Gross Domestic Product

Explain how GDP is

measured The broadest measure of aggregate economic activity, as well as the best-known and

’ most often used, is gross domestic product, or GDP. As in the example in Section 2.1,

a country's GDP may be measured by the product approach, the expenditure approach, or the income approach.

The Product Approach to Measuring GDP

The product approach defines a nation's gross domestic product (GDP) as the market value of final goods and services newly produced within a nation during a fixed period of time. In working through the various parts of this definition, we discuss some practical issues that arise in measuring GDP.

Market Value. Goods and services are counted in GDP at their market values— that is, at the prices at which they are sold. The advantage of using market values is that it allows adding the production of different goods and services. Imagine, for example, that you want to measure the total output of an economy that pro­duces 7 cars and 100 pairs of shoes. Adding the number of cars and the number of pairs of shoes to get a total output of 107 wouldn't make much sense because cars and shoes aren't of equal economic value. But suppose that each car sells for $20,000 and each pair of shoes sells for $80. Taking these market-determined prices as measures of relative economic values, you can calculate the value of cars pro­duced as $140,000 (7 ? $20,000) and the value of shoes produced as $8000 (100 ? $80). The total market value of production, or GDP, is $140,000 + $8000 = $148,000. Using market values to measure production makes sense because it takes into account differences in the relative economic importance of different goods and services.

A problem with using market values to measure GDP is that some useful goods and services are not sold in formal markets. Ideally, GDP should be adjusted upward to reflect the existence of these goods and services. However, because of the difficulty of obtaining reliable measures, some nonmarket goods and services simply are ignored in the calculation of GDP. Household production and child­rearing services performed within the household without pay, for example, are not included in GDP, although household production and child care that are provided for pay (for example, by professional housecleaners or by private day-care centers) are included. Similarly, because the benefits of clean air and water aren't bought and sold in markets, actions to reduce pollution or otherwise improve environmen­tal quality usually are not reflected in GDP (see "In Touch with Data and Research: Natural Resources, the Environment, and the National Income Accounts.").

Some nonmarket goods and services are partially incorporated in official GDP measures. An example is activities in the so-called underground economy. The underground economy includes both legal activities hidden from government record keepers (to avoid payment of taxes or compliance with regulations, for example) and illegal activities such as drug dealing, prostitution, and (in some places) gambling. Some might argue that activities such as drug dealing are "bads" rather than "goods" and shouldn't be included in GDP anyway—although a consistent application of this argument might rule out many goods and services currently included in GDP, such as cigarette production. Clearly, though, the ser­vices of a housepainter who is paid in cash to avoid taxes should be included in GDP. Government statisticians are unable to reliably adjust GDP figures to include estimates of the underground economy's size, but they do make some adjust­ments for underreported income.^[11]

A particularly important component of economic activity that does not pass through markets is the value of the services provided by government, such as defense, public education, and the building and maintenance of roads and bridges.

Newly Produced Goods and Services. As a measure of current economic activ­ity, GDP includes only goods or services that are newly produced within the current period. GDP excludes purchases or sales of goods that were produced in previous periods. Thus, although the market price paid for a newly constructed house would be included in GDP, the price paid in the sale of a used house is not counted in GDP. (The value of the used house would have been included in GDP for the year it was built.) However, the value of the services of the real estate agent involved in the sale of the used house is part of GDP, because those services are provided in the current period.

Final Goods and Services. Goods and services produced during a period of time may be classified as either intermediate goods and services or final goods and services. Intermediate goods and services are those used up in the produc­tion of other goods and services in the same period that they themselves were produced. For example, flour that is produced and then used to make bread in the same year is an intermediate good. The trucking company that delivers the flour to the bak­ery provides an intermediate service.

Final goods and services are those goods and services that are not intermedi­ate. Final goods and services are the end products of a process. For example, bread produced by the bakery is a final good, and a shopper's bus ride home from the bakery is a final service.

