Understanding GDP
by Rick Welch on April 17, 2014
Please read on to find out why gross domestic product or GDP is a bit like adding apples and oranges together.
Gross domestic product or GDP is defined as “the market value of all final goods and services produced within a country in a given period of time”. The GDP growth rate is the percent increase (or decrease) of a country’s GDP from one quarter to the next. During the 4th quarter of 2013, the GDP of the US economy increased at an annual rate of 2.4%, a solid performance which followed a stronger 4.1% increase during the 3rd quarter. For comparison, during the recent recession (defined as two consecutive quarters of negative GDP growth) we saw the following: -8.9% for 2008 Q4, -6.7% for 2009 Q1 and -0.7% for 2009 Q2. Over the past fifty years, the US economy has grown on average about 3.2% per year.
GDP measures two things at once: the total income of everyone in the economy and the total expenditure on the economy’s output of goods and services. If you are following this closely, you will realize that total income and total expenditure are just mirror images of each other and, in fact, for an economy as a whole, income must equal expenditure. Remember that each dollar you, as a buyer, spend (expenditure) is a dollar of income for the seller. GDP includes both tangible goods (food, clothing and cars) and intangible services (beauty salon, repairs and medical). In the case of goods, GDP only considers the value of the final product – think of the final value of the car, not the value of each individual part or component. GDP measures the value of production within the geographic boundaries of a country, thus, items are included in a nation’s GDP if they are produced domestically, regardless of the nationality of the producer.
I recall a college economics professor referring to GDP as like “adding apples and oranges together”. There is good reason behind that analogy. GDP is the sum of 4 very different components and in mathematical terms is written like this: GDP = C + I + G + NX. The “C”, is for consumption or the spending by households on goods and services. Consumer spending accounts for about 70% of GDP. “I” is for investment which includes both the purchase of new housing and the investment by businesses in new plants, equipment and inventory. Investment accounts for about 15% of GDP. The “G” stands for purchases of goods and services by local, state and federal governments. “G” accounts for about 20% of GDP. Recent efforts by both state and our federal government (for example, sequestration) to reduce their deficits have resulted in a noticeable fiscal drag on the US economy. In the 4th quarter of 2013, “G” fell 5.6%. It is expected that this drag will diminish as we move further into 2014.
Did you notice my new math in the preceding paragraph? Not to worry. When we add “C” (70%) and “I” (15%) and “G” (20%) we arrive at 105%! The last component of GDP, “NX” stands for net exports which are calculated by subtracting imports from exports. As a nation of consumers who consume more than we export, NX is typically about -5% of GDP. At present, our international trade deficit is about $40.0 billion which means that the US is earning less on overseas sales of American-produced goods while spending more on foreign products. A widening trade deficit (which would result in a larger negative value for “NX”) can act as a drag on domestic economic growth.
