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What Is GDP and Why Is It So Important to Economists and Investors?

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Since the time humankind became evolved enough to measure the economic impact of their economic activities, GDP has been one of the primary indicators for measuring the economy’s health and growth rate.

GDP is calculated by measuring the total production and consumption of a country. It is crucial for Economists & Investors as it provides a clear picture of the economic performance and the exact value to all the goods and services manufactured & consumed within a country in a specific time.

The Dollar value for Goods and Services produced in an economy over a certain period is perhaps the most closely monitored and important economic indicator both to economists and investors. As a metric, the total size of an economy is also defined as a calculation. 

The use of GDP as the primary means of evaluating the economic health of central bankers and setting the target interest rates in an economy also helps in getting a clear picture of the economic activities within a country.

What Exactly is GDP?

GDP is an abbreviation for Gross Domestic Production and it is the value of all the goods and services produced within a country’s demographic boundaries. It is assumed that the higher the GDP, the higher is the economic prosperity of the country. 

GDP is calculated by the combined added figure of total consumption, total investment (public & private sector), government spending and net trade deficit. The value of GDP is denoted as a percentage figure and this rate is analysed to understand the growth of the economy.

The GDP figures are not taken as a reference for predicting how the market may perform in the future but as a point for predicting how the economy has performed in the past. The GDP figure helps in getting a clear representation of how the investments and stocks have performed in the past.

How is GDP Important?

Investors look at the GDP figures if they want to analyse the economic potential of the market. Usually, a bad GDP means the overall production and consumption within an economy is low which denotes a low earning potential for any company.

The GDP figure allows central banks and policymakers in assessing whether an economy is expanding or contracting. It also helps in figuring out whether a recession or inflation event is on the horizon. Major economic changes such as a change in oil prices, effect of taxes and fiscal policy on the economy can be better analysed using the GDP figures.

GDP is important in identifying a healthy economy. A developing economy has a high GDP figure as the production and consumption of products within the economy is rising and this growth rate is taken as a positive sign. A higher GDP denotes a fast-growing economy and vice-versa.

A strong GDP is a sign of higher consumption, that means the production is also on the rise. To meet this production demand, industries will hire more workers as they have more revenue due to high demand. This generates employment in the country coupled with an increase in the spending power of the general population.

Developing economies tend to have a higher GDP than developed economies. Take the example of the USA, with a GDP growth rate of 2.9% (2018), it is still one of the most developed economies of the world. On the contrary, India, that is a developing nation had a GDP growth rate of 6.8%.

How is GDP Calculated?

GDP can be calculated in two ways: Either through the expenditure approach or the income approach. The result produced in both scenarios would be the same. If the GDP is to be calculated for a specific industry, the value-added approach is deployed. 

Let’s have a look at the formula deployed for calculating the GDP of a nation.

                                     GDP=C+I+G+(X-M)

Here: 

  •   C=Consumer spending
  •   I=Corporate or business spending
  •   G=Government spending
  •   X=Value of exports
  •   M=Value of imports

Consumer spending forms a chunk of the overall GDP growth of a nation. If consumer spending is low, it implies that the market has low investor confidence and customers are less willing to spend. This directly affects the GDP of a nation and lays out an uncertain image of the future.

Business spending and investment form another major part of the GDP. Higher business spending drives the employment numbers in a country and promotes the overall spending capability of the population.

Demerits of GDP

According to economists, GDP is not the perfect figure to analyse a nation’s economic growth. Below are the factors that limit GDP to form the perfect figure for assessing economic output.

  • GDP is Limited to Economic Output: The GDP figure is simply an analysis of the net production and consumption within a nation’s demographic borders. This does not take into account the physical and mental well-being of the citizens of the country. It does not include income disparity and takes the whole economy into account.
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  • GDP is an Imperfect Figure: GDP does not take into account the profits earned by overseas companies in a nation. This can have an overstated effect on a nation’s economy that does not provide the full picture of the economic growth.
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  • It Does Not Take Into Account the Shadow Economy: GDP is calculated by only analysing the official figures and does not take into account the shadow economy and unreported data. In nation’s such as India, where a significant chunk of the population relies on the informal sector, the GDP figures thus obtained may be inaccurate.

As is evident, GDP is not a perfect figure, but it is still one of the significant indicators of the extent of economic activity within a nation’s demographic boundaries.

Conclusion

GDP is a single figure that helps in identifying a host of information about a nation’s economic prowess. It is one of the most important figures that economists and investors analyse before investing in a company.

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