Sometimes the distinction between intermediate goods and final goods is sub­tle. For example, is a new lathe sold to a furniture manufacturer an intermediate good or a final good? Although the lathe is used to produce other goods, it is not used up during the year. Hence it is not an intermediate good; it is a final good. In particular, the lathe is an example of a type of final good called a capital good. Other more general examples of capital goods include factories, office buildings, equipment, software, and intellectual property, such as copyrights. A capital good is a good that is itself produced (which rules out natural resources such as land) and is used to produce other goods; however, unlike an intermediate good, a capi­tal good is not used up in the same period that it is produced. The preparers of the national income accounts decided to classify capital goods as final goods and thus to include their production in GDP. Their reasoning was that the addition to pro­ductive capacity from new capital goods represents economic activity.

Another subtle distinction between intermediate and final goods arises in the treatment of inventory investment. Inventories are stocks of unsold finished goods, goods in process, and raw materials held by firms. Inventory investment is the amount by which inventories increase during the year.^[12] For example, sup­pose that a baker began the year with $1000 worth of flour in her storeroom and that at the end of the year she is holding $1100 worth of flour. The difference between her beginning and ending stocks, or $100 worth of flour, equals the baker's inventory investment during the year. Even though the ultimate purpose of the baker's flour is for making bread, her increase in inventory repre­sents production of flour that is not used up during the year.^[13] As in the case of capital goods, inventory investment is treated as a final good and thus part of GDP because increased inventories on hand imply greater productive capacity in the future.

In the OrangeInc-JuiceInc example, we showed that total economic activity could be measured by summing the value added (value of output minus value of purchased inputs) for each producer. The advantage of the value-added technique is that it automatically includes final goods and excludes intermediate goods from the measure of total output. If you go back to that example, you will see that, by summing the value added of the two companies, we obtained a measure of eco­nomic activity that included the value of final sales of the two businesses to the public but excluded the intermediate goods (unprocessed oranges) sold to JuiceInc by OrangeInc.

GNP Versus GDP. Until 1991, most economists working with U.S. data focused on a measure of economic activity known as gross national product rather than on GDP. However, in 1991, primarily to conform with national income accounting practices in other major industrialized countries, the Department of Commerce began to use GDP as its basic measure of economic activity. The difference between GNP and GDP lies in the treatment of output produced by capital and labor work­ing outside their home (domestic) country. Specifically, gross national product (GNP) is the market value of final goods and services newly produced by domestic factors of production during the current period, whereas GDP is production taking place within a country.

In Touch with Data and Research

Natural Resources, the Environment, and the National Income Accounts

Much of any country's economic well-being flows from natural, rather than human-made, assets—land, rivers and oceans, natural resources (such as oil and timber), and indeed the air that everyone breathes. Ideally, for the purposes of economic and environmental planning, the use and misuse of natural resources and the environment should be appropriately measured in the national income accounts. Unfortunately, they are not. There are at least two important conceptual problems with the way the national income accounts currently handle the eco­nomic use of natural resources and the environment.

1. Natural resource depletion. When an oil driller pumps oil from an under­ground field, the value of the oil produced is counted as part of the nation's GDP; there is no offsetting deduction to account for the fact that nonrenewable resources are being depleted. In principle, the draining of the oil field can be thought of as a type of negative inventory investment because in a sense it reduces the inventory of oil. If it were included in the national income accounts, this negative inventory investment would reduce the computed value of GDP.

2. The costs and benefits of pollution control. Imagine that a company has the following choices: It can produce $100 million worth of output and in the process pollute the local river by dumping its wastes; alternatively, by using 10% of its workers to dispose properly of its wastes, it can avoid polluting but will get only $90 million of output. Under current national income accounting rules, if the firm chooses to pollute rather than not to pollute, its contribution to GDP will be larger ($100 million rather than $90 million) because the national income accounts attach no explicit value to a clean river. In an ideal accounting system, the economic costs

of environmental degradation would be subtracted in the calculation of a firm's contribution to output, and activities that improve the environment—because they provide real economic benefits—would be added to output.

Discussing the national income accounting implications of resource depletion and pollution may seem to trivialize these important problems. Actually, because GDP and related statistics are used frequently in policy analyses, abstract ques­tions of measurement often may turn out to have significant real effects. For exam­ple, economic development experts have expressed concern that some poor countries, in attempting to raise measured GDP as quickly as possible, have done so in part by overexploiting their natural resources and harming the environment. Conceivably, explicitly incorporating "hidden" resource and environmental costs into official measures of economic growth might cause these policies to be modi­fied. Similarly, in industrialized countries, political debates about the environment at times have emphasized the impact on conventionally measured GDP of pro­posed pollution control measures, rather than their impact on overall economic welfare. Better accounting for environmental quality might serve to refocus these debates to the more relevant question of whether, for any particular environmental proposal, the benefits (economic and noneconomic) exceed the costs.

