The Two Approaches to Calculating GDP
There are two ways to calculate GDP: the expenditure approach, and the income approach. Each method results, if done accurately, in the same GDP amount each year. The expenditure approach is based on what we spend on final goods and services. The income approach is based on how much money we earn through the various forms of income.
The Expenditure Approach to Calculating GDP
Goods and services are purchased by four different groups of buyers: consumers, businesses, state and local governments, and foreign countries. Therefore, GDP can be calculated by summing these four components:
|Consumption (C) + Investment (I) + Government Expenditures (G) + Net Exports (X).|
Examples of Consumption expenditures include spending by households on final products, such as clothing, televisions, dishwashers, computers, education, banking services, Ipods, cars, and food.
Investment represents purchases by businesses, such as machines, equipment, company-owned buses, forklifts, trucks, supplies, and buildings. It also includes inventory changes. Some goods may have been produced, but not sold (remember that GDP measures production, not sales). Investment in economic terminology does not mean the purchases of financial products, such as stocks and bonds. Stock and bond trades are merely transfers of ownership and do not directly represent production.
Government Expenditures are expenses by the government on items such as construction materials for roads and highways, supplies, tanks, weapons, school buildings, and stadiums. Expenditures on welfare programs are not included, because these expenditures do not represent production.
Net Exports are exports (products foreign countries buy from us) minus imports (goods we buy from other countries). Since 1983, United States imports have exceeded exports. Thus, for United States GDP, Net Exports is a negative number (see also the table in Section 1 of this unit).
The Income Approach to Calculating GDP
Gross Domestic Product can also be computed by adding everyone’s reported earnings. If you spend $10 on a CD, part of that money compensates the people who helped produce and market the CD, some of it goes to the store, some goes to pay for materials (the blank CDs, the computer, the CD writer, and software), and a portion includes royalties and fees to the creators of the CD, the artwork, and the technology. Allowing for indirect taxes (for example, sales tax) and depreciation, we conclude that computing GDP using the income approach gives us the same value as computing GDP using the expenditure approach.
The income approach adds these six categories to arrive at Gross Domestic Product:
|wages and salaries (w) +
interest (i) +
rent (r) +
corporate profits (p) +
indirect business taxes (ibt) +
capital consumption allowance (cca = depreciation)
Net Domestic Product
Net Domestic Product is gross domestic production minus the value of depreciation. It measures total production of final products minus what we lose each year due to obsolescence or the wearing out of machines and buildings. Thus, it is a measure of the net addition to our country’s wealth.
Similarly, net private domestic investment is gross private domestic investment minus depreciation. If a country produces more capital goods relative to ones that become obsolete or worn out, then it experiences an addition to its capital stock. If businesses produce exactly enough machinery to just replace the worn out or obsolete capital goods, then the country’s capital stock stays the same. If the country wants to experience economic growth, it can do so by increasing its capital stock. In Unit 1 we discussed that one of two ways to shift the production possibilities curve out is to increase resources, such as capital goods (the other way is to advance technology). One way to encourage increases in capital goods is to encourage more savings in the economy. This frees up funds in the financial markets, which allows businesses to borrow funds for investments in capital goods, as well as investments in technology and research.
For a video explanation of how to calculate Gross Domestic Product using the expenditure approach, please watch the following:
For a video explanation of how to calculate Gross Domestic Product using the income approach, please watch the following: