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Course: Macroeconomics > Unit 2
Lesson 1: Gross Domestic Product- Circular flow of income and expenditures
- Parsing gross domestic product
- More on final and intermediate GDP contributions
- Investment and consumption
- Income and expenditure views of GDP
- Value added approach to calculating GDP
- Components of GDP
- Expenditure approach to calculating GDP examples
- Examples of accounting for GDP
- Measuring the size of the economy: gross domestic product
- Lesson summary: The circular flow and GDP
- The circular flow model and GDP
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Measuring the size of the economy: gross domestic product
Read about GDP and how we measure it.
Key points
- The size of a nation’s economy is commonly expressed as its gross domestic product, or GDP, which measures the value of the output of all goods and services produced within the country in a year.
*GDP is measured by taking the quantities of all final goods and services produced and sold in markets, multiplying them by their current prices, and adding up the total.
- GDP can be measured either by the sum of what is purchased in the economy using the expenditures approach or by income earned on what is produced using the income approach.
- The expenditures approach represents aggregate demand (the demand for all goods and services in an economy) and can be divided into consumption, investment, government spending, exports, and imports. What is produced in the economy can be divided into durable goods, nondurable goods, services, structures, and inventories.
- To avoid double counting—adding the value of output to the GDP more than once—GDP counts only final output of goods and services, not the production of intermediate goods or the value of labor in the chain of production.
- The gap between exports and imports is called the trade balance. If a nation's imports exceed its exports, the nation is said to have a trade deficit. If a nation's exports exceed its imports, it is said to have a trade surplus.
Introduction
To understand macroeconomics, we first have to measure the economy. But how do we do that? Let's start by taking a look at the economy of the United States.
The size of a nation’s overall economy is typically measured by its gross domestic product, or GDP, which is the value of all final goods and services produced within a country in a given year. Measuring GDP involves counting up the production of millions of different goods and services—smart phones, cars, music downloads, computers, steel, bananas, college educations, and all other new goods and services produced in the current year—and summing them into a total dollar value.
The numbers are large, but the task is straightforward:
Step 1: Take the quantity of everything produced.
Step 2: Multiply it by the price at which each product sold.
Step 3: Add up the total.
In 2014, the GDP of the United States totaled $17.4 trillion, the largest GDP in the world.
It's important to remember that each of the market transactions that enter into GDP must involve both a buyer and a seller. The GDP of an economy can be measured by the total dollar value of what is purchased in the economy or by the total dollar value of what is produced.
Understanding how to measure GDP is important for analyzing connections in the macro economy and for thinking about macroeconomic policy tools.
GDP measured by components of demand
$17.4 trillion is a lot of money! Who buys all of this production? Let's break it down by dividing demand into four main parts:
- Consumer spending, or consumption
- Business spending, or investment
- Government spending on goods and services
- Spending on net exports
The table below shows how the four above components added up to the GDP for the United States in 2014. It's also important to think about how much of the GDP is made up of each of these components. You can analyze the percentages using either the table or the pie graph below it.
| Components of GDP on the demand side in trillions of dollars | Percentage of total | |
|---|---|---|
| Consumption | $11.9 | 68.4% |
| Investment | $2.9 | 16.7% |
| Government | $3.2 | 18.4% |
| Exports | $2.3 | 13.2% |
| Imports | –$2.9 | –16.7% |
| Total GDP | $17.4 | 100% |
A few patterns are worth noticing here. Consumption expenditure by households was the largest component of the US GDP 2014. In fact, consumption accounts for about two-thirds of the GDP in any given year. This tells us that consumers’ spending decisions are a major driver of the economy. However, consumer spending is a gentle elephant—when viewed over time, it doesn't jump around too much.
Investment demand accounts for a far smaller percentage of US GDP than consumption demand does, typically only about 15 to 18%. Investment can mean a lot of things, but here, investment expenditure refers to purchases of physical plants and equipment, primarily by businesses. For example, if Starbucks builds a new store or Amazon buys robots, these expenditures are counted under business investment.
