The expenditure method of calculating GDP adds together

Gross domestic product (GDP) measures an economy's production over a specified period of time. More specifically, gross domestic product is the "market value of all final goods and services produced within a country in a given period of time." There are a few common ways to calculate the gross domestic product for an economy, including the following:

• The Output (or Production) Approach: Add up the quantities of all final goods and services produced in an economy within a given time period and weight them by the market prices of each of the goods or services.
• The Expenditure Approach: Add up the money spent on consumption, investment, government spending, and net exports in an economy within a given time period.

The equations for each of these methods are shown above.

The importance of counting only final goods and services in gross domestic product is illustrated by the value chain for orange juice shown above. When a producer is not fully vertically integrated, the output of multiple producers will come together to create the final product that goes to the end consumer. By the end of this production process, a carton of orange juice that has a market value of $3.50 is created. Therefore, that carton of orange juice should contribute $3.50 to gross domestic product. If the value of intermediate goods were counted in gross domestic product, however, the $3.50 carton of orange juice would contribute $8.25 to gross domestic product. (It would even be the case that, if intermediate goods were counted, gross domestic product could be increased by inserting more companies into the supply chain, even if no additional output was created!)

Notice, on the other hand, that the correct amount of $3.50 would be added to gross domestic product if the value of both intermediate and final goods was counted ($8.25) but the cost of the inputs to production ($4.75) was subtracted out ($8.25-$4.75=$3.50).

A more intuitive way to avoid double counting the value of intermediate goods in gross domestic product is to, rather than try to isolate only final goods and services, look at the value added for each good and service (intermediate or not) produced in an economy. Value added is simply the difference between the cost of inputs to production and the price of output at any particular stage in the overall production process.

In the simple orange juice production process, described again above, final orange juice is delivered to the consumer via four different producers: the farmer who grows the oranges, the manufacturer who takes the oranges and makes orange juice, the distributor who takes the orange juice and puts it on store shelves, and the grocery store that gets the juice into the hands (or mouth) of the consumer. At each stage, there is a positive value added, since each producer in the supply chain is able to create output that has a higher market value than its inputs to production.

The total value added at all stages of production is what is then counted in gross domestic product, assuming of course that all stages occurred within the economy's borders rather than in other economies. Note that the total value added is, in fact, equal to the market value of the final good produced, namely the $3.50 carton of orange juice.

Mathematically, this total is equal to the value of the final output as long as the value chain goes all the way back to the first stage of production, where the value of the inputs to production is equal to zero. (This is because, as you can see above, the value of the output at a given stage of production is, by definition, equal to the value of the input at the next stage of production.)

The value-added approach is helpful when considering how to count goods with imported inputs (i.e. imported intermediate goods) in gross domestic product. Since gross domestic product only counts production within an economy's borders, it follows that only value that is added within an economy's borders is counted in gross domestic product. For example, if the orange juice above were made using imported oranges, only $2.50 of the value added would have taken place within in the economy's borders and thus $2.50 rather than $3.50 would be counted in gross domestic product.

The value-added approach is also helpful when dealing with goods where some inputs to production are not produced in the same time period as the final output. Since gross domestic product only counts production within the specified time period, it follows that only value that is added during the specified time period is counted in gross domestic product for that period. For example, if the oranges were grown in 2012 but the juice wasn't made and distributed until 2013, only $2.50 of the value added would have taken place in 2013 and therefore $2.50 rather than $3.50 would count in gross domestic product for 2013. (Note, however, that the other $1 would count in gross domestic product for 2012.)

Learning Objectives

• Describe how GDP it is measured as a component of total expenditure (demand)
• Explain how gross domestic product can be broken down and measured as different types of product

If we know that GDP is the measurement of everything that is produced, we should also ask the question, who buys all of this production? This demand can be divided into four main parts:

1. consumer expenditure (consumption)
2. investment expenditure
3. government expenditure on goods and services
4. net export expenditure

What do economists mean by investment, or investment expenditure? In calculating GDP, investment does not refer to the purchase of stocks and bonds or the trading of financial assets. It refers to the purchase of new capital goods, that is, business equipment, new commercial real estate (such as buildings, factories, and stores), residential housing construction, and inventories. Inventories that are produced this year are included in this year’s GDP—even if they have not yet sold. From the accountant’s perspective, it is as if the firm invested in its own inventories. Business investment in 2012 was over $2 trillion, according to the U.S. Bureau of Economic Analysis.