When U.S. capital and labor—also called factors of production—are used abroad, they produce output and earn income. This output and income are included in U.S. GNP but not in U.S. GDP because they don't represent produc­tion taking place within the United States. So, for example, the value of roads built by a U.S. construction company in Saudi Arabia, as measured by the fees that the construction company receives from the Saudi government, is counted in U.S. GNP but not in U.S. GDP. Similarly, when foreign capital or labor is used in the United States, the output produced and the income earned are part of U.S. GDP (because the production occurs within the United States) but not of U.S. GNP (they are counted in the foreign country's GNP instead). For example, the portion of the value of Japanese cars built in the United States that is attributable to Japanese capital and management counts in Japanese GNP and U.S. GDP, but not in U.S. GNP.

We define net factor payments from abroad (NFP) to be income paid to domestic factors of production by the rest of the world minus income paid to for­eign factors of production by the domestic economy. Using this concept, we express the relationship between GDP and GNP as

For the United States, GDP and GNP give similar measures of economic activ­ity. For example, in 2021 the U.S. GDP was $22,996.1 billion and the U.S. GNP was $23,248.5 billion, a difference of just over 1%. The distinction between GNP and GDP is more important for countries such as Egypt and Turkey that have many citizens working abroad. The reason is that income earned by workers abroad is part of a country's GNP but not its GDP.

The Expenditure Approach to Measuring GDP

A different perspective on the components of GDP is obtained by looking at the expenditure side of the national income accounts. The expenditure approach mea­sures GDP as total spending on final goods and services produced within a nation during a specified period of time. Four major categories of spending are added to get GDP: consumption, investment, government purchases of goods and services, and net exports of goods and services. In symbols,

Y = GDP = total production (or output)

= total income

= total expenditure;

C = consumption;

I = investment;

G = government purchases of goods and services;

NX = net exports of goods and services.

With these symbols, we express the expenditure approach to measuring GDP as

Y = C + I + G + NX. (2.3)

TABLE 2.1

Expenditure Approach to Measuring GDP in the United States, 2021

Equation (2.3), like Eq. (2.1), is one of the basic relationships in macroeconom­ics. Equation (2.3) is called the income-expenditure identity because it states that income, Y, equals total expenditure, C + I + G + NX. Recent U.S. data for the four categories of spending, along with some major subcategories, are given in Table 2.1. As you read the rest of this section, you should look at Table 2.1 to get a feel for the relative sizes of different components of spending in the U.S. economy.

Consumption. Consumption is spending by domestic households on final goods and services, including those produced abroad.^[14] It is the largest component of expenditure, usually accounting for a little more than two-thirds of GDP in the United States. Consumption expenditures are grouped into three categories:

1. consumer durables, which are long-lived consumer items, such as cars, televi­sions, furniture, and major appliances (but not houses, which are classified under investment);

2. nondurable goods, which are shorter-lived items, such as food, clothing, and fuel; and

3. services, such as education, health care, financial services, and transportation.

Investment. Investment includes both spending for new capital goods, called fixed investment, and increases in firms' inventory holdings, called inventory invest­ment. Fixed investment in turn has two major components:

1. business fixed investment, which is spending by businesses on structures (facto­ries, warehouses, and office buildings, for example), equipment (such as machines, vehicles, computers, and furniture), and intellectual property prod­ucts (such as software, investment in research and development, and literary, entertainment, and artistic originals); and

2. residential investment, which is spending on the construction of new houses and apartment buildings. Houses and apartment buildings are treated as cap­ital goods because they provide a service (shelter) over a long period of time.

Like consumption, investment includes spending on foreign-produced goods. Fixed investment in the United States is volatile, ranging from about 13% to almost 20% of GDP.