Investment demand is very important for the economy because it is where jobs are created, but it fluctuates more noticeably than consumption. Business investment is volatile. New technology or a new product can spur business investment, but then confidence can drop,
and business investment can pull back sharply.
If you've noticed any infrastructure projects—like road construction—in your community or state, you've seen how important government spending can be for the economy. Government expenditure accounts for about 20% of the GDP of the United States, including spending by federal, state, and local government.
It's important to remember that a significant portion of government budgets are transfer payments—like unemployment benefits, veteran’s benefits, and Social Security payments to retirees—that are excluded from GDP because the government does not receive a new good or service in return or exchange. The only part of government spending counted in demand is government purchases of goods or services produced in the economy—for example, a new fighter jet purchased for the Air Force (federal government spending), construction of a new highway (state government spending), or building of a new school (local government spending).
And finally, we must consider exports and imports when thinking about the demand for domestically produced goods in a global economy. First, we calculate spending on exports—domestically produced goods that are sold abroad. Then, we subtract spending on imports—goods produced in other countries that are purchased by residents of this country.
The net export component of GDP is equal to the dollar value of exports,
If exports and imports are equal, foreign trade has no effect on total GDP. However, even if exports and imports are balanced overall, foreign trade might still have powerful effects on particular industries and workers by causing nations to shift workers and physical capital investment toward one industry rather than another.
Based on the four components of demand discussed above—consumption,
GDP measured by what is produced
Everything that is purchased must be produced first. Instead of trying to think about every single product produced, let's break out five categories: durable goods, nondurable goods, services, structures, and change in inventories. You can see what percentage of the GDP each of these components contributes in the table and pie chart below.
Before we look at these categories in more detail, take a look at the table below and notice that total GDP measured according to what is produced is exactly the same as the GDP we measured by looking at the five components of demand above.
Since every market transaction must have both a buyer and a seller, GDP must be the same whether measured by what is demanded or by what is produced.
| Components of GDP on the supply side in trillions of dollars | Percentage of total | |
|---|---|---|
| Goods | ||
| Durable goods | $2.9 | 16.7% |
| Nondurable goods | $2.3 | 13.2% |
| Services | $10.8 | 62.1% |
| Structures | $1.3 | 7.4% |
| Change in inventories | $0.1 | 0.6% |
| Total GDP | $17.4 | 100% |
Let's take a look at the graph above showing the five components of what is produced, expressed as a percentage of GDP, since 1960. In thinking about what is produced in the economy, many non-economists immediately focus on solid, long-lasting goods—like cars and computers. By far the largest part of GDP, however, is services. Additionally, services have been a growing share of GDP over time.
You are probably already familiar with some of the leading service industries, like healthcare, education, legal services, and financial services. It has been decades since most of the US economy involved making solid objects. Instead, the most common jobs in the modern US economy involve a worker looking at pieces of paper or a computer screen; meeting with co-workers, customers, or suppliers; or making phone calls.
Even if we look only at the goods category, long-lasting durable goods like cars and refrigerators are about the same share of the economy as short-lived nondurable goods like food and clothing.
The category of structures includes everything from homes to office buildings, shopping malls, and factories.
Inventories is a small category that refers to the goods that have been produced by one business but have not yet been sold to consumers and are still sitting in warehouses and on shelves. The amount of inventories sitting on shelves tends to decline if business is better than expected or to rise if business is worse than expected.
The Problem of Double Counting
GDP is defined as the current value of all final goods and services produced in a nation in a year. But what are final goods? They are goods at the furthest stage of production at the end of a year.
Statisticians who calculate GDP must avoid the mistake of double counting—counting output more than once as it travels through the stages of production. For example, imagine what would happen if government statisticians first counted the value of tires produced by a tire manufacturer and then counted the value of a new truck sold by an automaker that contains those tires. The value of the tires would have been counted twice because the price of the truck includes the value of the tires!
