6.1Measuring the Size of the Economy: Gross Domestic Product

rate of more than 3% is considered good.

• Unemployment, as measured by the unemployment rate, is the percentage of people in the labor force who do not have a job. When people lack jobs, the economy is wasting a precious resource-labor, and the result is lower goods and services produced. Unemployment, however, is more than a statistic—it represents people’s livelihoods. While measured unemployment is unlikely to ever be zero, economists consider a measured unemployment rate of 5% or less low (good).
• Inflation is a sustained increase in the overall level of prices, and is measured by the consumer price index. If many people face a situation where the prices that they pay for food, shelter, and healthcare are rising much faster than the wages they receive for their labor, there will be widespread unhappiness as their standard of living declines. For that reason, low inflation—an inflation rate of 1–2%—is a major goal.

Frameworks

As you learn in the micro part of this book, principal tools that economists use are theories and models (see Welcome to Economics! for more on this). In microeconomics, we used the theories of supply and demand. In macroeconomics, we use the theories of aggregate demand (AD) and aggregate supply (AS). This book presents two perspectives on macroeconomics: the Neoclassical perspective and the Keynesian perspective, each of which has its own version of AD and AS. Between the two perspectives, you will obtain a good understanding of what drives the macroeconomy.

Policy Tools

National governments have two tools for influencing the macroeconomy. The first is monetary policy, which involves managing the money supply and interest rates. The second is fiscal policy, which involves changes in government spending/purchases and taxes. We will explain each of the items in Figure 6.2 in detail in one or more other chapters. As you learn these things, you will discover that the goals and the policy tools are in the news almost every day.

6.1 Measuring the Size of the Economy: Gross Domestic Product

LEARNING OBJECTIVES By the end of this section, you will be able to:

• Identify the components of GDP on the demand side and on the supply side
• Evaluate how economists measure gross domestic product (GDP)
• Contrast and calculate GDP, net exports, and net national product

Macroeconomics is an empirical subject, so the first step toward understanding it is to measure the economy. How large is the U.S. economy? Economists typically measure the size of a nation’s overall economy by its gross domestic product (GDP), which is the value of all final goods and services produced within a country in a given year. Measuring GDP involves counting the production of millions of different goods and services—smart phones, cars, music downloads, computers, steel, bananas, college educations, and all other new goods and services that a country produced in the current year—and summing them into a total dollar value. This task is straightforward: take the quantity of everything produced, multiply it by the price at which each product sold, and add up the total. In 2020, the U.S. GDP totaled $20.9 trillion, the largest GDP in the world. Each of the market transactions that enter into GDP must involve both a buyer and a seller. We can measure an economy's GDP either by the total dollar value of what consumers purchase in the economy, or by the total dollar value of what is the country produces. There is even a third way, as we will explain later.

GDP Measured by Components of Demand

Who buys all of this production? We can divide this demand into four main parts: consumer spending (consumption), business spending (investment), government spending on goods and services, and spending on net exports. (See the following Clear It Up feature to understand what we mean by investment.) Table 6.1 shows how these four components added up to the GDP in 2020, Figure 6.4 (a) shows the levels of consumption, investment, and government purchases over time, expressed as a percentage of GDP, while Figure 6.4 (b) shows the levels of exports and imports as a percentage of GDP over time. A few patterns about each of these components are worth noticing. Table 6.1 shows the components of GDP from the demand side. Components of GDP on the Demand Side (in trillions of dollars) Percentage of Total Consumption $14.0 67.2% Investment $3.6 17.4% Government $3.9 18.5% Exports $2.1 10.2% Imports –$2.7 –13.3% Total GDP $20.9 100% TABLE 6.1Components of U.S. GDP in 2022: From the Demand Side(Source: http://bea.gov/iTable/ index_nipa.cfm, Table 1.1.5)

FIGURE 6.3Percentage of Components of U.S. GDP on the Demand SideConsumption makes up over half of the demand side components of the GDP. Totals in the chart do not add to 100% because the Net Export Expenditure, Exports minus Imports, is actually a negative 3.1%, as shown in Table 6.1. (Source: http://bea.gov/iTable/ index_nipa.cfm, Table 1.1.10) CLEAR IT UP What does the word “investment” mean? What do economists mean by investment, or business spending? In calculating GDP, investment does not refer to purchasing stocks and bonds or trading financial assets. It refers to purchasing new capital goods, that is, new commercial real estate (such as buildings, factories, and stores) and equipment, residential housing construction, and inventories. Inventories that manufacturers produce this year are included in this year’s GDP—even if they are not yet sold. From the accountant’s perspective, it is as if the firm invested in its own inventories. Business investment in 2020 was $3.6 trillion, according to the Bureau of Economic Analysis.

