There is an important distinction to be made when anyone examines Gross Domestic Product (GDP). Before we go deeper let’s clarify what it means. Gross domestic product is the monetary value of all the finished goods and services produced in a country in each year. It entails all private and public consumption, investments, adding exports and subtracting imports. Simple equation illustrates,
GDP = C + I + G + (EX-IM)
GDP is an important indicator of economic health of a country, used by many as proxy for standard of living. Is it the full picture? what about the pulse of the economy?
Note: arguments that relate how GDP does not capture standard of living is for another post.
I will consider the case for my country Saudi Arabia. The graph below shows the GDP level for Saudi Arabia across time (in millions), specifically 1970-2016.
We see a rise from 1970 level compared with 2016 level, a large dip in the 80s, and a somewhat steady continuous rise. Consider now the growth rate of GDP. The growth rate of the economy is the percentage change of the GDP from one year to the next. Which explains how fast an economy is growing.
The graph above shows the growth rate of 46 years of Saudi Arabia. This graph does does not look as consistent as we thought it is by checking the first graph, when looking only at GDP level. Growth rate tells us a different story about the pulse of the economy, one that is far more interesting than the GDP level, where the only story is during the 80’s, which we can relate to in the growth picture. In that time frame Saudi’s GDP year on year declined by 20%.
Moreover, considering the case for Saudi we can see that it is far from being consistent or stable. However, if one would look at the level of GDP Saudi starting in 1970 compared to 2016 we can safely say that on average the growth rate for 46 years was 3.7%. Yet that is far from the truth now isn’t it.
As we know Saudi’s GDP stems from its oil production, then there must be a considerable effect from the oil price fluctuations. Oil prices are very volatile, check the two comparisons below. The left graph depicts the price of oil since 1986, where the right graph entails the change of oil prices year on year. We see that oil is very volatile across time.
Now let’s see how oil price fluctuations looks with Saudi GDP growth. Below we can see that there exists some sort of lag effect from oil prices on GDP. By lag I mean it might be that last year oil price change effects the following year in GDP growth.
There exists an intimate relationship between the change in oil price and GDP growth for Saudi Arabia. When one looks at GDP level we do not see the whole picture of the pulse of the economy. For a natural resource driven country we see plenty of volatility from its reliance on oil as main source of income. Yet we can conclude that in the long run (46 years) Saudi has grown on average 3.7% per annum.
Update* June 20th 2017
I acquired data that explains this relationship better. As the graph below shows, the Real GDP Growth of the Saudi Economy and Oil Sector growth. They exhibit a 0.77 correlation which indicates the intimacy mentioned previously.