Table 1 shows how these four components of demand added up to the GDP in 2016.

Figure 1 provides a visual representation of the five categories used to measure GDP by the components of demand.

Figure 1. Components of U.S. GDP. Consumption accounted for 68.7% of total GDP, investment expenditure for 16.3%, government spending for 17.6%, while net exports (exports minus imports) actually subtracted 2.7% from total GDP. The pie chart gives a nice visual of the components of GDP, but keep in mind that since the net export expenditure share is negative, the size of the pie is only approximately correct.

Figure 2(a) shows the levels of consumption, investment, and government purchases over time, expressed as a percentage of GDP. Consumption expenditure, that is, spending by households and individuals, is about two-thirds of GDP, but it moves relatively little over time. Investment expenditure and government spending on goods and services are each about the same order of magnitude, 15-20% of GDP.  Investment is the most variable category of expenditure, increasing and decreasing more than the other categories.  Figure 2(b) shows the levels of exports and imports as a percentage of GDP over time. 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.

Components of GDP on the Demand Side

• Consumption expenditure by households is the largest component of GDP, accounting for more than 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 (as shown in Figure 2). In recent years, consumption has been creeping up towards 70%.

Investment

• Investment expenditure refers to purchases of physical plant and equipment, primarily by businesses. If Starbucks builds a new store, or Amazon buys robots, these expenditures are counted 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.
• Investment includes any addition to business inventories.

Government Spending

• If you noticed any of the infrastructure projects (new bridges, highways, airports) launched during the recession of 2009, you saw how important government spending can be for the economy. Government expenditure in the United States is about 20% of GDP, and includes spending by all three levels of government: federal, state, and local.
• The only part of government spending counted in GDP 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 are transfer payments, like unemployment benefits, veteran’s benefits, and Social Security payments to retirees. These payments are excluded from GDP because the government does not receive a new good or service in return or exchange. Instead they are transfers of income from taxpayers to others.  What taxpayers spend the income on is captured in consumer expenditure.

Net Exports, or Trade Balance

• 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 are purchased by foreigners. By the same token, we must also subtract spending on imports—goods produced in other countries that are purchased by residents of this country. The net export component of GDP is equal to the value of exports (X) minus the value of imports (M), (X – M). The gap between exports and imports is also called the trade balance. If a country’s exports are larger than its imports, then a country is said to have a trade surplus. In the United States, exports typically exceeded imports in the 1960s and 1970s, as shown in Figure 2(b).

Since the early 1980s, imports have typically exceeded exports, and so the United States has experienced a trade deficit in most years. Despite growth in the trade deficit in the late 1990s and in the mid-2000s, the deficit typical remains less than 5% of GDP. Figure 2(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 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.

GDP Measured using Components of Demand

Based on these four components of demand, GDP can be measured as:

GDP = Consumption + Investment + Government Spending + Net Exports

GDP = C + I + G + (X – M)

Understanding how to measure GDP is important for analyzing connections in the macro economy and for thinking about macroeconomic policy tools.

Government economists at the Bureau of Economic Analysis (BEA), within the U.S. Department of Commerce, construct estimates of GDP from a variety of sources.

• Consumption. Once every five years, in the second and seventh year of each decade, the U.S. Census Bureau carries out a detailed census of businesses throughout the United States. In between, it carries out a monthly survey of retail sales. These figures are adjusted 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 also conducts a comprehensive survey of housing and residential finance. Together, these sources provide the main basis for figuring out what is produced for consumers.
• Investment. For investment, the Census Bureau carries out a monthly survey of construction and an annual survey of expenditures on physical capital equipment.
• Government Spending. For what is purchased by the federal government, the statisticians rely on the U.S. Department of the Treasury. An annual Census of Governments gathers information on state and local governments. Because a lot of government spending at all levels involves hiring people to provide services, a large portion of government spending is also tracked through payroll records collected by state governments and by the Social Security Administration.
• Net Exports: 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 adjustment is made for financial services that are produced in the United States for foreign customers.

