Gross Domestic Product (GDP) is an important metric calculated by the Bureau of Economic Analysis (in the United States) every quarter. GDP is a measure of the output of all goods and services produced. Because GDP measures the output of the economy, investors, economists, and policy makers pay close attention to the GDP growth rates to judge the performance of the economy. In fact, the definition of “recession” is based on having two quarters of negative real GDP growth.
In this article, we explore some of the nuances that go into the calculation of GDP and discuss the national income accounting definitions that are part of the GDP formula. Understanding the national income account definitions is important for understanding more complex economic concepts.
GDP measures the total expenditures on final goods in an economy, which by definition must equal the total income of the economy. In other words, a buyer’s expenditure on a final good is equal to the seller’s income of that final good. For example, let’s assume the GDP a simple economy consists only of automobiles. This economy produces 10 automobiles, which are sold for $20,000 each. The GDP of this economy is $200,000, which is also equal to the total income generated by this economy.
Final Goods – GDP is calculated based on the value of the final goods produced. In the above example, if the auto manufacturer purchases an engine for $5,000 that will go into its cars, should the engine be included in the calculation of GDP? The engine cost should be excluded because its value will ultimately be reflected in the market price of the car sold. To count the $5,000 engine expenditure now and then the $20,000 automobile expenditure later would result in a GDP that double counts the value of the engine. Therefore, raw materials and intermediate goods are not included in the calculation of GDP.
Finished Inventory – On the other hand, finished inventory is included in the calculation of GDP. For example, if our car manufacturer in the above example sells 10 cars but produces 11 cars with 1 car remaining in inventory, the value of the car in inventory is included in the calculation of GDP. However, when this car is ultimately sold out of inventory, we do not include its value in the calculation of GDP.
Used Goods – Used goods are not included in the calculation of GDP.
Imputed Values – In the US, certain items are calculated based on their “imputed value” since these items do not have an explicit market price but often represent income or value enjoyed within the economy. For example, individuals pay rent for their housing, which can be directly measured and included in GDP. However, homeowners also enjoy housing and often pay a mortgage to pay for the home. To account for these housing services, the BEA includes “owner-occupied rent” which is an estimate of how much the homeowner would pay in rent for their home. Imputed rent is not included for other consumer durable goods. Additionally, GDP includes the income of government workers, who are providing services to the public. For example, police services are not sold to the public, but it is a service with value that is being provided, so its value is included in GDP.
Real GDP vs. Nominal GDP
Nominal GDP is the measure of the output of the economy at today’s prices. It is essentially the quantity of goods produced multiplied by the price of those goods in today’s dollars.
Nominal GDP = Price * Quantity
Since nominal GDP utilizes current prices, nominal GDP can go up simply due to a change in prices. For example, let’s assume that from 2017 to 2018, the quantity produced in the economy is 0%, but the price level (inflation) increases 5%. This would imply that the 2018 nominal GDP growth rate is 5%. That 5% nominal GDP growth rate may sound good at first glance, but since no additional quantities of goods were produced, the nominal growth in GDP simply due to inflation does not increase the economic well being of the citizens in the economy.
A better measure of the true productive growth in the economy is real GDP. Real GDP holds the price level constant from a prior base year and only looks at the change in quantities produced.
Real GDP = Base Year Price * Current Year Quantity
For example, if the base year is 2015. The real GDP in 2018 would be measured based on the quantities of all goods produced in 2018 multiplied by the individual prices of those goods in 2015.
When calculating GDP, economists frequently refer to a concept known as GDP Deflator.
GDP Deflator = Nominal GDP / Real GDP
The GDP deflator is the measure of the change in price vs. the base year. When you multiply the real GDP by the GDP deflator, you calculate the nominal GDP. Historically, the BEA calculated GDP by setting a base year and then changing that base year every five years so that the price level does not become too outdated. Currently, the BEA has changed their methodology to now update the base year every year when calculating real GDP and real GDP growth rates.
National Income Accounts
GDP can be broken down into four categories:
GDP (Y) = Consumption (C) + Investment (I) + Government Purchases (G) + Net Exports (NX)
Y = C + I + G + NX
Consumption – consumption includes durable goods, non-durable goods, and services purchased by households
Investment – investment includes business fixed investment (capital expenditures), residential fixed investment (purchase of housing), and business inventories. It is important to note that the purchase of housing relates to the purchase of new homes, not used homes
Government purchases – government purchases include goods and services purchased by federal, state, and local governments. It includes services provided by government employees but does not include payments for social welfare programs
Net exports – net exports consist of the value of all exports (goods and services) less the value of all imports (goods and services). When positive, net exports represent income to the domestic economy and is a positive contributor to GDP
- Net Exports = Exports – Imports
- Since the Consumption, Investment, and Government Purchases accounts include purchases of both domestic and foreign items, the Imports account includes consumption of foreign goods/services, investment in foreign goods/services, and government purchases of foreign goods/services
Below is a summary directly from BEA website, showing the national income accounts for 2016 and 2017 US GDP:
This chart shows that $18 trillion US GDP can be broken down as roughly 66% consumption, 17% investment, and 17% government purchases with a $858Bn trade deficit acting as a drag to GDP.
This trade deficit must be financed by borrowing from foreign sources (or selling assets to foreigners), which is a concept that you can learn more about in our article about trade deficits.