Measuring the Size of the Economy: Gross Domestic Product
By the end of this section, you will be able to:
- Identify the components of GDP on the demand side and on the supply side
- Evaluate how economists measure gross domestic product (GDP)
- Contrast and calculate GDP, net exports, and net national product
Macroeconomics is an empirical subject, so the first step toward understanding it is to measure the economy.
How large is the U.S. economy? Economists typically measure the size of a nation’s overall economy by its gross domestic product (GDP), which is the value of all final goods and services produced within a country in a given year. Measuring GDP involves counting 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 that a country produced in the current year—and summing them into a total dollar value. This task is straightforward: take the quantity of everything produced, multiply it by the price at which each product sold, and add up the total. In 2016, the U.S. GDP totaled $18.6 trillion, the largest GDP in the world.
Each of the market transactions that enter into GDP must involve both a buyer and a seller. We can measure an economy's GDP either by the total dollar value of what consumers purchase in the economy, or by the total dollar value of what is the country produces. There is even a third way, as we will explain later.
GDP Measured by Components of Demand
Who buys all of this production? We can divide this demand into four main parts: consumer spending (consumption), business spending (investment), government spending on goods and services, and spending on net exports. (See the following Clear It Up feature to understand what we mean by investment.) Table shows how these four components added up to the GDP in 2016. Figure (a) shows the levels of consumption, investment, and government purchases over time, expressed as a percentage of GDP, while Figure (b) shows the levels of exports and imports as a percentage of GDP over time. A few patterns about each of these components are worth noticing. Table shows the components of GDP from the demand side.
|Components of GDP on the Demand Side (in trillions of dollars)||Percentage of Total|
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 2016 was $3 trillion, according to the Bureau of Economic Analysis.
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, 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.
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 make adjustments 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.
Visit this website to read FAQs on the BEA site. You can even email your own questions!
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(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 (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:
Understanding how to measure GDP is important for analyzing connections in the macro economy and for thinking about macroeconomic policy tools.
GDP Measured by What is Produced
Everything that we purchase somebody must first produce. Table breaks down what a country produces into five categories: durable goods, nondurable goods, services, structures, and the change in inventories. Before going into detail about these categories, notice that total GDP measured according to what is produced is exactly the same as the GDP measured by looking at the five components of demand. Figure provides a visual representation of this information.
|Components of GDP on the Supply Side (in trillions of dollars)||Percentage of Total|
|Change in inventories||$0.0||0.0%|
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. Figure shows these 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. Moreover, services have been a growing share of GDP over time. A detailed breakdown of the leading service industries would include healthcare, education, and legal and financial services. It has been decades since most of the U.S. economy involved making solid objects. Instead, the most common jobs in a modern 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 within the overall category of goods, 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 one business has produced but has not yet 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.
Another Way to Measure GDP: The National Income Approach
GDP is a measure of what is produced in a nation. The primary way GDP is estimated is with the Expenditure Approach we discussed above, but there is another way. Everything a firm produces, when sold, becomes revenues to the firm. Businesses use revenues to pay their bills: Wages and salaries for labor, interest and dividends for capital, rent for land, profit to the entrepreneur, etc. So adding up all the income produced in a year provides a second way of measuring GDP. This is why the terms GDP and national income are sometimes used interchangeably. The total value of a nation’s output is equal to the total value of a nation’s income.
The Problem of Double Counting
We define GDP as the current value of all final goods and services produced in a nation in a year. 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, in which they count output more than once as it travels through the production stages. For example, imagine what would happen if government statisticians first counted the value of tires that a tire manufacturer produces, and then counted the value of a new truck that an automaker sold that contains those tires. In this example, the statisticians would have counted the value of the tires twice-because the truck's price 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. Statisticians exclude intermediate intermediate goods, which are goods that go into producing other goods, from GDP calculations. From the example above, they will only count the Ford truck's value. The value of what businesses provide to other businesses is captured in the final products at the end of the production chain.
The concept of GDP is fairly straightforward: it is just the dollar value of all final goods and services produced in the economy in a year. In our decentralized, market-oriented economy, actually calculating the more than $18 trillion-dollar U.S. GDP—along with how it is changing every few months—is a full-time job for a brigade of government statisticians.
|What is Counted in GDP||What is not included in GDP|
|Business investment||Transfer payments and non-market activities|
|Government spending on goods and services||Used goods|
|Net exports||Illegal goods|
Notice the items that are not counted into GDP, as Table outlines. 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 Friedrich Schneider's recent study of shadow economies, he estimated the underground economy in the United States 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.
Visit this website to read about the “New Underground Economy.”
Other Ways to Measure the Economy
Besides GDP, there are several different but closely related ways of measuring the size of the economy. We mentioned above that we can think of GDP as total production and as total purchases. We can also think of it as total income since anything one produces and sells yields income.
