1.3 Module 11: Gross Domestic Product (GDP)

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In the previous module we used the circular-flow diagram to show that adding up consumer spending, investment spending, government spending, and the value of exports minus the value of imports would give us a measure of a country’s gross domestic product.

In this module we will formally define gross domestic product, or GDP, and then look at how it is calculated.

Gross Domestic Product Defined

A consumer’s purchase of a new car from a dealer is one example of a sale of final goods and services: goods and services sold to the final, or end, user. But an automobile manufacturer’s purchase of steel from a steel foundry or glass from a glassmaker is an example of a sale of intermediate goods and services: goods and services that are inputs into the production of final goods and services. In the case of intermediate goods and services, the purchaser—another firm—is not the final user.

Gross domestic product, or GDP, is the total value of all final goods and services produced in an economy during a given period, usually a year. In 2013 the GDP of the United States was $16,803 billion, or about $53,086 per person.

Calculating GDP

Government statisticians use three methods to calculate GDP:

1. Survey and add up the total value of the production of final goods and services.
2. Add up aggregate spending on domestically produced final goods and services in the economy—the sum of consumer spending, investment spending, government purchases of goods and services, and exports minus imports.
   

   Aggregate spending—the total spending on domestically produced final goods and services in the economy—is the sum of consumer spending (C), investment spending (I), government purchases of goods and services (G), and exports minus imports (X − IM).

3. Sum the total factor income earned by households from firms in the economy.

To illustrate how the methods of calculating GDP work, we will consider a hypothetical economy, shown in Figure 11-1. This economy consists of three firms—American Motors, Inc., which produces one car per year; American Steel, Inc., which produces the steel that goes into the car; and American Ore, Inc., which mines the iron ore that goes into the steel. GDP in this economy is $21,500, the value of the one car per year the economy produces. Let’s look at how the three different methods of calculating GDP yield the same result.

In this hypothetical economy consisting of three firms, GDP can be calculated in three different ways: 1) measuring GDP as the value of production of final goods and services, by summing each firm’s value added; 2) measuring GDP as aggregate spending on domestically produced final goods and services; and 3) measuring GDP as factor income earned by households from firms in the economy.

Measuring GDP as the Value Of Production Of Final Goods and ServicesThe first method for calculating GDP is to add up the value of all the final goods and services produced in the economy—a calculation that excludes the value of intermediate goods and services. Why are intermediate goods and services excluded? After all, don’t they represent a very large and valuable portion of the economy?

To understand why only final goods and services are included in GDP, look at the simplified economy described in Figure 11-1. Should we measure the GDP of this economy by adding up the total sales of the iron ore producer, the steel producer, and the auto producer?

If we did, we would in effect be counting the value of the steel twice—once when it is sold by the steel plant to the auto plant and again when the steel auto body is sold to a consumer as a finished car. And we would be counting the value of the iron ore three times—once when it is mined and sold to the steel company, a second time when it is made into steel and sold to the auto producer, and a third time when the steel is made into a car and sold to the consumer. So counting the full value of each producer’s sales would cause us to count the same items several times and artificially inflate the calculation of GDP.

In Figure 11-1, the total value of all sales, intermediate and final, is $34,700: $21,500 from the sale of the car, plus $9,000 from the sale of the steel, plus $4,200 from the sale of the iron ore. Yet we know that GDP—the total value of all final goods and services in a given year—is only $21,500.

Steel is an intermediate good because it is sold to other product manufacturers like automakers or refrigerator makers, and rarely to final buyers, such as consumers.

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To avoid double-counting, we count only each producer’s value added in the calculation of GDP: the difference between the value of its sales and the value of the inputs it purchases from other businesses. That is, at each stage of the production process we subtract the cost of inputs—the intermediate goods—at that stage. In this case, the value added of the auto producer is the dollar value of the cars it manufactures minus the cost of the steel it buys, or $12,500. The value added of the steel producer is the dollar value of the steel it produces minus the cost of the ore it buys, or $4,800.

Only the ore producer, who we have assumed doesn’t buy any inputs, has value added equal to its total sales, $4,200. The sum of the three producers’ value added is $21,500, equal to GDP.