FIGURE 6.4Components of GDP on the Demand Side (a) Consumption is about two-thirds of GDP, and it has been on a slight upward trend over time. Business investment hovers around 15% of GDP, but it fluctuates more than consumption. Government spending on goods and services is slightly under 20% of GDP and has declined modestly over time. (b) Exports are added to total demand for goods and services, while imports are subtracted from total demand. If exports exceed imports, as in most of the 1960s and 1970s in the U.S. economy, a trade surplus exists. If imports exceed exports, as in recent years, then a trade deficit exists. (Source: http://bea.gov/iTable/ index_nipa.cfm, Table 1.1.10) Consumption expenditure by households is the largest component of GDP, accounting for about two-thirds of the GDP in any year. This tells us that consumers’ spending decisions are a major driver of the economy. However, consumer spending is a gentle elephant: when viewed over time, it does not jump around too much, and has increased modestly from about 60% of GDP in the 1960s and 1970s. Investment expenditure refers to purchases of physical plant and equipment, primarily by businesses. If Starbucks builds a new store, or Amazon buys robots, they count these expenditures under business investment. Investment demand is far smaller than consumption demand, typically accounting for only about 15–18% of GDP, but it is very important for the economy because this is where jobs are created. However, it fluctuates more noticeably than consumption. Business investment is volatile. New technology or a new product can spur business investment, but then confidence can drop and business investment can pull back sharply. If you have noticed any of the infrastructure projects (new bridges, highways, airports) launched during the 2009 recession, or if you received a stimulus check during the pandemic-induced recession of 2020–2021, you have seen how important government spending can be for the economy. Government expenditure in the United States is close to 20% of GDP, and includes spending by all three levels of government: federal, state, and local. The only part of government spending counted in demand is government purchases of goods or services produced in the economy. Examples include the government buying a new fighter jet for the Air Force (federal government spending), building a new highway (state government spending), or a new school (local government spending). A significant portion of government budgets consists of transfer payments, like unemployment benefits, veteran’s benefits, and Social Security payments to retirees. The government excludes these payments from GDP because it does not receive a new good or service in return or exchange. Instead they are transfers of income from taxpayers to others. If you are curious about the awesome undertaking of adding up GDP, read the following Clear It Up feature. CLEAR IT UP How do statisticians measure GDP? Government economists at the Bureau of Economic Analysis (BEA), within the U.S. Department of Commerce, piece together estimates of GDP from a variety of sources. Once every five years, in the second and seventh year of each decade, the Bureau of the Census carries out a detailed census of businesses throughout the United States. In between, the Census Bureau carries out a monthly survey of retail sales. The government adjusts these figures with foreign trade data to account for exports that are produced in the United States and sold abroad and for imports that are produced abroad and sold here. Once every ten years, the Census Bureau conducts a comprehensive survey of housing and residential finance. Together, these sources provide the main basis for figuring out what is produced for consumers. For investment, the Census Bureau carries out a monthly survey of construction and an annual survey of expenditures on physical capital equipment. For what the federal government purchases, the statisticians rely on the U.S. Department of the Treasury. An annual Census of Governments gathers information on state and local governments. Because the government spends a considerable amount at all levels hiring people to provide services, it also tracks a large portion of spending through payroll records that state governments and the Social Security Administration collect. With regard to foreign trade, the Census Bureau compiles a monthly record of all import and export documents. Additional surveys cover transportation and travel, and make adjustments for financial services that are produced in the United States for foreign customers. Many other sources contribute to GDP estimates. Information on energy comes from the U.S. Department of Transportation and Department of Energy. The Agency for Health Care Research and Quality collects information on healthcare. Surveys of landlords find out about rental income. The Department of Agriculture collects statistics on farming. All these bits and pieces of information arrive in different forms, at different time intervals. The BEA melds them together to produce GDP estimates on a quarterly basis (every three months). The BEA then "annualizes" these numbers by multiplying by four. As more information comes in, the BEA updates and revises these estimates. BEA releases the GDP “advance” estimate for a certain quarter one month after a quarter. The “preliminary” estimate comes out one month after that. The BEA publishes the “final” estimate one month later, but it is not actually final. In July, the BEA releases roughly updated estimates for the previous calendar year. Then, once every five years, after it has processed all the results of the latest detailed five-year business census, the BEA revises all of the past GDP estimates according to the newest methods and data, going all the way back to 1929. LINK IT UP Visit this website (https://openstax.org/l/beafaq) to read FAQs on the BEA site. You can even email your own questions! When thinking about the demand for domestically produced goods in a global economy, it is important to count spending on exports—domestically produced goods that a country sells abroad. Similarly, we must also subtract spending on imports—goods that a country produces in other countries that residents of this country purchase. The GDP net export component is equal to the dollar value of exports (X) minus the dollar value of imports (M), (X – M). We call the gap between exports and imports the trade balance. If a country’s exports are larger than its imports, then a country has a trade surplus. In the United States, exports typically exceeded imports in the 1960s and 1970s, as Figure 6.4(b) shows. Since the early 1980s, imports have typically exceeded exports, and so the United States has experienced a trade deficit in most years. The trade deficit grew quite large in the late 1990s and in the mid-2000s. Figure 6.4 (b) also shows that imports and exports have both risen substantially in recent decades, even after the declines during the Great Recession between 2008 and 2009. As we noted before, if exports and imports are equal, foreign trade has no effect on total GDP. However, even if exports and imports are balanced overall, foreign trade might still have powerful effects on particular industries and workers by causing nations to shift workers and physical capital investment toward one industry rather than another. Based on these four components of demand, we can measure GDP as: Understanding how to measure GDP is important for analyzing connections in the macro economy and for thinking about macroeconomic policy tools.

