Chapter 4.1: Gross Domestic Product

4.1 Measuring the Size of the Economy: Gross Domestic Product

Learning Objectives

By the end of this section, you will be able to:

• Identify the components of the Gross Domestic Product GDP
• Evaluate how economists measure (GDP)
• Understand the breakdown of GDP into its four major components

Frequently, we encounter individuals expressing opinions about the condition of the economy, ranging from remarks like “The economy is flourishing” to “The economy is in a dire state.” What do these statements signify, and how does the economy impact us? The key concept is the Gross Domestic Product (GDP), compiled by the Bureau of Economic Analysis (BEA), the government agency responsible for analyzing the state of the economy, within the US Department of Commerce.

To put it simply, GDP refers to the overall market value of a nation’s output. It serves as a numerical representation of all newly generated items within a specific country over the course of a year. If this figure increases, it indicates that the country is producing more, suggesting an improvement in the economy. Conversely, a decline in GDP signifies reduced production, indicating a less favorable economic situation.

GDP Definition

GDP is the market value of all final goods and services produced within a country within a given period.

Market Value- refers to a current dollar amount.

Final Goods- refers to the goods and services being measured that are ready for immediate consumption, as opposed to intermediate good. Intermediate goods are goods that are produced by one firm for use in further processing by another firm. The value of intermediate goods are not counted in GDP.

Within a country refers to all final goods and services produced inside the US is part of the US GDP.

Exclusion from GDP

• GDP is concerned with current output. Old output was already counted when it was originally produced. If you buy a used car, since no new production has taken place, it is not counted as part of the GDP. A house is only part of GDP when it was first built.
• Sales of stocks and bonds are not counted as part of the GDP, because their sales have nothing to do with production. Even sales of stock that yield a profit are not part of GDP.
• Imported goods are not part of the GDP.
• The value of intermediate goods is not counted toward the GDP.
• Government transfers of money toward the population such as social security payments are not included in the GDP
• The Underground Economy is not included in the GDP

Components of GDP

There are four main units in a country’s economy: households, firms, government, and the international economy. GDP is divided among four components of expenditure: consumption, investment, government purchases, and net exports.

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

C= Consumption – spending by households

• 3 categories:
• Durable goods (example: buying a refrigerator)
• Non-Durable Goods (example: buying groceries)
• Services (example: going to the doctor)

I= Investment- spending by firms

• 3 categories:
• Residential Investment- households buy a house or an apartment.
• Non-Residential Investment- spending by firms on capital goods
• Change in inventories- number of inventories that go up or down every year.

G = Government Purchases – spending by government in exchange of a good or a service

• Federal Purchases
• State and Local Purchases

(X-M) = Net Exports

• Exports – Imports
• Exports (X)- goods produced locally but sold abroad.
• Imports (M) – goods produced abroad but sold locally.

	Components of GDP on the Demand Side (in trillions of dollars)	Percentage of Total
Consumption	$14.0	67.2%
Investment	$3.6	17.4%
Government	$3.9	18.5%
Exports	$2.1	10.2%
Imports	–$2.7	–13.3%
Total GDP	$20.9	100%

Table 4.1 Components of U.S. GDP in 2022: From the Demand Side (Source: http://bea.gov/iTable/index_nipa.cfm, Table 1.1.5)

“Percentage of Components of U.S. GDP on the Demand Side” by OpenStax, is licensed under CC BY 4.0

Figure 4.1 Percentage of Components of U.S. GDP on the Demand Side Consumption makes up over half of the demand side components of the GDP. Totals in the chart do not add to 100% due to rounding. (Source: http://bea.gov/iTable/index_nipa.cfm, Table 1.1.10)

Clear It Up

What does the word “investment” mean?

What do economists mean by investment, or business spending? In calculating GDP, investment does not refer to purchasing stocks and bonds or trading financial assets. It refers to purchasing new capital goods, that is, new commercial real estate (such as buildings, factories, and stores) and equipment, residential housing construction, and inventories. Inventories that manufacturers produce this year are included in this year’s GDP—even if they are not yet sold. From the accountant’s perspective, it is as if the firm invested in its own inventories. Business investment in 2020 was $3.6 trillion, according to the Bureau of Economic Analysis.

“Components of GDP on the Demand Side”  by OpenStax, is licensed under CC BY 4.0

Figure 4.2 Components of GDP on the Demand Side

(a) Consumption is about two-thirds of GDP, and it has been on a slight upward trend over time. Business investment hovers around 15% of GDP, but it fluctuates more than consumption. Government spending on goods and services is slightly under 20% of GDP and has declined modestly over time. (b) Exports are added to total demand for goods and services, while imports are subtracted from total demand. If exports exceed imports, as in most of the 1960s and 1970s in the U.S. economy, a trade surplus exists. If imports exceed exports, as in recent years, then a trade deficit exists. (Source: http://bea.gov/iTable/index_nipa.cfm, Table 1.1.10)

Consumption expenditure by households is the largest component of GDP, accounting for about two-thirds of the GDP in any 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 does not jump around too much, and has increased modestly from about 60% of GDP in the 1960s and 1970s.

