The Composition of Gross Domestic Product
Measuring gross domestic product (GDP) gives us an idea of the total production of an economy over a particular period. GDP is made up of the total market value of all final goods and serviced produced in an economy (but that doesn’t include government transfers). The formula to remember is Y = C + I + G + X.
- How can gross domestic product and poverty rates indicate standards of living?
- How can major events, such as a war or natural disasters, affect gross domestic product?
- Why is it important to keep track of the gross domestic product?
- What are some criticism, if any, of the gross domestic product as a measure of economic activity?
This lesson and the next few lesson, we're going to be considering the topic of macroeconomics.
So, let's get started.
The broadest measure of how the economy is doing is Gross Domestic Product - the GDP.
It's most important to get the precise definition of GDP. The idea is that it's the market value of all the final goods and services newly produced in a country during some time period. The key ideas are underline.
What do you mean by market value? It's the total amount that people spend or produced measured by the market prices.
Next important word is final goods that are produced, not intermediate goods. Any kind of production process, whether it's producing cars, has intermediate goods - any steel or aluminum, producing the tire in the car you need, or rubber - those are the intermediate goods that are used to produce the final goods.
Newly produced means we don't have a used car that is purchased because that was produced earlier year. We only look at the new car that was produced because we're interested in what was produced in a particular year.
And finally, it's in a country. Domestic refers to in a country like the United States and then off course this refers to a time period. It's the time period that measures what was actually produced during that period of time.
Note that there are few things that are omitted from gross domestic product. Unpaid work at home and the underground economy doesn't count. Illicit drug trade or just informal work where income isn't reported - say a painter of a house gets a payment but that's not counted either.
We hope that those things don't change in great magnitude over time by great amounts over time so they don't really affect the general pattern of GDP. I think that is generally true for the economy like the United States.
Finally, lets emphasize that the GDP doesn't measure everything. It doesn't measure how long people live, doesn't measure infant mortality, doesn't measure income distribution. It's the total amount produced in the economy - not attempting to measure everything.
So now let's consider particular case of how GDP is calculated and measured and the example would be the United States economy in the second quarter of 2013.
I have listed here what the gross domestic product actually is. It's the total amount produced in the second quarter for 2013. So, the annual rate is a measure that pertains to a whole year. So more precisely $16.661 trillion represent what's produced in the second quarter but in an annual rate. The way to think about is if the economy produced in all quarter of 2013 - the first, the third and the fourth- what it produced in the second quarter, then the total production in the year would be $16.661 trillion. So multiply by 4, you get an annual rate. Having said that, now let's consider the other parts of this gross domestic product and how you can divide it up.
One part is consumption - that's what people are spending on consumption goods. Investments is the amount businesses spend and then at the bottom you switch to government purchase, which is what the government spends.
And then something has to be subtracted here. What's subtracted is net exports. And if you look at the bottom, net exports is represented by the difference between exports and imports. So, the $509 billion with a minus sign is exports minus imports and exports are $2,239 and imports are $2,748 so the difference is $509. So, by taking in and adding in that export, which happens to be negative in this case, you're making an important adjustment that reflects what the GDP is.
So, I have to subtract it out and the statisticians have to subtract it out and so effectively they subtracted it out as part of the imports number. And by adding in net exports, which is exports minus imports, you're subtracting that imports. Similarly, there are some goods that are produced in the United States but are consume elsewhere where the United States will export them. So, you want to count them in your production of GDP even though no firm, no government, no individual purchased it. So that got to be added and that's why exports are added again. By adding in that exports, we add in exports and subtract imports and that's what's illustrated in the table.
So that's basically how you get the GDP. If you add up all those numbers, you get the total and then indeed there are some symbols that the economist use to represent these things. Y is the symbol for the gross domestic product and we will use in our models. C is consumption. I is investments. X is net exports and use G for government purchases. And since C + I + X + G = Y, we have an important equation.
This important equation is used in our models and it used to examine relationships. It's actually true. It's an accounting identity and one of the equation in our models which will always hold.
Again, Y equals C plus I plus X plus G where X is exports minus imports and now you know why we can think of it that way.
Having shown how we measure, lets' just go back and make sure we know why we did these various things.
The key idea is that when we add up spending, what people spend in consumption, what households spend in consumption, or what businesses spend in investment, our aim is to get measure of production so I say keep your eyes on the ball when you're thinking about this. We want to measure production in the economy in a particular period.
We can think about four spending groups that buy things: households, firms, government, and foreigners. Consumption is what households spends, investment is what businesses spend.
When the consumer goes and buys the pumpkin, then that consumer's house consumption will go up and inventory will go down and that's how adding up these numbers becomes GDP.
I mentioned why we add in that net exports and I just finally emphasize that the G in the C + I + G is only government purchases. It's the purchases of tanks for the military. Or it's the payment of school teachers to teach school. It doesn't include transfers like Social Security transfers to retired people or doesn't include food stamps for the poor to buy food. Those are considered transfers from the government to the individuals. It doesn't represent a production of a product.