GDP Measured by What is Produced

Everything that we purchase somebody must first produce. Table 6.2 breaks down what a country produces into five categories: durable goods, nondurable goods, services, structures, and the change in inventories. Before going into detail about these categories, notice that total GDP measured according to what is produced is exactly the same as the GDP measured by looking at the five components of demand. Figure 6.5 provides a visual representation of this information. Components of GDP on the Supply Side (in trillions of dollars) Percentage of Total Goods Durable goods $3.5 16.7% Nondurable goods $2.8 13.4% Services $12.7 60.8% Structures $1.9 9.1% Change in inventories $0.0 0.0% Total GDP $20.9 100% TABLE 6.2Components of U.S. GDP on the Production Side, 2020(Source: http://bea.gov/iTable/ index_nipa.cfm, Table 1.2.5)

FIGURE 6.5Percentage of Components of GDP on the Production Side Services make up over 60 percent of the production side components of GDP in the United States. Since every market transaction must have both a buyer and a seller, GDP must be the same whether measured by what is demanded or by what is produced. Figure 6.6 shows these components of what is produced, expressed as a percentage of GDP, since 1950.

FIGURE 6.6Types of Production Services are the largest single component of total supply, representing over 60 percent of GDP, up from about 45 percent in the early 1950s. Durable and nondurable goods constitute the manufacturing sector, and they have declined from 40 percent of GDP in 1950 to about 30 percent in 2016. Nondurable goods used to be larger than durable goods, but in recent years, nondurable goods have been dropping to below the share of durable goods, which is less than 20% of GDP. Structures hover around 10% of GDP. We do not show here the change in inventories, the final component of aggregate supply. It is typically less than 1% of GDP. In thinking about what is produced in the economy, many non-economists immediately focus on solid, long- lasting goods, like cars and computers. By far the largest part of GDP, however, is services. Moreover, services have been a growing share of GDP over time. A detailed breakdown of the leading service industries would include healthcare, education, and legal and financial services. It has been decades since most of the U.S. economy involved making solid objects. Instead, the most common jobs in a modern economy involve a worker looking at pieces of paper or a computer screen; meeting with co-workers, customers, or suppliers; or making phone calls. Even within the overall category of goods, long-lasting durable goods like cars and refrigerators are about the same share of the economy as short-lived nondurable goods like food and clothing. The category of structures includes everything from homes, to office buildings, shopping malls, and factories. Inventories is a small category that refers to the goods that one business has produced but has not yet sold to consumers, and are still sitting in warehouses and on shelves. The amount of inventories sitting on shelves tends to decline if business is better than expected, or to rise if business is worse than expected. Another Way to Measure GDP: The National Income Approach GDP is a measure of what is produced in a nation. The primary way GDP is estimated is with the Expenditure Approach we discussed above, but there is another way. Everything a firm produces, when sold, becomes revenues to the firm. Businesses use revenues to pay their bills: Wages and salaries for labor, interest and dividends for capital, rent for land, profit to the entrepreneur, etc. So adding up all the income produced in a year provides a second way of measuring GDP. This is why the terms GDP and national income are sometimes used interchangeably. The total value of a nation’s output is equal to the total value of a nation’s income.