As we have mentioned, increases in inventories are included in investment spending, regardless of why inventories rose. In particular, if a firm produces goods that it can't sell, the resulting rise in inventories counts as investment by the firm. For the purposes of national income accounting, the firm has, in effect, pur­chased the unsold goods from itself. This accounting rule is useful because it guar­antees that production and expenditure will always be equal in the national income accounts. Anything that is produced must, by definition, either be bought by a customer or "purchased" by the firm itself.

Government Purchases of Goods and Services. Government purchases of goods and services, which include any expenditure by the government for a currently produced good or service, foreign or domestic, is the third major compo­nent of spending. Government purchases in the United States recently have been about one-sixth of GDP. Note in Table 2.1 that in the United States the majority of government purchases are made by state and local governments, not the Federal government.

Not all the checks written by the government are for purchases of current goods and services. Transfers, a category that includes government payments for Social Security and Medicare benefits,^[15] unemployment insurance, Temporary Assistance for Needy Families (TANF) payments, and so on, are payments (pri­marily to individuals) by the government that are not made in exchange for cur­rent goods or services. As a result, they are excluded from the government purchases category and are not counted in GDP as calculated by the expenditure approach. Similarly, interest payments on the national debt are not counted as part of government purchases.

Much like the distinction between private-sector consumption and invest­ment, some part of government purchases goes toward current needs (such as employee salaries) and some is devoted to acquiring capital goods (such as office buildings). In the U.S. national income and product accounts, government spend­ing on capital goods (buildings, equipment, software, and intellectual property) is often reported separately from other government purchases. Investment by the government is fairly sizable—more than $600 billion annually in recent years, or about one-fifth of the amount invested annually by the private sector. When we speak of "investment" in the national income accounts, however, we are generally referring to investment by the private sector, I; for simplicity, we include govern­ment investment as part of government purchases of goods and services, G.

Net Exports. Net exports are exports minus imports. As discussed in Chapter 1, exports are the goods and services produced within a country that are purchased by foreigners; imports are the goods and services produced abroad that are pur­chased by a country's residents. Net exports are positive if exports are greater than imports and negative if imports exceed exports.

Exports are added to total spending because they represent spending (by for­eigners) on final goods and services produced in a country.^[16] Imports are subtracted from total spending because consumption, investment, and government pur­chases are defined to include imported goods and services. Subtracting imports ensures that total spending, C + I + G + NX, reflects spending only on output produced in the country. For example, an increase in imports may mean that Americans are buying Japanese cars instead of American cars. For fixed total spending by domestic residents, therefore, an increase in imports lowers spending on domestic production.

The Income Approach to Measuring GDP

The third and final way to measure GDP is the income approach. It calculates GDP by adding the incomes received by producers, including profits, and taxes paid to the government. A key part of the income approach is a concept known as national income. National income is the sum of eight types of income (see Table 2.2 for recent U.S. data).

1. Compensation of employees. Compensation of employees is the income of work­ers (excluding the self-employed) and includes wages, salaries, employee benefits (including contributions by employers to pension plans), and employer contributions to Social Security. As you can see from Table 2.2, com­pensation of employees is the largest component of national income, account­ing for 54.4% of GDP, on average, in the past 25 years.

2. Proprietors' income. Proprietors' income is the income of the nonincorporated self-employed. Because many self-employed people own some capital (exam­ples are a farmer 's tractor or a dentist's X-ray machine), proprietors' income includes both labor income and capital income. Proprietors' income has aver­aged about 7.6% of GDP over the past 25 years.

3. Rental income of persons. Rental income of persons, a small item, is the income earned by individuals who own land or structures that they rent to others. Some miscellaneous types of income, such as royalty income paid to authors,

TABLE 2.2

Income Approach to Measuring GDP in the United States, 2021

recording artists, and others, also are included in this category. Rental income of persons averaged 2.5% of GDP over the past 25 years.^[17]

4. Corporate profits. Corporate profits are the profits earned by corporations and represent the remainder of corporate revenue after wages, interest, rents, and other costs have been paid. Corporate profits are used to pay taxes levied on corporations, such as the corporate income tax, and to pay dividends to share­holders. The rest of corporate profits after taxes and dividends, called retained earnings, are kept by the corporations. Corporate profits have averaged a bit over 10% of GDP over the past 25 years, but the amount of profits earned by corporations may change dramatically from year to year or even from quarter to quarter. Table 2.2 shows that corporate profits were 12.2% of GDP in 2021, somewhat higher than the 25-year average.