To avoid this problem—which would overstate the size of the economy considerably—government statisticians count just the value of final goods and services in the chain of production that are sold for consumption, investment, government, and trade purposes. Intermediate goods, which are goods that go into the production of other goods, are excluded from GDP calculations. This means that in the example above, only the value of the truck would be counted. The value of what businesses provide to other businesses is captured in the final products at the end of the production chain.
| What is counted in GDP | What is not included in GDP |
|---|---|
| Consumption | Intermediate goods |
| Business investment | Transfer payments and non-market activities |
| Government spending on goods and services | Used goods |
| Net exports | Illegal goods |
Take a look at the table above showing which items get counted toward GDP and which don't. The sales of used goods are not included because they were produced in a previous year and are part of that year’s GDP.
The entire underground economy of services paid “under the table” and illegal sales should be counted—but is not—because it is impossible to track these sales. In a recent study by Friedrich Schneider of shadow economies, the underground economy in the United States was estimated to be 6.6% of GDP, or close to $2 trillion dollars in 2013 alone.
Transfer payments, such as payment by the government to individuals, are not included, because they do not represent production. Also, production of some goods—such as home production as when you make your breakfast—is not counted because these goods are not sold in the marketplace.
Summary
- The size of a nation’s economy is commonly expressed as its gross domestic product, or GDP, which measures the value of the output of all goods and services produced within the country in a year.
- GDP is measured by taking the quantities of all goods and services produced, multiplying them by their prices, and summing the total.
- GDP can be measured either by the sum of what is purchased in the economy or by what is produced.
- Demand can be divided into consumption, investment, government, exports, and imports. What is produced in the economy can be divided into durable goods, nondurable goods, services, structures, and inventories.
- To avoid double counting—adding the value of output to the GDP more than once—GDP counts only final output of goods and services, not the production of intermediate goods or the value of labor in the chain of production.
- The gap between exports and imports is called the trade balance. If a nation's imports exceed its exports, the nation is said to have a trade deficit. If a nation's exports exceed its imports, it is said to have a trade surplus.
Self-check questions
Country A has export sales of $20 billion, government purchases of $1,000 billion, business investment is $50 billion, imports are $40 billion, and consumption spending is $2,000 billion. What is the dollar value of GDP?
Which of the following are included in GDP, and which are not?
- The cost of hospital stays
- The rise in life expectancy over time
- Child care provided by a licensed day care center
- Child care provided by a grandmother
- The sale of a used car
- The sale of a new car
- The greater variety of cheese available in supermarkets
- The iron that goes into the steel that goes into a refrigerator bought by a consumer
Review questions
- What are the main components of measuring GDP with what is demanded?
- What are the main components of measuring GDP with what is produced?
- Would you usually expect GDP as measured by what is demanded to be greater than GDP measured by what is supplied, or the reverse?
- Why must double counting be avoided when measuring GDP?
Problem
Last year, a small nation with abundant forests cut down $200 worth of trees. $100 worth of trees were then turned into $150 worth of lumber. $100 worth of that lumber was used to produce $250 worth of bookshelves. Assuming the country produces no other outputs, and there are no other inputs used in the production of trees, lumber, and bookshelves, what is this nation's GDP?
In other words, what is the value of the final goods produced including trees, lumber and bookshelves?
Want to join the conversation?
The value of the lumber is (150- 100) (profit minus expenditures)= 50 dollars
The value of the bookshelves would be (250- 100)= 150 because you don't want to count the value of lumber twice + lumber would be considered the expenditure
Then the value of the trees themselves would be $200- half of it being used and half of it just in storage as inventory... 50+150+200= 400
OR
The final sale was worth 250 plus the unused lumber 50 plus the 100 worth of trees in inventory
250+50+100= 400(22 votes)
Why would you count the $100 of trees in inventory considering that these trees were already a part of this nation's economy (they were only cut down in the year in question)?(1 vote)
"Would you usually expect GDP as measured by what is demanded to be greater than GDP measured by what is supplied, or the reverse?"
What is the answer to this question?(1 vote)
From the reading:
"It's important to remember that each of the market transactions that enter into GDP must involve both a buyer and a seller. The GDP of an economy can be measured by the total dollar value of what is purchased in the economy or by the total dollar value of what is produced."
