Notes

What types of spending make up GDP? Look again at the markets for goods and services in Figure 10.2, 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:

(10-1) GDP = C + I + G + X − IM

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 10-1 in later modules!

Net exports are the difference between the value of exports and the value of imports (X − IM).

Measuring GDP as Factor Income Earned from Firms in the Economy A 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 10.3 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 10.4 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 2009: $14,259 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.


In the left bar in Figure 10.4, we see the breakdown of GDP by value added according to sector, the first method of calculating GDP. Of the $14,259 billion, $10,669 billion consisted of value added by businesses. Another $1,760 billion consisted of value added by government, in the form of military, education, and other government services. Finally, $1,830 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 10.4 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 $390 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, consumer spending (C), which is 70. 8% of GDP, dominates the picture. But some of that spending was absorbed by foreign-produced goods and services. In 2009, the value of net exports, the difference between the value of exports and the value of imports (X − IM in Equation 10-1), was negative—the United States was a net importer of foreign goods and services. The 2009 value of X − IM was −$390 billion, or −2.7% of GDP. Thus, a portion of the right bar extends below the horizontal axis by $390 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 11.4% of GDP; government purchases of goods and services (G) constituted 20.6% of GDP.


The U.S. is a net importer of goods and services, such as these toys made on a production line in China. Photo by Feng Li/Getty Images
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. Don’t 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.

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