5. Net interest. Net interest is interest earned by individuals from businesses and foreign sources minus interest paid by individuals. Net interest has varied from 2.6% to 5.3% of GDP each year over the past 25 years, averaging 3.7% of GDP.

6. Taxes on production and imports. Taxes on production and imports include indi­rect business taxes, such as sales and excise taxes, that are paid by businesses to Federal, state, and local governments, as well as customs duties and taxes on residential real estate and motor vehicle licenses paid by households. These taxes have averaged about 6.5% of GDP for the past 25 years.

7. Business current transfer payments (net). Business current transfer payments are payments made by businesses to individuals or governments or foreigners, but not for wages or taxes or as payment for services. Instead, such transac­tions as charitable donations, insurance payments, FDIC insurance premiums paid by banks, and legal settlements are covered by this category of income. Business current transfer payments have been between 0.6% and 0.9% of GDP each year for the past 25 years.

8. Current surplus of government enterprises. Current surplus of government enter­prises is essentially the profit of businesses that are owned by governments, such as water, electric, and sewer companies; trash companies; mass transit firms; and housing firms. Current surplus of government enterprises is often negative when the firms suffer losses, as has occurred in each of the past 17 years, though the losses have never been more than 0.2% of GDP.

In addition to the eight components of national income just described, three other items need to be accounted for to obtain GDP:

■ statistical discrepancy;

■ depreciation; and

■ net factor payments from abroad.

Statistical discrepancy arises because data on income are compiled from dif­ferent sources than data on production; the production measure minus the income measure equals the statistical discrepancy. Thus, a positive statistical discrepancy means that the income measure adds up to less than the production measure. National income plus the statistical discrepancy equals net national product (NNP), as indicated in Table 2.2.

Depreciation (also known as consumption of fixed capital) is the value of the capital that wears out during the period over which economic activity is being mea- sured.¹0 In the calculation of the components of national income (specifically, propri­etors' income, corporate profits, and rental income), depreciation is subtracted from total, or gross, income. Thus, to compute the total or gross amount of income, we must add back in depreciation. The sum of net national product and depreciation is gross national product (GNP). Gross national product and gross domestic product are called gross because they measure the nation's total production or equivalently output of goods and services without subtracting depreciation.

As we discussed earlier, to go from GNP to GDP we have to subtract net factor payments from abroad, NFP (see Eq. 2.2). As we have already mentioned and as you can see from Table 2.2, for the United States net factor payments are relatively small and so GDP and GNP are very close.

Private Sector and Government Sector Income. In this section we have measured economic activity as the sum of all the incomes received in an economy. Sometimes, however, economists need to know how much of total income was received by the private sector (households and businesses) and how much accrues to the government sector, which in the United States consists of Federal, state, and local governments. For example, in trying to predict the demand for consumer goods, focusing on the income available to the private sector might be more useful than focusing on the income of the economy as a whole.

The income of the private sector, known as private disposable income, mea­sures the amount of income the private sector has available to spend. In general, as for a household, the disposable income of the private sector as a whole equals income received from private-sector activities, plus payments received by the private sector from the government, minus taxes paid to the government. The precise definition is

private disposable income = Y + NFP + TR + INT — T, (2.4)

where

Y = gross domestic product (GDP);

NFP = net factor payments from abroad;

TR = transfers received from the government;

INT = interest on government debt;

T = taxes.

As you can see from Eq. (2.4), private disposable income equals private sector income earned at home (GDP) and abroad (net factor payments from abroad, NFP);^{[18] [19]} plus payments to the private sector from the government sector (transfers, TR, and interest on government debt, INT);^[20] minus taxes paid to the government, T.

The part of GDP that is not at the disposal of the private sector is the net income of the government sector. Net government income equals taxes paid by the private sector, T, minus payments from the government to the private sector (transfers, TR, and interest on government debt, INT):

net government income = T — TR — INT. (2.5)

Adding Eqs. (2.4) and (2.5) yields the sum of private disposable income and net government income, Y + NFP, which is gross national product.

2.3