The Problem of Double Counting

We define GDP as the current value of all final goods and services produced in a nation in a year. What are final goods? They are goods at the furthest stage of production at the end of a year. Statisticians who calculate GDP must avoid the mistake of double counting, in which they count output more than once as it travels through the production stages. For example, imagine what would happen if government statisticians first counted the value of tires that a tire manufacturer produces, and then counted the value of a new truck that an automaker sold that contains those tires. In this example, the statisticians would have counted the value of the tires twice- because the truck's price includes the value of the tires. To avoid this problem, which would overstate the size of the economy considerably, government statisticians count just the value of final goods and services in the chain of production that are sold for consumption, investment, government, and trade purposes. Statisticians exclude intermediate goods, which are goods that go into producing other goods, from GDP calculations. From the example above, they will only count the Ford truck's value. The value of what businesses provide to other businesses is captured in the final products at the end of the production chain. The concept of GDP is fairly straightforward: it is just the dollar value of all final goods and services produced in the economy in a year. In our decentralized, market-oriented economy, actually calculating the more than $21 trillion-dollar U.S. GDP—along with how it is changing every few months—is a full-time job for a brigade of government statisticians. What is Counted in GDP What is not included in GDP Consumption Intermediate goods Business investment Transfer payments and non-market activities Government spending on goods and services Used goods Net exports Illegal goods TABLE 6.3Counting GDP Notice the items that are not counted into GDP, as Table 6.3 outlines. The sales of used goods are not included because they were produced in a previous year and are part of that year’s GDP. The entire underground economy of services paid “under the table” and illegal sales should be counted, but is not, because it is impossible to track these sales. In Friedrich Schneider's recent study of shadow economies, he estimated the underground economy in the United States to be 6.6% of GDP, or close to $2 trillion dollars in 2013 alone. Transfer payments, such as payment by the government to individuals, are not included, because they do not represent production. Also, production of some goods—such as home production as when you make your breakfast—is not counted because these goods are not sold in the marketplace. LINK IT UP Visit this website (https://openstax.org/l/undergroundecon) to read about the “New Underground Economy.”

Other Ways to Measure the Economy

Besides GDP, there are several different but closely related ways of measuring the size of the economy. We mentioned above that we can think of GDP as total production and as total purchases. We can also think of it as total income since anything one produces and sells yields income. One of the closest cousins of GDP is the gross national product (GNP). GDP includes only what country produces within its borders. GNP adds what domestic businesses and labor abroad produces, and subtracts any payments that foreign labor and businesses located in the United States send home to other countries. In other words, GNP is based more on what a country's citizens and firms produce, wherever they are located, and GDP is based on what happens within a certain county's geographic boundaries. For the United States, the gap between GDP and GNP is relatively small; in recent years, only about 0.2%. For small nations, which may have a substantial share of their population working abroad and sending money back home, the difference can be substantial. We calculate net national product (NNP) by taking GNP and then subtracting the value of how much physical capital is worn out, or reduced in value because of aging, over the course of a year. The process by which capital ages and loses value is called depreciation. We can further subdivide NNP into national income, which includes all income to businesses and individuals, and personal income, which includes only income to people. The gross national income (GNI) includes the value of all goods and services produced by people from a country—whether in the country or not. Unlike the other methods, GNI essentially measures the wealth of a nation because it focuses on income, not output. As you will see in the discussion regarding global economic diversity, the World Bank now uses GNI to classify nations according to economic status. For practical purposes, it is not vital to memorize these definitions. However, it is important to be aware that these differences exist and to know what statistic you are examining, so that you do not accidentally compare, say, GDP in one year or for one country with GNP or NNP in another year or another country. To get an idea of how these calculations work, follow the steps in the following Work It Out feature. WORK IT OUT Calculating GDP, Net Exports, and NNP Based on the information in Table 6.4: a. What is the value of GDP? b. What is the value of net exports? c. What is the value of NNP? Government purchases $120 billion Depreciation $40 billion Consumption $400 billion Business Investment $60 billion Exports $100 billion Imports $120 billion Income receipts from rest of the world $10 billion Income payments to rest of the world $8 billion TABLE 6.4 Step 1. To calculate GDP use the following formula: Step 2. To calculate net exports, subtract imports from exports. Step 3. To calculate NNP, use the following formula:

