light bulb hadn’t been invented…
Obviously, you can bid adieu to the telephone, computers, and the internet.
But no one needs any of that stuff anyways… Right?
You see... With discoveries, productivity increases. And so does the standard of living.
Electricity, heating, showers, etc. All of these things increased the productive power of society at large.
And with increased production, comes: Lower prices. Yep, in most instances, that ends up happening.
And what then?
People can afford more.
The producers also need more workers to make those extra units.
So economists come into the Frey, young scientists as they are (Econ as a discipline is young from a historical perspective).
They try to determine how to improve the well-being of society through allocation of resources to the most productive activities.
But how do they know things are working?
How do we know society is better now than it was before?
It’s clear when we look back several hundred years, but how about last year?
What about next year?
Well, if you’ve ever tried to lose weight, the only way to work at it is by using a scale.
Because the scale doesn’t lie.
You added weight, you lost it, or you remained the same.
Otherwise, how would you know?
Unless you were losing a ton of weight (or gaining it), there was no other way to know.
OK Emil, but what does that have to do with economists?
In order to work, economists had to devise a measure of production.
And so GDP was born.
Now, they could measure this year’s GDP and compare it to last years’ GDP.
Did the economy grow?
Or did we produce fewer goods and services?
GDP wasn’t the only measurement.
A bazillion different measurements exist. Economic indicators abound and abound.
But GDP has remained the most important measurement of GROWTH.
And guided by it, nations have strived to improve their economies.
For the most part, the world has succeeded in improving its standard of living.
This came hand in hand with tremendous growth as measured by GDP (especially in the past few hundred years).
Hope you’re feeling good, cause I am.
GDP tells us whether things are gettting better or worse.
And GDP shows us when those pesky recessions come around (to some, 2 consecutive quarters of negative GDP growth -shrinking GDP- is a recession).
But wait, there’s more.
Sadly, GDP isn’t perfect.
The first and most important thing to keep in mind is… Prices don’t stay the same.
What do I mean by this?
Well, to calculate GDP, in super-duper-simple terms, we have to have the prices of goods in the economy.
And we also need the quantity of goods and services (let’s call them goods and that’s it) produced and sold.
Thus, if the economy only sold 100 watches at $50 each, we would get a GDP of $5,000, right?
Well, here’s the issue.
Next year we could produce the same 100 watches, but sell them at $51 each. Thus, GDP would be $5,100.
But did we actually produce more?
Imagine a weight scale telling you you’re slimmer, but you’re not!
Oh, the Horror…
Well, luckily, those Econ guys ain’t quitters.
No. They decided to make a better measurement of growth.
A measurement which captured the real growth of the economy.
they called it…
Imaginative? No. But I like that they kept it simple.
Real GDP is just GDP with an adjustment for prices.
This adjustment makes it so we can compare GDP’s from different periods (say last year’s and this year’s) in the same terms.
For our watch example, we would get a real GDP of $5,000 on both years.
Thus, no real growth occurred (see what I did there?).
In practice this price adjustment is done by a simple division which expresses price in terms of “base year” prices.
The base year is just the year whose prices we will use for comparison purposes. Otherwise, we would be comparing different prices again, no?
Thus, when you see GDP chained, year 1991: it means the data for every year from 1991 is expressed in prices of 1991, thus making them comparable.x
Another thing you see often on published statistics is the “seasonally adjusted” phrase, which is just another adjustment done to data to make it comparable across seasons.
What does that mean? Well, you can’t really compare this quarter’s GDP to last quarter’s GDP.
Why? Because there are seasonal elements. For example, close to 40% of yearly retail sales are done in the last quarter (Christmas, Thanksgiving, Holidays, anyone?).
Hence, you will get differences in the data due only to “what time of the year was it”.
To get around this, some pretty smart statisticians worked out a way to iron-out such seasonal differences to make the numbers comparable.
And that’s it.
But enough about that.
This is why you came here. The meat of the article.
When traders talk GDP they are referring to Real GDP, since that’s what Central Banks care about.
And Central Banks care about the Real GDP because it is a much better measure than nominal (the normal, bland, non-price adjusted) GDP.
Thus, if you’re paying attention to GDP numbers, make sure they are for the ‘real’ one.
Ok, but why is GDP important for fx traders.
Well, I just mentioned the Central Banks care about GDP didn’t I?
In forex economist 2 I went over the specifics of why that’s important.
In a nutshell:
Central Banks can increase and decrease the supply of a currency by different means (most important: by changing interest rates).
And the Bank’s decision to increase or decrease rates (or anything else they do, really) comes down to how the economy is doing.
Generally, they want the economy to grow within a certain range (say 2-4%, for example).
Less than that and we are falling behind!
More than that and inflation will destroy us!
So for example, the Central Bank of England feels like the economy is heating up given the latest inflation numbers.
Thus, Bank representatives stated that interest rates might have to rise (currency increase in price) if the next GDP figures come out strong.
Hence, the markets will pay a heck of a lot of attention to such a data release.
See how it all comes together?
And if it doesn’t make sense, go read some other articles.
GDP isn’t the whole picture, as you can see from the last example, you would also need to see how inflation came out. And likely, how the work market is faring as well.
And it also depends on what the Central Bank cares most about.
In the case of the FED (USA’s Central Bank), they have the double mandate of keeping inflation AND growth within reasonable limits.
While other banks only have to keep inflation contained (maintain price stability, blah, blah.).
I’m thankful though. Price stability is one hell of an important thing.
See you soon,
The Forex Economist
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