Another way of understanding GDP is to study its components and how they fit together. Economists split the production of goods and services in many different ways depending on the questions they are asking. We present two common ways of splitting GDP:

As we will see, both formulas prove useful for understanding business cycles and economic growth.

Economists have found it useful, especially for the analysis of short-run economic fluctuations, to split GDP into consumption (C ), investment (I), government purchases (G ) and exports minus imports (NX). The latter two terms are often put together and written as net exports, NX. To understand why this is equivalent to thinking of GDP as the market value of all final goods and services produced within a country in a year, note that produced goods can be consumed, invested, or purchased by governments or foreigners. Finally, some consumed, invested, and government-purchased goods are imported. Imported goods are not part of U.S. GDP, so we subtract imports. Thus, GDP can also be written as

The national spending identity: Y = C + I + G + NX

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where:

We explain each of these factors more in turn.

Consumption spending is private spending on final goods and services. Most consumption spending is made by households, such as spending on cars and chickens. Consumption spending, however, also includes spending on health care whether the spending comes from your pocket, an insurance company, or the government (as with Medicaid and Medicare). Note that while economists think of education as an investment in “human capital,” the Bureau of Economic Analysis includes education as consumption spending alongside purchases of automobiles, MP3 players, and televisions. How would you classify your education spending? Are you here to consume (party!) or invest for the future (study hard!)?

Investment spending is private spending on tools, plant, and equipment that are used to produce future output. Most investment spending is made by businesses but an important exception is that new home production is counted as investment. It’s important to emphasize that by “investment,” economists mean spending on tools, plant, and equipment (capital).When a farmer buys a tractor, that is investment. If your university builds new classrooms and labs, that is investment. Buying IBM stock, however, is not investment, as this is a mere change in ownership of some capital goods from one person to another.

The third component of GDP is government purchases, or spending by all levels of government on final goods and services. Government purchases include spending on tanks, airplanes, office equipment, and roads, as well as spending on wages for government employees (in this case the government is implicitly thought of as the purchaser of services such as military services). This category includes both government consumption items (like toner cartridges for printers) and government investment items (like roads and levees), and is thus also called government consumption and investment purchases.

A large part of what government does is transfer money from one citizen to another citizen; about 21% of the spending of the federal government, for example, is for Social Security payments. Unemployment and disability insurance, various welfare programs, and Medicare are also large transfer programs. We do not include transfers in government purchases because if we did, we would be double-counting. When the senior citizen buys a television with his or her Social Security check or consumes health care through Medicare, it is counted in the consumption portion of GDP. Thus, we do not also count the check as part of government purchases. Another way of thinking about this is that we count only government purchases off final goods and services. When the government sends a check to a senior citizen, it is not purchasing a final good or service—it is transferring wealth.

Net exports is exports minus imports. If a nation sells more final goods and services abroad than it buys from other nations, net exports will be positive. A nation that imports more than it exports has negative net exports. Note that U.S. imports contribute to the GDP of other nations—the 1 ocations where that value was produced—and we don’t want to count them twice; thus in GDP for the United States, we include U.S. exports but subtract U.S. imports. Importing goods and services remains a valuable activity (French cheese is delicious!), but the purpose of the GDP measure is to evaluate domestic production.

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Figure 6.6 shows the four components of U.S. GDP in 2013. Consumption is by far the largest component, accounting for $11.5 trillion, or 68.5% of U.S. GDP. Investment was $2.7 trillion, or 15.9% of GDP, government purchases $3.1 trillion, or 18.6%, and net exports were -$0.5 trillion, or -3.1%. If you look at the “long-term averages” part of Figure 6.6, you’ll get an idea of the relative sizes of these numbers in recent times. In later chapters on a ggregate demand and business cycles, you will see that changes in these categories represent one way of thinking about the causes or sources of short-run economic downturns and that is one reason why we have covered these particular categories.

When a consumer spends money, the money is received by workers (employee compensation = wages + benefits), landlords (rent), owners of capital (interest), and businesses (profit). Thus, we have yet another way of calculating GDP: We can add up all the spending or we can add up all the receiving. The first method is called the spending approach, while the second is called the factor income approach. The factor income approach:

Y = Employee compensation + Rent + Interest + Profit

As usual, some corrections are necessary to get the accounting right. For example, not every dollar spent on goods and services is a dollar received in income. Sales taxes are one exception with which you can identify. Sales taxes create a difference between what consumers pay and what businesses and workers receive so if we calculate GDP using the income approach, we need to add sales taxes.*

For our purposes, the details are less important than the basic idea: Every dollar spent is a dollar of income received so if we are careful in our accounting, we can measure GDP by summing up all the spending on final goods and services or by summing up everyone’s income.

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Each of the ways of splitting GDP throws a different light on the economy. Economists who study business fluctuations, for example, are often interested in splitting GDP according to the national spending identity because consumption, investment, government purchases, and net exports behave differently over time. Consumption spending, for example, tends to be much more stable than investment spending. Economists are interested in understanding the causes and consequences of these differences.

The factor income approach is useful if we are thinking about how economic growth is divided between employee compensation, rent, interest, and profits. It turns out, for example, that the largest payment in GDP is to labor. Employee compensation (wages and other benefits) accounts for about 54% of GDP—more than most people expect and much larger than corporate profits, which are around 10% of GDP. The share of GDP going to labor has been quite stable over time, although some evidence suggests that this share has fallen slightly in recent years. Economists are interested in understanding what drives the relative sizes of these shares.

It also helps to have more than one way of counting GDP because different methods are subject to different errors. Calculating GDP in more than one way lets us check our calculations.

No way of splitting GDP is better than another—it all depends on the questions being asked. Many other methods of splitting GDP are also possible and useful. We could look at the market value of food versus all other items, or durable versus nondurable goods, or we could break down GDP into finer geographic areas like regions or states (the latter is called gross state product). In principle, there are millions of ways of building a GDP measure by summing up its smaller parts. Economists continue to refine the idea of GDP, to improve the measurement of GDP, and to develop new ways of splitting GDP.