The Bad Economist

What’s so Gross about the Domestic Product? March 17, 2011

The Gross Domestic Product (GDP) is one of the fundamental ideas of introductory macroeconomics. That’s because GDP is the core of one of the best ways to measure citizens’ well-being. We’ll get to that in a future post, though. For now, let’s talk about what GDP measures, and pretend that we’re not going to allow international trade. That makes this a closed economy model.

Let’s start with a simple premise: Everything that’s produced is purchased by someone. That makes sense in a couple of ways. A household can buy something, another business can buy something, the government can buy something, or… businesses can produce goods and store them for future use. For now, let’s treat this as the business buying its own goods to resell later.

GDP is defined as the market value of all final goods and services produced within a country in a given period of time. If we’re talking about the United States’ GDP for 2010, then it amounts to the prices of everything that was made in the US in 2010. The word ‘final’ means that if one company produces something that’s used as an input for another product, then only the last product counts. That means that some goods, like flour, might be final goods sometimes and intermediate goods other times. If I own a bakery, then I’ll buy a five-pound sack of flour to use in making bread, and so the flour is intermediate (since it’s used to produce another, final good). If I buy flour to make the same loaf of bread at home, then the flour might be used in home production, but since home-produced goods aren’t sold, then the flour is last sold to a consumer, and so it’s a final good. Since a consumer makes the purchase, it’s called Consumption.

Imagine that a box factory produces 600 boxes on December 31, 2010 and then sells them on January 1, 2011. Then, we have a sale of final goods, but the final goods weren’t produced in 2011, so they can’t count toward 2011 GDP. This requires the idea of inventory, which can be defined as goods that are produced but not sold. Inventory sales need to be subtracted from spending when calculating GDP.

Spending by businesses is on two things: intermediate goods (to produce final goods) and capital production (that is, stuff that allows them to be more efficient). All together, we call this spending by businesses Investment, which has a special definition in macroeconomics. Make sure not to confuse ‘investment’ in macro with the idea of putting money in stocks and bonds and hoping it grows. When taking a macro class, ‘investment’ pretty much means ‘spending by businesses.’ Inventory gets subtracted from investment, because it represents using past-produced goods. Those goods would have been counted as GDP in a previous year, so they need to be subtracted now even though a consumer purchased them.

Consumption and business spending aren’t the only things that need to be counted, though. Sometimes a business will produce a good that isn’t bought by a consumer. (I, for example, have never purchased a space shuttle, even though clearly someone’s producing them.) This is why we need to count Government spending.

Everything that’s produced is purchased, as long as we define ‘purchased’ to include ‘stored in inventory,’ and then we can subtract inventory sales from future GDP. Even though someone consumes a good that might have been produced in the previous year, subtracting it as inventory spending allows us to maintain the definition of GDP as ‘everything produced in the US in 2010’ while at the same time having an easy way to calculate it: just add up everything we buy!

This leads directly to the expenditure method for calculating GDP: just add up all the spending by consumers, by businesses, and by the government. In math, the letter Y is often used to represent output, and GDP represents the production (i.e. output) in an economy. So, we can use the formula

where C is consumption spending, I is business spending (including subtracting inventory) and G is government spending. (In an open economy we’d need to account for imports and exports. That will come later.)

These two definitions (“the final market value of all goods and services produced in an economy in a given period of time” and “C + I + G”) are equivalent. In a future post, we’ll talk about how to put that to use.