22.c. Gross Domestic Product, or GDP for short, measures the value of a nation's output of goods and services for some period of time, usually a year. It is not the only measure of output--the Federal Reserve, for example, publishes an index of industrial production--but the GDP has become a favorite among economists because it is the most comprehensive of output measures.

Until the 1990s the Commerce Department computed Gross National Product (GNP) instead of Gross Domestic Product. The differences between the two are slight and involve how to count earnings of assets owned by foreigners. Gross National Product counts the earnings in the homeland of the owner of the asset while Gross Domestic Product counts them in country in which the assets are located. For the United States there is virtually no difference between the two measures.

GDP, The total market value of all final goods and services produced in a country in a given year, equal to total consumer, investment and government spending, plus the value of exports, minus the value of imports. The GDP report is released at 8:30 am EST on the last day of each quarter and reflects the previous quarter. Growth in GDP is what matters, and the U.S. GDP growth has historically averaged about 2.5-3% per year but with substantial deviations.

Real GDP is an important indicator to track because it provides the greatest and broadest sectoral detail of any other series. Data reflect income as well as expenditure flows. Sectoral coverage includes durable and nondurable goods, structures, and services. Also, price data by sector are available for detailed subcomponents. Because of the detail available in the GDP reports, this series provides comprehensive information on supply and demand conditions, including information for various types of developing imbalances over the business cycle.

Real GDP is a quarterly figure, but is released on a monthly basis with an initial estimate-referred to as the "advance" estimate-and two subsequent revisions over the following two months. The Bureau of Economic Analysis (BEA) produces the GDP figures and releases the advance estimate generally during the fourth week of the first month following the reference quarter. That is, the first quarter advance estimate is published in late April, and subsequent first estimates are released in July, October, and January.

The first important issue in understanding economics is the development of a measure of economic well-being. Ideally there should be an ambiguous measure, but in fact we have only developed an approximate measure, which has certain built in biases.Gross domestic product or GDP is the broadest measure of the health of the US economy. The measure of the USA's output of goods and services is calculated by the Commerce Department using the following items[1]:

  • Personal consumption
  • Government expenditures
  • Private investment
  • Inventory growth
  • Trade balance

Figure 22.C.a

There are three alternative ways of deriving GDP: sum of expenditures, sum of incomes, and sum of value added (either by industry, by firm or by establishment, depending on what data are available). Basically, expenditures are measured more directly than income. The expenditure components for GDP is also most closely followed by markets. As stated previously, the expenditure approach to estimating GDP clearly is the method most closely followed by the financial markets. The major expenditure components are personal consumption (C), gross private domestic investment (I), government purchases (G), and net exports (X-M); they form the familiar identity of:

GDP = C + I + G + X - M.

Example 22.C.1

Real dollars
(1992 dollars) Current dollars
GDP GDP = I + C + G + (E – I)
United States: 1980 4,615 2,784= 466 + 1,760 + 573 - 15
(Billion of dollars) 1985 5,323 4,180= 715 + 2,705 + 875- 114
1990 6,1365,744= 800 + 3,839 + 1,176 - 71
1995 6,742 7,265= 1038 + 4,958 + 1,356 - 86
1997 7,191 8,083= 1238 + 5,489 + 1,454 - 97
($1000 millions = 1 Billion: $1000 Billion = 1 Trillion)

Expenditure measure of GDPThe expenditure measure of GDP is obtained by adding up all spending:

private consumption (spending on items such as food and clothing) + government consumption (spending on public sector salaries and so on) + investment(spending on houses, factories, and so on) = final domesticdemand+ stock building (increase in inventories) = total domestic demand +exports of goods and services (foreigners' spending) - imports of goods and services (spending abroad) = GDP

Basically we can say that GDP is divided into four categories, according to the final purchaser:

GDP = / Consumer Spending[2]+ Business and Residential Investment[3] + Government Spending[4] - Trade Deficit[5]

