ECON102: Principles of Macroeconomics

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 is 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 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.

Table 6.1 Components of U.S. GDP in 2022: From the Demand Side

Figure 6.3 Percentage of Components of U.S. GDP on the Demand Side Consumption makes up over half of the demand side components of the GDP. The chart's total does not add up to 100 percent because the Net Export Expenditure, Exports minus Imports, is actually a negative 3.1%, as shown in Table 6.1.

Figure 6.4 Components of GDP on the Demand Side (a) Consumption is about two-thirds of GDP and has been slightly upward over time. Business investment hovers around 15 percent of GDP but fluctuates more than consumption. Government spending on goods and services is slightly under 20 percent 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. A trade surplus exists if exports exceed imports, as in most of the 1960s and 1970s in the U.S. economy. If imports exceed exports, as in recent years, then a trade deficit exists.

Household consumption expenditure 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 plants 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.

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 the 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 follows:

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

GDP Measured by What is Produced

Table 6.2 Components of U.S. GDP on the Production Side, 2020

Figure 6.5 Percentage 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 6.6 Types 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 are 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 inventory sitting on shelves tends to decline if business is better than expected or 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 is 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, calculating the more than $21 trillion U.S. GDP – along with how it changes every few months – is a full-time job for a brigade of government statisticians.

Notice the items that are not counted in 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 it 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 payments by the government to individuals, are not included because they do not represent production. Also, the 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.

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 a country produces within its borders. GNP adds what domestic businesses and labor abroad produce 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 subtracting the value of how much physical capital is worn out or reduced in value because of aging over 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 measures a nation's wealth 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 GDP in one year or for one country with GNP or NNP in another year or another. To get an idea of how these calculations work, follow the steps in the following Work It Out feature.

Source: Rice University, https://openstax.org/books/principles-macroeconomics-3e/pages/6-1-measuring-the-size-of-the-economy-gross-domestic-product
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