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Economists measure the functioning of an economy in a wide range of ways, but two of the most important measures of an economy’s performance are its total output, called the Gross Domestic Product (GDP), and the cost of participating in the economy as a consumer, called the Consumer Price Index (CPI). The CPI is the subject of the next chapter. In this chapter, we focus on GDP.
Gross Domestic Product, or GDP, measures the total value of economic activity within a country. More precisely, GDP is the sum of the market values, or prices, of all final goods and services produced in an economy (as will be explained in a moment). GDP is calculated for a specific period of time, usually a year or a quarter of a year. Most of the time, GDP means annual GDP. GDP is normally expressed in the local currency, but when the GDPs of two or more countries are compared, they have to be converted into some common currency.
What Goes Into GDP
The calculation of GDP includes only final goods and services. It excludes intermediate goods and services. Consider the example of a magazine photo shoot. The magazine uses a caterer who serves 30 sandwiches at $7 each, and it pays the photographer $80 per hour for 6 hours of work. The magazine issue the photos are eventually published in sells 1 million copies at $9 each. In this case, the total contribution to GDP is \($9\times1M = $9M\) (where M denotes million), because the magazine copies sold to readers are the only final good or service involved.
The $9M goes to pay the caterer and the photographer, as well as the feature writers, the proofreaders, the printers, and everybody else whose work contributed to the final product. In other words, the economic value of the intermediate goods and services that contributed to the final product is contained in the economic value of that final product. If our GDP calculation included the caterer’s pay \(($7\times30 = $210)\) separately and the photographer’s pay \(($80\times6 = $480)\) separately, but then also included the full $9M their pay came out of, then we would be double-counting.
Contributions to GDP are broken down into four standard categories, or components, as described by the following equation:
\(Y = C + I + G + NX\)
Y represents economic output, or GDP. C is consumer spending, I is investment spending, G is government purchases, and NX is net exports.
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Consumer spending, C, is the sum of expenditures by households on durable goods, nondurable goods, and services. Examples include clothing, food, and health care.
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Investment, I, means capital investment: expenditures on all things that will be used to produce goods and services for sale in the future. Examples include land, buildings, and machinery. Goods that are stored as inventory, to be sold later, are also counted under capital investment. So is spending on training to improve workers’ skills.
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Government spending, G, is the sum of expenditures by all government bodies on goods and services. Examples include naval ships and salaries to government employees.
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Net exports, NX, is the difference between foreign spending on domestically produced goods and domestic spending on imported foreign goods. In other words, net exports describes the difference between exports and imports.
This method of calculating GDP is called the expenditure approach, because it involves adding up amounts of money spent in various categories. Another method, called the income approach, involves adding up amounts of money received by households and other kinds of income-earners. Because every economic transaction being counted involves a product moving in one direction while funds move in the other direction (see the circular flow diagram in the chapter What Is Economics?), the two methods should in principle produce the same result.
Gross Domestic Product versus Gross National Product
GDP isn’t the only way of measuring an economy’s total output or income. Gross National Product, or GNP, is the sum value of all goods and services produced by citizens of a country, regardless of their location. The distinction between GDP and GNP rests on differences in counting production by foreigners in a country and by nationals outside of a country. For the GDP of a particular country, production by foreigners within that country is counted and production by nationals outside of that country is not counted. For GNP, production by foreigners within a particular country is not counted and production by nationals outside of that country is counted. Thus, while GDP is the value of goods and services produced within a country, GNP is the value of goods and services produced by citizens of a country.
The distinction between GDP and GNP is theoretically important, but not often practically consequential. Since the majority of production within a country is by nationals within that country, GDP and GNP are usually very close together. In general, macroeconomists rely more on GDP than GNP as the measure of a country's total output. However, if a lot of workers from an economically underdeveloped country take jobs overseas and send money back home to their families, the home country’s GNP may be significantly greater than its GDP.
