Gross Domestic Product (GDP)

When an entrepreneur starts a business, they do so hoping to profit by buying the inputs to produce a product or service that can be sold for a price high enough to cover the cost of the inputs and to adequately compensate the entrepreneur for their effort. However, businesses take time to become profitable, to learn what works and what doesn't. Meanwhile, a business must know how it is doing. Accounting measures that performance. Similarly, assessing the state of the economy and its growth rate is beneficial, to better manage it for optimal growth.

National income accounting is accounting for the nation as a whole. The Bureau of Economic Analysis (BEA), an agency of the Commerce Department, assesses the health of the economy by collecting statistics periodically and comparing production levels with recent and historical measurements. It has many subaccounts in its National Income and Product Accounts (NIPAs), as the BEA calls these national accounts. The main NIPA sectors include:

Subsectors include:

Because one person's expense is another person's income, national income accounting includes both national expenditures and national income, and they should equal.

The primary national account is the gross domestic product. Gross domestic product (GDP) is the total market value of all final goods and services produced in a given year within the United States, whether produced by citizens, companies, or by foreigners in the United States. Hence, cars manufactured by GM, Ford, Toyota, and Honda in the United States are considered part of GDP. However, cars produced by GM and Ford in China are not included, nor are Toyotas and Hondas manufactured in Japan.

GDP is a monetary measure: output is measured by summing the prices of all final products and services produced within the United States. Only final goods and services are counted, to avoid multiple counting since their prices cover the cost of all intermediate products and services used to produce the final output. Another way to calculate GDP is to measure the value added to each product or service at each stage of its production.

GDP excludes nonproduction transactions: public transfer payments, such as Social Security; private transfer payments, such as gifts; and financial market transactions since securities represent either ownership, such as with stocks, or they represent loans, such as bonds. Financial securities do not represent real production but simply represent the means to finance production. Likewise, secondhand sales are excluded because no production is involved except for the sales service. For instance, goods sold in a consignment shop would not be part of the GDP, but the services provided by the consignment shop would be included.

Because GDP measures output in terms of prices, the buyer pays the price and the seller receives it. Therefore, GDP can be measured by using either the expenditures approach, which sums the amount paid for final goods and services, or the income approach, which measures the income received for producing products and services. Both approaches should nearly equal.

GDP statistics are usually expressed in nominal dollars, unadjusted for inflation, called the nominal GDP. But a more accurate measure of economic growth is the real GDP, measured in terms of a dollar for a given year. Currently, real GDP is measured in 2017 chained dollars.

GDP Interactive Graphs (links open in a new window):

Determining GDP Using the Expenditures Approach

Since everything produced by the economy is purchased, one method of measuring GDP is by measuring total expenditures. Expenditures can be divided into 4 major categories: personal consumption expenditures, gross private domestic investment, government purchases, and net exports. Personal consumption expenditures include purchases for durable consumer goods, which are goods with an expected lifetime exceeding 1 year, such as automobiles, household appliances, and electronic equipment; nondurable consumer goods are goods with an expected lifetime of 1 year or less, such as food and toiletries, and consumer expenditures for services, such as for doctors, dentists, and lawyers.

Gross private domestic investment includes all final purchases of machinery, equipment, and tools by businesses + all construction + changes in inventories. Private domestic investment are goods not purchased by a government or one of its agencies. Domestic means it was purchased within the country. Investment includes residential construction since residential buildings can be rented out, even if occupied by owners. Owner-occupied residences have an imputed rent, which is added to GDP, even though the homes are not rented.

Inventory is included because businesses invest in producing inventory; however, not all is sold. If inventories declined during the year, then the difference between the prior year's and the current year's inventory is subtracted from investments; otherwise, it would be counted twice since some inventory produced in a previous year was sold. For instance, an inventory of 10 million cars at the beginning of the year and 5 million cars at year-end means that 5 million cars were sold but not produced in the current year, so they, as durable consumer goods, would count as consumer expenditures but since they were not produced in the current year, their value must be subtracted.

Business investment does not include the transfer of securities or tangible assets, such as real estate, furniture, or motor vehicles. Securities simply represent ownership or some other financial relationship but are not actual goods or services. Resold tangible assets, i.e. used goods, are also not included in GDP since this simply transfers ownership: it does not represent production. Investment in the economic sense means the production of real goods and services, not the transfer of ownership.