Investment expenditure refers to purchases of physical plant and equipment, primarily by businesses. If Starbucks builds a new store, or Amazon buys robots, they count these expenditures under business investment. Investment demand is far smaller than consumption demand, typically accounting for only about 15–18% of GDP, but it is very important for the economy because this is where jobs are created. However, 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 have noticed any of the infrastructure projects (new bridges, highways, airports) launched during the 2009 recession, or if you received a stimulus check during the pandemic-induced recession of 2020–2021, you have seen how important government spending can be for the economy. Government expenditure in the United States is close to 20% of GDP, and includes spending by all three levels of government: federal, state, and local. The only part of government spending counted in demand is government purchases of goods or services produced in the economy. Examples include the government buying a new fighter jet for the Air Force (federal government spending), building a new highway (state government spending), or a new school (local government spending). A significant portion of government budgets consists of transfer payments, like unemployment benefits, veteran’s benefits, and Social Security payments to retirees. The government excludes these payments from GDP because it does not receive a new good or service in return or exchange. Instead they are transfers of income from taxpayers to others. If you are curious about the awesome undertaking of adding up GDP, read the following Clear It Up feature.

Clear It Up

How do statisticians measure GDP?

Government economists at the Bureau of Economic Analysis (BEA), within the U.S. Department of Commerce, piece together estimates of GDP from a variety of sources.

Once every five years, in the second and seventh year of each decade, the Bureau of the Census carries out a detailed census of businesses throughout the United States. In between, the Census Bureau carries out a monthly survey of retail sales. The government adjusts these figures with foreign trade data to account for exports that are produced in the United States and sold abroad and for imports that are produced abroad and sold here. Once every ten years, the Census Bureau conducts a comprehensive survey of housing and residential finance. Together, these sources provide the main basis for figuring out what is produced for consumers.

For investment, the Census Bureau carries out a monthly survey of construction and an annual survey of expenditures on physical capital equipment.

For what the federal government purchases, the statisticians rely on the U.S. Department of the Treasury. An annual Census of Governments gathers information on state and local governments. Because the government spends a considerable amount at all levels hiring people to provide services, it also tracks a large portion of spending through payroll records that state governments and the Social Security Administration collect.

With regard to foreign trade, the Census Bureau compiles a monthly record of all import and export documents. Additional surveys cover transportation and travel, and adjust for financial services that are produced in the United States for foreign customers.

Many other sources contribute to GDP estimates. Information on energy comes from the U.S. Department of Transportation and Department of Energy. The Agency for Health Care Research and Quality collects information on healthcare. Surveys of landlords find out about rental income. The Department of Agriculture collects statistics on farming.

All these bits and pieces of information arrive in different forms, at different time intervals. The BEA melds them together to produce GDP estimates on a quarterly basis (every three months). The BEA then “annualizes” these numbers by multiplying by four. As more information comes in, the BEA updates and revises these estimates. BEA releases the GDP “advance” estimate for a certain quarter one month after a quarter. The “preliminary” estimate comes out one month after that. The BEA publishes the “final” estimate one month later, but it is not actually final. In July, the BEA releases roughly updated estimates for the previous calendar year. Then, once every five years, after it has processed all the results of the latest detailed five-year business census, the BEA revises all of the past GDP estimates according to the newest methods and data, going all the way back to 1929.

When thinking about the demand for domestically produced goods in a global economy, it is important to count spending on exports—domestically produced goods that a country sells abroad. Similarly, we must also subtract spending on imports—goods that a country produces in other countries that residents of this country purchase. The GDP net export component is equal to the dollar value of exports (X) minus the dollar value of imports (M), (X – M). We call the gap between exports and imports the trade balance. If a country’s exports are larger than its imports, then a country has a trade surplus. In the United States, exports typically exceeded imports in the 1960s and 1970s, as Figure 4.2(b) shows.

Since the early 1980s, imports have typically exceeded exports, and so the United States has experienced a trade deficit in most years. The trade deficit grew quite large in the late 1990s and in the mid-2000s. Figure 4.2(b) also shows that imports and exports have both risen substantially in recent decades, even after the declines during the Great Recession between 2008 and 2009. As we noted before, 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 these four components of demand, we can measure GDP as:

GDP = Consumption + Investment + Government Spending + Net Exports

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

Understanding how to measure GDP is important for analyzing connections in the macro economy and for thinking about macroeconomic policy tools.

Work It Out

Calculating GDP, Net Exports

Based on the information in table 4.2:

What is the value of GDP?

What is the value of net exports?

Government purchases	$120 billion
Consumption	$400 billion
Business Investment	$60 billion
Exports	$100 billion
Imports	$120 billion

Table 4.2

Step 1. To calculate GDP use the following formula:

Net Exports: $100 billion – $129 billion= – $20 billion or a trade deficit of $20 billion

Net Export = International trade Balance

The term “net exports” refers to the difference between exports and imports, commonly known as the trade balance. A trade surplus occurs when exports exceed imports, while a trade deficit occurs when imports surpass exports.

Examples:

Exports = $100; Imports = $150; Trade Balance = deficit of $50

Exports = $200; Imports = $75: Trade Balance = surplus of $125

Exports = $100: Imports = $100; Trade Balance= $0 (balance)

This chapter is a remixed version of the chapters  6.1 Measuring the Size of the Economy: Gross Domestic Product in Principles of Macroeconomics 3e by OpenStax, published under a Creative Commons Attribution 4.0 International License. Other additions and modifications have been made in accord with the style, structure, and audience of this guide.