Because a buyer and seller must be involved it shouldn't matter which perspective you are looking at it from, the quantified result should be the same. If either side (buyer or seller) were not included then one could expect a difference in the measurements but we are measuring the total amount that has changed hands not what is strictly being produced (but potentially not sold) or what is strictly being demanded (but not potentially fulfilled).
TL;DR we are measuring what changes hands - doesn't matter if your the buyer or seller.(3 votes)
I have two questions.
1. There is this paragraph in the text above.
To avoid this problem—which would overstate the size of the economy considerably—government statisticians count just the value of final goods and services in the chain of production that are sold for consumption, investment, government, and trade purposes. Intermediate goods, which are goods that go into the production of other goods, are excluded from GDP calculations.
So do raw materials etc. bought by firms are not considered any category of demand? How about other nondurable goods bought by firms for producing goods and services? Are they investments? Consumption? Neither?
2. What exactly is done differently by statisticians when they use the expenditure method and production method to calculate GDP? Coz I would imagine that, to find out how much is purchased by costomers, the government still has to collate information from the businesses that sold them.(3 votes)
Raw materials bought by firms are not counted in aggregate expenditures. Non-durable equipment that is used to produce goods and services are counted as investments.
The government will ask consumer-facing businesses how much they get in revenue as part of their tax statements. That is the amount of consumption.(2 votes)
When the GDP doubles, that means that the average person in the economy is producing twice as much output per year?(3 votes)
If only new goods and services count toward GDP, does that mean that jobs and the salaries that they pay to get counted to GDP in the year the jobs are created and never again for as long as the jobs exist? Secondly, does an increase in the market value of a job over time not due to inflation also not count toward the GDPs of the years other than that when the job was first created?(1 vote)- Jobs are not counted in GDP at all, because they are not final goods or services. Jobs are intermediate services which are used to produce final goods and services.(4 votes)
If, on the first pie chart (Percentage of Components of U.S. GDP on the Demand Side), consumption (light blue) represents 68% of the total, then the size of its corresponding slice is not right. That looks more like 52%.(2 votes)
That pie chart looks so strange, because they added the -16.7% from the imports and pretended like it was +16.7%. I reported this to OpenStax.(2 votes)
- Example of how to compute GDP using the the approaches(2 votes)
- the answer should be $250, since at this is the furthest from the production which is based on lumber from the info provided above.(0 votes)
You are not counting the left over lumber and trees, these will be final goods until they become bookshelves down the line. After they become bookshelves you'd subtract them again, but that's not what its asking. It's asking for right now. total answer should be $400(7 votes)
- In the expenditure approach for the USA GDP, how can the Consumption be the greatest part of the GDP? I would have assumed that in order to spend, you must first have the money so you will need the wages, which would be part of the Investment.
==> Is this showing that USA households are basically borrowing for spending? Or that they are using their savings to pay for their spending?
==> But if this is the case, shouldn't we expect a catch up at some point, and see an increase in investment to pay for the debt accumulated by households?(1 vote)
I think you might have a misunderstanding about what is included in "Investment" in the expenditures approach to measuring GDP.
When you use the expenditures approach, wages are not included because that would lead to double counting. Investment only includes spending on goods and services by firms.
There is another approach to calculating GDP that takes a different approach: the income approach. In this way, GDP= wages + interest + rent + profits.(3 votes)
- Review questions
What are the main components of measuring GDP with what is demanded?
Ans : consumption , investment , government spending ,and net exports
What are the main components of measuring GDP with what is produced?
Ans : durable goods , non durable goods ,services , structures ,and inventories
Would you usually expect GDP as measured by what is demanded to be greater than GDP measured by what is supplied, or the reverse?
Ans : whether GDP is measured by what is demanded or supplied ,it has to be the same according to every market requiring a buyer and a seller.
Why must double counting be avoided when measuring GDP?
Ans : Double counting cause miscalculations in GDP ,and this error will overstate the GDP number because it add the value of the same item more than once(2 votes)