Another critical measure of the economy is the net addition of capital stock. Since some of the capital goods produced are used to replace worn-out machinery and equipment, this investment does not increase the stock of real capital in the economy. Gross investment includes all investment, including capital for replacing worn-out machinery and equipment. Net investment equals the gross investment minus depreciation, which measures the capital stock that must be replaced. An increase in capital stock expands the production possibility frontier: the economy can produce a greater output.

Net Investment = Gross Investment − Depreciation

Remember: Financial Investments Are Not Capital Investments

Economists use the word investment differently from most people. People think of investments as financial investments, such as buying stocks or bonds. However, in economics, investment refers to the purchase of capital stock, used to produce other goods or services. Buying stock on a stock exchange is simply buying shares from another investor. However, even if buying shares in an IPO, only the amount invested in capital stock would be considered an investment in the economic sense. Much of the IPO money is used to pay founders and early investors, or to pay debt or operating expenses rather than to purchase capital stock.

Most goods consumers buy are consumption goods, but not always. Sometimes the distinction between consumption goods and investment goods is arbitrary, but there must be an official distinction between them, to prevent double counting. For instance, economists classify buying a new car as purchasing a consumption good, even though it leads to a demand for auto services later. On the other hand, paying to have a new house built is considered a capital investment because a new house will lead to more demand for housing services, such as additions or repairs, cleaning, landscaping, and other services for houses. Buying an existing house does not add to the residential capital stock, so it is not considered a capital investment, even if it turns out to be a wise financial investment.

Government purchases include goods and services that the government uses to provide public services, and expenditures for social capital, such as for schools and highways. Government purchases include purchases made by all government entities, including federal, state, and local governments. However, it does not include transfer payments, such as paying Social Security or welfare benefits.

When computing total expenditures, imported goods must be subtracted from purchases since imported goods and services were not produced within the country. Exports, however, are included since they are produced within the country. However, exports are a separate item because they are purchased by foreigners, which is not included in the other categories. Rather than subtracting imports and adding exports, government economists use net exports, equal to exports minus imports, which is often represented by the symbol X. Note that when the value of imports exceeds the value of exports, then net exports is negative and subtracted from the GDP.

Net Exports (NX) = Exports − Imports

To summarize, GDP can be calculated thus:

GDP

Usually, this equation is written in this abbreviated form:

GDP = C + I + G + NX

Determining GDP by Using the Income Approach by Calculating Gross Domestic Income (GDI)

Since goods and services are sold, someone receives that income. Hence, another way of calculating GDP is by calculating the national income, aka gross domestic income (GDI), equal to the compensation of all employees, rents, interest, proprietors' income, and corporate profits.

GDP = GDI

The largest part of GDI is, by far, employee compensation. Compensation includes payments by the employer into social security and private pension funds, and payments for health and disability insurance for employees. Rents include the money received for renting out real estate by property owners, whether by households or businesses. However, only net rents are included, the total rent minus depreciation of rental property.

Interest includes the total sums paid by private businesses for loans, including the interest paid on savings, certificates of deposits, and corporate bonds.

Proprietors' income includes not only income earned by proprietorships but also partnerships and other unincorporated businesses, such as limited partnerships. Corporate profits can be divided into 3 categories:

  1. corporate income taxes;
  2. retained earnings, used for future expansion and to maintain liquidity;
  3. dividends, that portion of after-tax earnings paid to stockholders of the company.

The first 5 terms of the equation yield GDI, which is the Americans' total income, whether earned domestically or abroad.

The GDI approach yields a figure which is less than the expenditures approach, because indirect business taxes are added to the expenditures approach. These taxes include general sales taxes, excise taxes, property taxes, license fees, and customs duties. Example: buying something for $1 with a 6% sales tax is to pay $1.06 total. This $1.06 is added as a whole to the expenditure approach, but the $.06 sales tax was not used to produce the good or service, so it is not included in GDI — indirect business taxes are simply a form of transfer payment from the taxpayer to the government. Hence, indirect business taxes must be added to GDI to more accurately compare it to the expenditures approach.

Another adjustment that must be made is the consumption of fixed capital, calculated as depreciation of durable goods. Goods wear out over time. If capital goods were expensed when they were produced, it would understate profits for the first year but overstate profits in succeeding years, distorting actual profits. To account for the extended lifetime of durable goods, various methods of depreciation are used to expense capital goods over their expected lifetime, thus giving a better measure of profitability.

