Measuring the Size of the Economy: Gross Domestic Product Quiz

PDF page 455: 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.

PDF page 455: 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.

PDF page 455: 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 19.1 shows how these four components added up to the GDP in 2016. Figure 19.4 (a) shows the levels of consumption, investment, and government purchases over time, expressed as a percentage of GDP, while Figure 19.4 (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 19.1 shows the components of GDP from the demand side.

PDF page 455: 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 19.1 shows how these four components added up to the GDP in 2016. Figure 19.4 (a) shows the levels of consumption, investment, and government purchases over time, expressed as a percentage of GDP, while Figure 19.4 (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 19.1 shows the components of GDP from the demand side.

PDF page 456: 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.

PDF page 456: 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.

PDF page 457: 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.

PDF page 457: 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.

PDF page 458: 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 19.4(b) shows. Since the early 1980s, imports have typically exceeded exports, and so the United States has experienced a trade

PDF page 458: 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 19.4(b) shows. Since the early 1980s, imports have typically exceeded exports, and so the United States has experienced a trade

PDF page 459: deficit in most years. The trade deficit grew quite large in the late 1990s and in the mid-2000s. Figure 19.4 (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: GDP = Consumption + Investment + Government + Trade balance GDP = C + I + G + (X – M) Understanding how to measure GDP is important for analyzing connections in the macro economy and for thinking about macroeconomic policy tools.

PDF page 459: Components of GDP on the Supply Side (in trillions of Percentage of dollars) Total Goods Durable goods $3.0 16.1% Nondurable goods $2.5 13.4% Services $11.6 62.4% Structures $1.5 8.1% Change in $0.0 0.0% inventories Total GDP $18.6 100%

PDF page 461: 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