One of the closest cousins of GDP is the gross national product (GNP). GDP includes only what country produces within its borders. GNP adds what domestic businesses and labor abroad produces, and subtracts any payments that foreign labor and businesses located in the United States send home to other countries. In other words, GNP is based more on what a country's citizens and firms produce, wherever they are located, and GDP is based on what happens within a certain county's geographic boundaries. For the United States, the gap between GDP and GNP is relatively small; in recent years, only about 0.2%. For small nations, which may have a substantial share of their population working abroad and sending money back home, the difference can be substantial.
We calculate net national product (NNP) by taking GNP and then subtracting the value of how much physical capital is worn out, or reduced in value because of aging, over the course of a year. The process by which capital ages and loses value is called depreciation. We can further subdivide NNP into national income, which includes all income to businesses and individuals, and personal income, which includes only income to people.
For practical purposes, it is not vital to memorize these definitions. However, it is important to be aware that these differences exist and to know what statistic you are examining, so that you do not accidentally compare, say, GDP in one year or for one country with GNP or NNP in another year or another country. To get an idea of how these calculations work, follow the steps in the following Work It Out feature.
Calculating GDP, Net Exports, and NNP
Based on the information in Table:
- What is the value of GDP?
- What is the value of net exports?
- What is the value of NNP?
|Government purchases||$120 billion|
|Business Investment||$60 billion|
|Income receipts from rest of the world||$10 billion|
|Income payments to rest of the world||$8 billion|
Step 1. To calculate GDP use the following formula:
Step 2. To calculate net exports, subtract imports from exports.
Step 3. To calculate NNP, use the following formula:
Key Concepts and Summary
Economists generally express the size of a nation’s economy as its gross domestic product (GDP), which measures the value of the output of all goods and services produced within the country in a year. Economists measure GDP by taking the quantities of all goods and services produced, multiplying them by their prices, and summing the total. Since GDP measures what is bought and sold in the economy, we can measure it either by the sum of what is purchased in the economy or what is produced.
We can divide demand into consumption, investment, government, exports, and imports. We can divide what is produced in the economy into durable goods, nondurable goods, services, structures, and inventories. To avoid double counting, 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.
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?
GDP is C + I + G + (X – M). GDP = $2,000 billion + $50 billion + $1,000 billion + ($20 billion – $40 billion) = $3,030
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
- A used car sale
- A new car sale
- The greater variety of cheese available in supermarkets
- The iron that goes into the steel that goes into a refrigerator bought by a consumer.
- Hospital stays are part of GDP.
- Changes in life expectancy are not market transactions and not part of GDP.
- Child care that is paid for is part of GDP.
- If Grandma gets paid and reports this as income, it is part of GDP, otherwise not.
- A used car is not produced this year, so it is not part of GDP.
- A new car is part of GDP.
- Variety does not count in GDP, where the cheese could all be cheddar.
- The iron is not counted because it is an intermediate good.
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 you avoid double counting when measuring GDP?
Critical Thinking Question
U.S. macroeconomic data are among the best in the world. Given what you learned in the Clear It Up "How do statisticians measure GDP?", does this surprise you, or does this simply reflect the complexity of a modern economy?
What does GDP not tell us about the economy?
Last year, a small nation with abundant forests cut down $200 worth of trees. It then turned $100 worth of trees into $150 worth of lumber. It used $100 worth of that lumber to produce $250 worth of bookshelves. Assuming the country produces no other outputs, and there are no other inputs used in producing trees, lumber, and bookshelves, what is this nation's GDP? In other words, what is the value of the final goods the nation produced including trees, lumber and bookshelves?
U.S. Department of Commerce: Bureau of Economic Analysis. “National data: National Income and Product Accounts Tables.” http://bea.gov/iTable/iTable.cfm?ReqID=9&step=1.
U.S. Department of Commerce: United States Census Bureau. “Census of Governments: 2012 Census of Governments.” http://www.census.gov/govs/cog/.
United States Department of Transportation. “About DOT.” Last modified March 2, 2012. http://www.dot.gov/about.
U.S. Department of Energy. “Energy.gov.” http://energy.gov/.
U.S. Department of Health & Human Services. “Agency for Healthcare Research and Quality.” http://www.ahrq.gov/.
United States Department of Agriculture. “USDA.” http://www.usda.gov/wps/portal/usda/usdahome.
Schneider, Friedrich. Department of Economics. “Size and Development of the Shadow Economy of 31 European and 5 other OECD Countries from 2003 to 2013: A Further Decline.” Johannes Kepler University. Last modified April 5, 2013. http://www.econ.jku.at/members/Schneider/files/publications/2013/ShadEcEurope31_Jan2013.pdf.