Definition of Gross Domestic Product
Gross Domestic Product (GDP) is one measure of economic activity, the total amount of goods and services produced in the United States in a year. It is calculated by adding together the market values of all of the final goods and services produced in a year.
• It is a gross measurement because it includes the total amount of goods and services produced, some of which are simply replacing goods that have depreciated or have worn out.
• It is domestic production because it includes only goods and services produced within the U.S.
• It measures current production because it includes only what was produced during the year.
• It is a measurement of the final goods produced because it does not include the value of a good when sold by a producer, again when sold by the distributor, and once more when sold by the retailer to the final customer. We count only the final sale.
Changes in GDP from one year to the next reflect changes in the output of goods and services and changes in their prices. To provide a better understanding of what actually is occurring in the economy, real GDP is also calculated. In fact, these changes are more meaningful, as the changes in real GDP show what has actually happened to the quantities of goods and services, independent of changes in prices.
Explanations of GDP and its Components
Gross domestic product consists of goods and services produced for consumption, for investment, for government, and for export. The GDP accounts are broken down into consumption spending, investment spending, government spending, and spending on U.S. exports. To arrive at the amount actually produced (that is, GDP) our spending on imports is subtracted from those other amounts of spending. Thus, GDP = consumption spending + investment spending + government spending + (export spending – import spending)
Consumption spending consists of consumer spending on goods and services. It is often divided into spending on durable goods, non-durable goods, and services. These purchases currently account for 70 percent of GDP.
Durable goods are items such as cars, furniture, and appliances, which are used for several years.
Non-durable goods are items such as food, clothing, and disposable products, which are used for only a short time period.
Services include rent paid on apartments (or estimated values for owner-occupied housing), airplane tickets, legal and medical advice or treatment, electricity and other utilities. Services are the fastest growing part of consumption spending.
Investment spending accounts for 17 percent of GDP, but varies significantly from year to year.
Non-residential fixed investment is the creation of tools and equipment to use in the production of other goods and services. Examples are the building of factories, the production of new machines, and the manufacturing of computers for business use.
Residential investment is the building of a new homes or apartments.
Inventory changes consist of changes in the level of stocks of goods necessary for production and finished goods ready to be sold.
Government spending consists of federal, state, and local government spending on goods and services such as research, roads, defense, schools, and police and fire departments. This spending (19 percent) does not include transfer payments such as Social Security, unemployment compensation, and welfare payments, which do not represent production of goods and services. Federal defense spending now accounts for approximately 5 percent of GDP. State and local spending on goods and services accounts for 12 percent of GDP, while federal spending is 7 percent of GDP.
Exports are goods and services produced in the U.S. and purchased by foreigners – currently about 10 percent of GDP.
Imports are items produced by foreigners and purchased by U.S. consumers are equal to 16 percent of GDP. Net exports (exports minus imports) are negative and are about 6 percent of the GDP.
GDP as a Measure of Well-Being
Changes in real GDP are a more accurate representation of meaningful economic growth than changes in nominal GDP, because changes in real GDP represent changes in quantities produced, while prices are held constant. Real GDP per capita is even more relevant because it measures goods and services produced per person and thus approximates the amount of goods and services each person can enjoy. If real GDP grows, but the population grows faster, then each person, on average, is actually worse off than the change in real GDP would indicate.
Consider the table below. While the mainland part of China has a GDP of $991 billion, its GDP per capita is only $791.30. Hong Kong has a much smaller GDP of $159 billion. However, its GDP per capita is much higher at $23,639.58. Other nations, such as France and Germany, may have quite different GDPs, but GDPs per capita that are very close.
GDP per capita is not a perfect estimate of well-being. When individuals grow their own food, build their own houses and sew their own clothes, they are not producing goods and services to be sold in a marketplace and therefore GDP does not change. As a result, many countries in South America and Africa have a low GDP per capita that underestimates their well-being.
(The comparisons in the above table are of nominal GDP per capita, not real GDP per capita. As we are comparing per capita figures for the same year there is no need to deflate the nominal figures into real figures.)
Interactive Exercise
1. Given the following data (in billions of current dollars),
a. W hat is the level of government spending in the calculation of GDP?
b. What is the level of investment?
c. What is the level of net exports?
d. Calculate the level of gross domestic product.
Discussion questions
If gross domestic product increases by 10 percent over a year, are we better off? Why or why not?
If consumers begin to purchase automobiles manufactured abroad instead of those manufactured in the U.S., what will happen to real GDP? Will the answer be different if consumers are simply increasing their spending and those purchases are of automobiles manufactured abroad?