Measuring GDP As Spending On Domestically Produced Final Goods And ServicesAnother way to calculate GDP is by adding up aggregate spending on domestically produced final goods and services. That is, GDP can be measured by the flow of funds into firms. Like the method that estimates GDP as the value of domestic production of final goods and services, this measurement must be carried out in a way that avoids double-counting.

In terms of our steel and auto example, we don’t want to count both consumer spending on a car (represented in Figure 11-1 by the sales price of the car) and the auto producer’s spending on steel (represented in Figure 11-1 by the price of a car’s worth of steel). If we counted both, we would be counting the steel embodied in the car twice.

We solve this problem by counting only the value of sales to final buyers, such as consumers, firms that purchase investment goods, the government, or foreign buyers. In other words, in order to avoid the double-counting of spending, we omit sales of inputs from one business to another when estimating GDP using spending data. You can see from Figure 11-1 that aggregate spending on final goods and services—the finished car—is $21,500.

As we’ve already pointed out, the national accounts do include investment spending by firms as a part of final spending. That is, an auto company’s purchase of steel to make a car isn’t considered a part of final spending, but the company’s purchase of new machinery for its factory is considered a part of final spending. What’s the difference? Steel is an input that is used up in production; machinery will last for a number of years. Since purchases of capital goods that will last for a considerable time aren’t closely tied to current production, the national accounts consider such purchases a form of final sales.

What types of spending make up GDP? Look again at Figure 10-2 of the circular-flow diagram, and you will see that one source of sales revenue for firms is consumer spending. Let’s denote consumer spending with the symbol C. Figure 10-2 shows three other components of sales: sales of investment goods to other businesses, or investment spending, which we will denote by I; government purchases of goods and services, which we will denote by G; and sales to foreigners—that is, exports—which we will denote by X.

In reality, not all of this final spending goes toward domestically produced goods and services. We must take account of spending on imports, which we will denote by IM. Income spent on imports is income not spent on domestic goods and services—it is income that has “leaked” across national borders. So to calculate domestic production using spending data, we must subtract spending on imports. Putting this all together gives us the following equation, which breaks GDP down by the four sources of aggregate spending:

where C = consumer spending, I = investment spending, G = government purchases of goods and services, X = sales to foreigners, or exports, and IM = spending on imports. Note that the value of X − IM—the difference between the value of exports and the value of imports—is known as net exports. We’ll be seeing a lot of Equation 11-1 in later modules!

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Measuring GDP As Factor Income Earned From Firms In The EconomyA final way to calculate GDP is to add up all the income earned by factors of production in the economy—the wages earned by labor; the interest earned by those who lend their savings to firms and the government; the rent earned by those who lease their land or structures to firms; and the profit earned by the shareholders, the owners of the firms’ physical capital. This is a valid measure because the money firms earn by selling goods and services must go somewhere; whatever isn’t paid as wages, interest, or rent is profit. And part of profit is paid out to shareholders as dividends.

Figure 11-1 shows how this calculation works for our simplified economy. The shaded column at the far right shows the total wages, interest, and rent paid by all these firms as well as their total profit. Summing up all of these yields a total factor income of $21,500—again, equal to GDP.

We won’t emphasize the income method as much as the other two methods of calculating GDP. It’s important to keep in mind, however, that all the money spent on domestically produced goods and services generates factor income to households—that is, there really is a circular flow.

The Components of GDP

Now that we know how GDP is calculated in principle, let’s see what it looks like in practice.

Figure 11-2 shows the first two methods of calculating GDP side by side. The height of each bar above the horizontal axis represents the GDP of the U.S. economy in 2013: $16,803 billion. Each bar is divided to show the breakdown of that total in terms of where the value was added and how the money was spent.

The two bars show two equivalent ways of calculating GDP. The height of each bar above the horizontal axis represents $16,803 billion, U.S. GDP in 2013. The left bar shows the breakdown of GDP according to the value added of each sector of the economy. The right bar shows the breakdown of GDP according to the four types of aggregate spending: C + I + G + X − IM. The right bar has a total length of $16,803 billion + $494 billion = $17,297 billion. The $494 billion, shown as the area extending below the horizontal axis, is the amount of total spending absorbed by net imports (negative net exports) in 2013.

Source: Bureau of Economic Analysis.

