With all the economic data releases that come out all the bloody time, it's important to know
which ones we actually need to take notice of and which ones are really going to inform us
about how an economy is performing. Amongst the most important of these is an
economy's GDP, its Gross Domestic Product. This is a critical piece of information for
economists, traders, investors and even everyday life,
because it affects everyone. It can really affect the country you're living in
So in this video, I'll be explaining what GDP is, why it's so important and how it's calculated.
It's one of those terms you hear all the time, even if you have nothing to do with
finance or economics, Gross Domestic Product.
You might hear it on the news, UK GDP fell by 0.3%,
US GDP is up by 1.2%. But what does it actually mean?
Well essentially GDP is our measure of national income or output.
It shows the value of all goods and services produced in a period of time. Typically quarterly
or annually. Let's start by understanding a very fundamental
concept of macroeconomics, which is the circular flow of income.
This diagram gives us a very simple model of the economy as a whole.
This is called the circular flow diagram and it can be drawn in a few different ways,
but basically it's showing us the same thing each time. Let's start off with the main part which is
what we call the 'Inner Flow'
The inner flow is showing us the basic assumption that income will circulate an economy,
because firms will pay households in the form of wages, dividends on shares, interest, rent
and so on. The households will in turn give this money
back to domestic firms when they consume domestic goods and services.
And by domestic, we of course mean, from the same country or the same economy.
So in this lala dream land, if firms pay out all their money to households,
and households spend all their money with those firms.
Then the money goes round and round at the same speed and nothing changes.
Income stays the same. It's sort of like a Truman Show type dream world with a closed economy
But we know in reality, that isn't what happens at all. What takes place are what we call withdrawals
and injections. A withdrawal takes place from a household if they decide to
save some of their income, which means it's
come out of the inner flow and instead gets put in a financial institution
like a bank. Or perhaps the household may get taxed and the
money's withdrawn from the inner flow and it goes to the government instead
Likewise for a company, they may pay their tax and in that case the money's coming
from them to the government
unless they're a major conglomerate and decide to bypass paying tax completely
but that's probably a topic for another time. I like Starbucks too much to knock them.
Even if I found out today that they've got faecal matter in their ice!
Anyway, another type of withdrawal is through imports. Buying things abroad,
or how about paying a workforce from a different economy.
These all contribute to withdrawals from that inner flow.
So what happens now?
Well, now we have what we call 'injections'. This is where other sources outside the inner
flow will contribute funds into the inner flow as well. For example, if a firm needs to expand or
needs new equipment. They may decide to borrow money from the bank
or get outside investment. These are funds which may have originally
come from the households in the inner flow and it comes back into it
Or what about government expenditure, when the government invests in things?
This comes from taxes that came from the inner flow and it's going back in
Or export expenditure to make up for the import expenditure.
When there is an imbalance between injections and withdrawals,
this means there is a change in what we call 'aggregate demand'.
This is just like the basics of supply and demand that we talk about all the time,
except now we're talking about aggregates which is basically
the total spending on goods and services.
If there is a rise in aggregate demand, this means that there's economic growth
Injections have been exceeding withdrawals. Output is increasing and that's leading therefore to
more being paid in wages, rent, interest payments, dividends and so on.
As a result of this, unemployment will usually fall and inflation will usually rise.
And I guess you can imagine what will happen if the withdrawals are exceeding the injections
and there is a reduction in output. The opposite is probably going to happen.
So now, with everything we just discussed, we are essentially talking about GDP.
National income or output is measured with GDP.
There are three common ways of measuring GDP: there's the expenditures approach, the income
approach and the output approach. If you were sitting an exam in economics,
you'd probably need to know all three of these calculations but we'll just focus on the most common
one, which is the expenditures approach. Although really the three types should give the same
outcome anyway.
The expenditures approach states that GDP equals
C plus I plus G plus X minus M
In other words. Gross Domestic Product equals... Consumption of goods and services plus gross
investment, plus government purchases, plus exports minus
imports.
Now there are all kinds of other limitations, criticisms and other factors that we need to include
if we want to compare one economy to another because GDP just doesn't cut it on its own.
But that's not something that we're going to cover in this video as it's not really necessary for us right now,
unless of course, you're planning on becoming an economist or someone that deals very closely with
the analysis of an economy's output. In which case, we will be covering that in detail
in our economics course that should be coming out very soon, so keep an eye out for that one
For this video, we'll just go over one key concept,
because it's important even for understanding GDP in every day life
Because hey, who doesn't interact with GDP in every day life?
Anyway, this one's the difference between real GDP and nominal GDP.
This is something we need to consider if we want to compare an
economy's GDP from one year to the next, because it factors in the effect of inflation.
Nominal GDP is sometimes called 'money GDP' because
it just measures GDP in the current prices. However, 'real GDP' can sometimes be called
'GDP at constant prices' because it measures GDP in prices in one particular
year - the base year. So, for example, if national income is higher
by 5% this year, but in the same period of time prices have
gone up by 5%, then the average person has no advantage at
all. It stays the same. So a nominal GDP figure would be misleading,
whereas a real GDP figure would show the reality.
This is just one of the limitations of looking at GDP in isolation.
In fact, there are many, but that doesn't make GDP any less important.
Just because we can't rely on GDP statistics to inform us of whether a
country's standard of living has improved or not,
doesn't mean it doesn't tell as a hell of a lot about the state of that economy.
So I still recommend following it and making use of it and also being careful when it's coming out
because of the market volatility
So there you go guys, broadly speaking, that is GDP.
We've talked about the importance of it as a data point,
what it actually means and what is causing the rise or fall of the figure
and how it's calculated. So now when you hear it on the news, you can
explain it to everyone else and you'll be the life and sould of the party!
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