Explain why the three methods of calculating GDP produce the same estimate of GDP.
Let’s start by considering the relationship between the total value added of all domestically produced final goods and services, and aggregate spending on domestically produced final goods and services. These two quantities are equal because every final good and service produced in the economy is either purchased by someone or added to inventories, and additions to inventories are counted as spending by firms. Next, consider the relationship between aggregate spending on domestically produced final goods and services, and total factor income. These two quantities are equal because all spending that is channeled to firms to pay for purchases of domestically produced final goods and services is revenue for firms. Those revenues must be paid out by firms to their factors of production in the form of wages, profit, interest, and rent. Taken together, this means that all three methods of calculating GDP are equivalent.
Question
Identify each of the sectors to which firms make sales. What are the various ways in which households are linked with other sectors of the economy?
Firms make sales to other firms, households, the government, and the rest of the world. Households are linked to firms through the sale of factors of production to firms, through purchases from firms of final goods and services, and through lending funds to firms in the financial markets. Households are linked to the government through their payment of taxes, their receipt of transfers, and their lending of funds to the government to finance government borrowing via the financial markets. Finally, households are linked to the rest of the world through their purchases of imports and transactions with foreigners in financial markets.
Question
Consider Figure 10.3. Explain why it would be incorrect to calculate total value added as $30,500, the sum of the sales price of a car and a car’s worth of steel.
You would be counting the value of the steel twice—once as it was sold by American Steel to American Motors and once as part of the car sold by American Motors.