In the left bar in Figure 11-2, we see the breakdown of GDP by value added according to sector, the first method of calculating GDP. Of the $16,803 billion, $12,688 billion consisted of value added by businesses. Another $2,036 billion consisted of value added by government, in the form of military, education, and other government services. Finally, $2,079 billion of value added was added by households and institutions. For example, the value added by households includes the value of work performed in homes by professional gardeners, maids, and cooks.

The right bar in Figure 11-2 corresponds to the second method of calculating GDP, showing the breakdown by the four types of aggregate spending. The total length of the right bar is longer than the total length of the left bar, a difference of $494 billion (which, as you can see, extends below the horizontal axis). That’s because the total length of the right bar represents total spending in the economy, spending on both domestically produced and foreign-produced—imported—final goods and services.

Within the bar at right, consumer spending (C), which is 68.4% of GDP, dominates the picture. But some of that spending was absorbed by foreign-produced goods and services. In 2013, the value of net exports, the difference between the value of exports and the value of imports (X − IM in Equation 11-1), was negative—the United States was a net importer of foreign goods and services. The 2013 value of X − IM was −$494 billion, or −2.9% of GDP. Thus, a portion of the right bar extends below the horizontal axis by $494 billion to represent the amount of total spending that was absorbed by net imports and so did not lead to higher U.S. GDP. Investment spending (I) constituted 15.9% of GDP; government purchases of goods and services (G) constituted 18.6% of GDP.

GDP: What’s In and What’s Out?

It’s easy to confuse what is included and what isn’t included in GDP. So let’s stop here and make sure the distinction is clear.

Be sure not to confuse investment spending with spending on inputs. Investment spending—spending on productive physical capital, the construction of structures (residential as well as commercial), and changes to inventories—is included in GDP. But spending on inputs is not. Why the difference?

Recall the distinction between resources that are used up and those that are not used up in production. An input, like steel, is used up in production. A metal-stamping machine, an investment good, is not. It will last for many years and will be used repeatedly to make many cars. Since spending on productive physical capital—investment goods—and the construction of structures is not directly tied to current output, economists consider such spending to be spending on final goods. Spending on changes to inventories is considered a part of investment spending so it is also included in GDP. Why? Because, like a machine, additional inventory is an investment in future sales. And when a good is released for sale from inventories, its value is subtracted from the value of inventories and so from GDP.

Used goods are not included in GDP because, as with inputs, to include them would be to double-count: counting them once when sold as new and again when sold as used.

The United States is a net importer of goods and services, such as computers from China, which is, by far, the biggest exporter to the United States.

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Also, financial assets such as stocks and bonds are not included in GDP because they don’t represent either the production or the sale of final goods and services. Rather, a bond represents a promise to repay with interest, and a stock represents a proof of ownership. And for obvious reasons, foreign-produced goods and services are not included in calculations of gross domestic product.

Here is a summary of what’s included and not included in GDP:

Included

• Domestically produced final goods and services, including capital goods, new construction of structures, and changes to inventories

Not Included

• Intermediate goods and services
• Inputs
• Used goods
• Financial assets such as stocks and bonds
• Foreign-produced goods and services

OUR IMPUTED LIVES

The value of the services that family members provide to each other is not counted as part of GDP.

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An old line says that when a person marries the household cook, GDP falls. And it’s true: when someone provides services for pay, those services are counted as a part of GDP. But the services family members provide to each other are not. Some economists have produced alternative measures that try to “impute” the value of household work—that is, assign an estimate of what the market value of that work would have been if it had been paid for. But the standard measure of GDP doesn’t contain that imputation.

GDP estimates do, however, include an imputation for the value of “owner-occupied housing.” That is, if you buy the home you were formerly renting, GDP does not go down. It’s true that because you no longer pay rent to your landlord, the landlord no longer sells a service to you—namely, use of the house or apartment. But the statisticians make an estimate of what you would have paid if you rented whatever you live in, whether it’s an apartment or a house. For the purposes of the statistics, it’s as if you were renting your dwelling from yourself.

If you think about it, this makes a lot of sense. In a homeowning country like the United States, the pleasure we derive from our houses is an important part of the standard of living. So to be accurate, estimates of GDP must take into account the value of housing that is occupied by owners as well as the value of rental housing.

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