6.2 Adjusting Nominal Values to Real Values

LEARNING OBJECTIVES By the end of this section, you will be able to:

• Contrast nominal GDP and real GDP
• Explain GDP deflator
• Calculate real GDP based on nominal GDP values

When examining economic statistics, there is a crucial distinction worth emphasizing. The distinction is between nominal and real measurements, which refer to whether or not inflation has distorted a given statistic. Looking at economic statistics without considering inflation is like looking through a pair of binoculars and trying to guess how close something is: unless you know how strong the lenses are, you cannot guess the distance very accurately. Similarly, if you do not know the inflation rate, it is difficult to figure out if a rise in GDP is due mainly to a rise in the overall level of prices or to a rise in quantities of goods produced. The nominal value of any economic statistic means that we measure the statistic in terms of actual prices that exist at the time. The real value refers to the same statistic after it has been adjusted for inflation. Generally, it is the real value that is more important.

Converting Nominal to Real GDP

Table 6.5 shows U.S. GDP at five-year intervals since 1960 in nominal dollars; that is, GDP measured using the actual market prices prevailing in each stated year. Figure 6.7 also reflects this data in a graph. Year Nominal GDP (billions of dollars) GDP Deflator (2012 = 100) 1960 542.4 16.6 1965 742.3 17.8 1970 1,073.3 21.7 1975 1,684.9 29.8 1980 2,857.3 42.2 1985 4,339.0 54.5 1990 5,963.1 63.6 1995 7,639.7 71.8 2000 10,251.0 78.0 2005 13,039.2 87.5 2010 15,049.0 96.2 2015 18,206.0 104.7 2020 20,893.7 113.6 TABLE 6.5U.S. Nominal GDP and the GDP Deflator(Source: https://apps.bea.gov/itable/index.cfm, Table 1.1.5 and Table 1.1.9)

Simpler explanation — Cambridge AS & A Level Economics

national income Gross domestic product The most widely used measure of national income is known as gross domestic product (GDP). GDP is used by economists, governments and international organisations to assess what is produced, earned and spent in an economy. ‘Gross’ means total, ‘domestic’ refers to the home economy and product means ‘output’. So, for example, Pakistan’s GDP is a measure of the total value of output produced by the factors of production based in Pakistan in a year. Gross national income Gross national income (GNI) is increasing in importance as a measure.

GNI is included, for instance, by the United Nations in its Human Development Index. GNI goes further than GDP in changing the focus from output produced in a country to income earned by the country’s residents and firms regardless of where it is earned. As well as adding net property income from abroad, GNI also includes other sources of income that residents receive from abroad and deducts other sources of income that foreigners receive from the country. These payments are net receipts of compensation of employees and net taxes less subsidies on products. Compensation of employees is wages earned by workers who are resident in one country but who work abroad for short periods.

These include seasonal and cross-border workers. National income statistics provide a measure of an economy’s performance. In 1984, Richard Stone won the Nobel Prize for economics (see Figure 15.2) for his work on the development of national income statistics. In pairs, prepare a presentation on the work of a Nobel Prize winner in economics. (You will find a list of Nobel Prize winners in ‘Prize in Economic Sciences’ on the Nobel Prize website.) Some tax revenue on products may be paid to other countries and international organisations and some production subsidies may be received by other governments and international organisations.