For instance, suppose you purchased a delivery truck for $50,000. If this were expensed in the 1st year, your profit would be less by $50,000. In the 2nd year, profits would increase by $50,000 for the same revenue and expenses except for the truck since you do not have to buy a new truck. However, at some point the truck must be replaced. Hence, some money must be set aside to make this purchase, usually by apportioning part of the cost of the capital good over its expected lifetime.

Because GDI includes income earned by Americans abroad, which is not counted in the expenditures approach, this income must be subtracted in the income approach, while the income earned by foreigners from domestic production must be added since such income is not included in national income but is counted as part of the expenditure approach. These adjustments are summarized as the net foreign factor income:

Net Foreign Factor Income

Hence, the net foreign factor income is added in the income approach to equalize it to the figure derived from the expenditures approach. To summarize:

GDP

= Wages

The BEA Revises its Estimates Periodically

Because the BEA gets its information from many sources and some information is available sooner, the BEA initially estimates national accounts, which are revised as better information becomes available. Even though the initial information is incomplete, it is still desirable to have it sooner rather than later. Hence, the BEA issues several versions of the national accounts for each quarter. The 1st quarterly estimate is the advance estimate, issued near the end of the 1st month after the end of each quarter. Then this estimate is revised in each of the next 2 months. Then the next quarter begins, when new estimates will again be issued, following the same pattern. So, for instance, an advance estimate for the 3rd quarter, ending in September, will be issued near the end of October, then the 1st revision will be issued in November, and the final revision will be issued in December. Then the 1st quarter begins, where estimates will be issued for the previous quarter.

The BEA also issues annual GDP estimates that are revised several times. Each July, revisions of the previous year's quarterly estimates are issued, then 2 other revisions of the same estimates are issued in the next 2 July's. Finally, all the NIPAs are comprehensively revised every 5 years.

Seasonal Adjustments

Christmas and the approach of winter create more economic activity in the 4th quarter than in the other quarters. Because this increased economic activity is normal, the BEA adjusts the GDP and GDI to filter out this seasonal variation, so that changes to these national accounts reflect fundamental factors rather than seasonal variation.

GDP Does Not Measure What Is Not Reported

GDP does not measure total output or total utility. Because GDP measures only the value of all final goods and services, which is measured by the prices of those goods and services, any output not sold or not reported will not be included in the GDP. For instance, if someone sells his services as a housecleaner, and he cleans someone's house for payment, that is included as GDP. (If he claims the income!) However, cleaning his own residence is not included as part of the GDP even though it is economic output. (After all, the house gets cleaned whether he does it himself or pays someone else to do it.)

Another source of economic output not measured in the GDP is the underground economy, whose output is unreported because people wish to avoid taxes or because the output is illegal, such as selling heroin or other illicit drugs. Many immigrants, for instance, work under the table, as they say, to avoid detection by immigration authorities and to avoid the payment of taxes. Other activities of the underground economy include the manufacture and transport of drugs, money laundering services, and prostitution.

Not all illegal activities would be included in the GDP anyway, even if they were reported. Burglary and robbery, for instance, would not be included since these activities simply transfer the ownership of the stolen items.

Free activities are not included in the GDP, while those costing money are included. For instance, playing basketball at an outdoor court would not be included in the GDP, but paying to see a movie would be included.

GDP also does not account for the quality of the goods and services since the price of the output is not necessarily related to the quality of the output. GDP also does not include the cost of negative externalities, such as littering and pollution, unless the government forces companies to pay for them, such as by the assessment of a carbon tax.

Leisure has value, evidenced by the fact that as compensation increases, most people choose to consume more leisure and work less. However, because leisure does not have a price tag, there is no measure of it in the GDP.

GDP also does not measure whether the distribution of output is fair. More of the GDP is distributed to those with more money. However, more money does not necessarily go to those who work the hardest. Indeed, it often goes to those who work the least since inheritance is taxed much less than working income. Tax laws are skewed to favor the wealthy since they can influence legislators with their money. In most countries, working income is taxed the most, while investment income and inheritance is taxed considerably less — both forms of income accrue mostly to the wealthy, and with lower taxation, the wealthy increase their wealth even more.

Conclusion

Even though GDP does not measure all output, it still allows economists to assess the state of the economy, providing a solid foundation to predict its future course and to measure the results of public policies.