Many other sources contribute to the estimates of GDP. Information on energy comes from the U.S. Department of Transportation and Department of Energy. Information on healthcare is collected by the Agency for Health Care Research and Quality. Surveys of landlords provide information about rental income. The Department of Agriculture collects statistics on farming.

All of these bits and pieces of information arrive in different forms, at different time intervals. The BEA melds them together to produce estimates of GDP on a quarterly basis (every three months). These numbers are then “annualized” by multiplying by four. That is, quarterly GDP estimates what annual GDP would be if the trend over the three months continued for twelve months. As more information comes in, these estimates are updated and revised. The “advance” estimate of GDP for a certain quarter is released one month after a quarter. The “preliminary” estimate comes out one month after that. The “final” estimate is published one month later, but it is not actually final. In July, roughly updated estimates for the previous calendar year are released. Then, once every five years, after the results of the latest detailed five-year business census have been processed, the BEA revises all of the past estimates of GDP according to the newest methods and data, going all the way back to 1929. Read FAQs on the BEA site. You can even email your own questions!

GDP Measured by Type of Product

The Expenditure Approach divides GDP based on who is doing the spending: Consumption (households), Investment (businesses and households), Government Spending (governments) and Net Exports (the rest of the world).

GDP can also be measured by examining what is produced, instead of what is demanded. Everything that is purchased must be produced first. Table 2 breaks down GDP a different way, based on the type of output produced: durable goods, nondurable goods, services, structures, and the change in inventories.  

Consumer Expenditure (from the expenditure approach you read about above) consists of spending on durable goods, nondurable goods, and services. The same thing is true of Government and Net Export Expenditures. Investment Expenditures is a combination of durable goods (like business equipment) and structures e.g. factories, office buildings, retail stores and residential construction). 

Figure 3 provides a visual representation of the five categories used to measure GDP by type of product.

Figure 3. GDP by type of product, 2016.

Note that whether you decompose GDP into expenditure components or by type of product the total is exactly the same. Figure 4 shows the components of GDP by Type of Product, expressed as a percentage of GDP, since 1960. Services are the largest single component of GDP, representing over half. Nondurable goods used to be larger than durable goods, but in recent years, nondurable goods have been dropping closer to durable goods, which is about 15% of GDP. Structures hover around 10% of GDP, though they’ve been declining in recent years. The change in inventories, the final component of aggregate supply, is not shown here; it is typically less than 1% of GDP.

Figure 4. Types of Product.

Let’s take a closer look at these components of GDP:

Goods and Services

In thinking about what is produced in the economy, many non-economists immediately focus on solid, long-lasting goods, like cars and computers. Goods that last three or more years are called durable goods. Goods that last less than three years are called nondurable goods. 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, Table 2 shows that 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.

Structures

The category of structures includes everything from homes, to office buildings, shopping malls, and factories. The new structures that were built, or produced, during a time period are counted in this measure of GDP, which is another way of looking at investment, as it was discussed above in focusing on demand to measure GDP.

Change in Inventories

Inventories is a small category that refers to the goods that have been produced by one business but have not yet been 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. When a business produces output but fails to sell it, the increase in inventory is treated as an investment expenditure.

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.

These questions allow you to get as much practice as you need, as you can click the link at the top of the first question (“Try another version of these questions”) to get a new set of questions. Practice until you feel comfortable doing the questions.

durable good: a good that last three years or more, such as a car or  refrigerator gross domestic product (GDP): the value of the output of all final goods and services produced within a country in a year inventory: good that has been produced, but not yet been sold national income: includes all income earned: wages, profits, rent, and profit income nondurable good: a good that lasts less than three years, such as food and clothing service: product which is intangible (in contrast to goods) such as entertainment, healthcare, or education structure: building used as residence, factory, office building, retail store, or for other purposes trade balance: gap between exports and imports trade deficit: exists when a nation’s imports exceed its exports and is calculated as imports –exports trade surplus: exists when a nation’s exports exceed its imports and is calculated as exports – imports

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