Example 22.C.2 " Bureau of Economic Analysis "released a report :

GROSS DOMESTIC PRODUCT: FIRST QUARTER 2003 (FINAL)

CORPORATE PROFITS: FIRST QUARTER 2003 (REVISED)

Real gross domestic product -- the output of goods and services produced by labor and property located in the United States – increased at an annual rate of 1.4 percent in the first quarter of 2003,according to revised estimates released by the Bureau of Economic Analysis. In the fourth quarter, real GDP also increased 1.4 percent. The major contributors to the increase in real GDP in the first quarter were personal consumption

expenditures (PCE) and residential fixed investment. The contributions of these components were partly offset by negative contributions from private inventory investment and from nonresidential fixed investment. Imports, which are a subtraction in the calculation of GDP, decreased.

The final estimate of the first-quarter increase in real GDP is 0.5 percentage point, or $10.9billion, lower than the preliminary estimate issued last month. The downward revision to the percentage change in real GDP primarily reflected a downward revision to non farm private inventory investment and an upward revision to imports that were partly offset by an upward revision to equipment and software.

Advance Preliminary Final

(Percent change from preceding quarter)

Real GDP...... 1.6 1.9 1.4

Current-dollar GDP...... 4.2 4.4 3.8

Income measure of GDP

The income measure of GDP is based on total incomes from production. It is essentially the total of:

  • wages and salaries of employees;
  • income from self-employment;
  • trading profits of companies;
  • trading surpluses of government corporations and enterprises; and
  • income from rents.

These are known as factor incomes.

Market prices and factor cost

Many transactions are subject to taxes and subsidies. Sales tax or value-added tax (VAT) and subsidized housing are obvious examples. The expenditure measure of GDP records market prices, which includes these taxes and subsidies. The income and output measures are generally reported at factor cost (that is, they exclude taxes and subsidies). The relationship is simple:

GDP at market prices - indirect taxes + subsidies = GDP at factor cost

GDP at current and constant prices

GDP figures are reported in current and constant prices.

- Output data are generally collected in both current and constant prices. The constant price figures for each industry are obtained by valuing current output in the prices applicable in a given base year; say, 1990 or 1995.

- Expenditure data are mostly collected in current prices. They are converted into constant prices by the same adjustment process used with output data, or - slightly differently - by deflating each component by an estimated price indicator. Once the current and constant price versions of the expenditure measure are available, they are used to calculate an overall deflator (that is, the price index) which is used with the income measure.

- Income data are collected in current prices and converted into constant prices using deflators derived from the expenditure measure.

The distinction between current and constant price measures of GDP is very important. Current price GDP could grow rapidly simply because prices are rising. But GDP measured at constant prices shows how the quantity of output is changing. Every component of GDP (consumption, investment, exports, imports) is measured at both constant and current prices to allow economists to see how real output is changing, or how demand is changing for each type of expenditure, or how incomes are changing after adjusting for inflation.

Gross Domestic Product and its Limitations

A commonly overlooked bias of the gross domestic product is its focus only on produced goods and services. It ignores totally how those goods and services are produced. In particular, it ignores the nature of the labor market and how it is organized. For instance in a slave society and a non-slave society producing equal quantities of goods and services the gross domestic product would be the same. But these two societies would have vastly different implications for the economic well-being of all their citizens. This would be especially true for the slaves.

The public would put some value on how goods and services are produced as well and its quantity. But the measure of gross domestic product ignores this how question, with its only focus on the quantity of output. A humane, democratic work environment with personal security for its workforce has real value for society. The gross domestic product by measuring only the quantity of output ignores this aspect of society’s well-being.

Another problem with GDP that has fascinated economists involves the size of the "underground economy," the economic activity unreported to the government because those engaged in it are attempting to avoid taxes. When a waitress takes tips that she does not report, or a plumber offers to work for less if paid in cash rather than by check, or a farmer who sells vegetables at a roadside stand understates his revenues to the IRS, each is part of the underground economy.

Pollution can also lead to the difficulty in locating where to include those benefits and cost (which country or region). Since pollution or the benefits can be felt either locally, regionally or globally, measuring economic well-being becomes a problem when the benefits (which add to GDP) and cost (pollution which should be subtracted from GDP) are not both felt within the same state borders.[6]

Natural disasters in the developed countries such as earthquakes, hurricanes, and tornadoes result in increases in the gross domestic product. The price for the necessary cleanup and reconstruction is added to the GDP. Also some human activity such as crime, war, results in increased spending, and that spending is added to the gross domestic product.

Figure 22.C.b

Application 22.C.a

How can we increase economic growth in the future?
Economic growth is a function of the technological innovation and the amount and quality of labor and capital in the economy:
Increased labor force participation increases output. Expanded, improved education creates more productive workers. Business and government spending on research and development enhance our abilities to produce and allow each worker to become more productive, increasing incomes for all. Finally, to achieve a higher level of GDP in the future, consumers need to limit consumption spending and increase savings today, permitting businesses to invest more in capital goods. If resources are invested into building an economy now, future generations will enjoy a higher level of economic growth; our businesses will produce more goods and consumers can purchase more goods. Expansion of output at rates faster than our population growth is what gives us the opportunity to enjoy higher standards of living.

Figure 22.C.c

The output measure of GDP is obtained by combining value added (value of production less cost of inputs) by all businesses: agriculture, mining, manufacturing and services. Output data are usually presented in index form (that is, with a base year such as 1990 equal to 100).

Figure 22.C.d

Problem Set 22.C

22.c1Given the following data (in billions of current dollars), calculate the current level of gross domestic product.

Consumption spending / $7,000
Social security payments / 500
Income tax receipts / 1,000
Exports / 1,100
Business purchases of new factories and equipment and changes in inventories / 1,500
Federal government spending on goods and services / 550
Construction of new homes / 200
State and local spending on goods and services / 1,300
Imports / 1,500
Wages / 6,000

22.c2If gross domestic product increases by 10 percent over a year, are we better off? Why or why not?

22.c3Increases in real GDP represent more production of goods and services. Why would the Federal Reserve ever undertake a policy to slow down the rate of growth in production?

22.4If consumers begin to purchase automobiles manufactured abroad instead of those manufactured in the US, 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?

22.c5Why are wages and profits not included in gross domestic product?

Bibliography

-"Guide to Economic Indicator"sby Norman Frumkin

-Wall Street Journal Web Site

-"Country Report" by Economist Intelligence Unit

(MarketIndicators & Forecasts)

- "Expenditure on gross domestic product : sources and methods"

Publisher: Statistics New Zealand

- "World Product and Income: International Comparisons of Real Gross Domestic Product" by Irving B. and Kravis

-COOL FIRE TECHNOLOGY

[1]By USA TODAY ( 06/01/00- Updated 11:00 AM ET )

[2]Purchase of goods and services by U.S. individuals, accounting for about 2/3 of the GDP. (News commentators like to say that "consumer spending makes up two-thirds of the economy.") This number includes products of both domestic and foreign origin

[3] On the cash flow statement and in economics, investment means spending that results in an increase in assets. This includes capital spending on plant and equipment, i.e. a real increase in the means of production; but it also includes any swelling of unsold inventory, which can indicate a problem with consumer demand. Residential investment mainly refers to the purchase of homes. Annual business and residential investment respectively make up about 12% and 4% of the GDP.

[4] Spending by the federal, state, and local governments, accounting for about 20% of the GDP.

[5]Annual amount spent by U.S. individuals, companies, and government agencies on foreign-made products, minus the amount spent by foreign entities on U.S.-made products; accounting for about negative 2% of the GDP.

[6]Minnesota State University, Mankato.