|RESOURCES FOR THE INQUIRING MIND|
In this module, you will learn
Tutorial: How to calculate the GDP
The basic formula for calculating the GDP is:
Y = C + I + E + G where Y = GDP C = Consumer Spending I = Investment made by industry E = Excess of Exports over Imports G = Government Spending
This formula is almost self-evident (if you take time to think about it)!
GDP is a measure of all the goods and services produced domestically. Therefore, to calculate the GDP, one only needs to add together the various components of the economy that are a measure of all the goods and services produced.
Many of the goods and services produced are purchased by consumers. Therefore, what consumers spend on them (C) is a measure of that component.The next component is the somewhat mysterious quantity "I," or investment made by industry. However, this quantity is mysterious only because investment does not have its ordinary meaning. When calculating the GDP, investment does NOT mean what we normally think of in the case of individuals. It does not mean buying stocks and bonds or putting money in a savings account (S in the diagram for Exercise 1, below). When calculating the GDP, investment means the purchases made by industry in new productive facilities, or, the process of "buying new capital and putting it to use" (Gambs, John, Economics and Man, 1968, p. 168). This includes, for example, buying a new truck, building a new factory, or purchasing new software. This is indicated in the diagram by an arrow pointing from one factory (enterprise) to another. In essence, it shows the factory "reproducing itself" by buying new goods and services that will produce still more goods and services. NOTE: There is a money-flow relationship between personal savings, S, and investment, I, but this does not figure directly in calculating the GDP. See Exercise 1 below.
The next component is E, or the difference between the value of all exports and the value of all imports. If Exports exceeds imports, it adds to the GDP. If not, it subtracts from the GDP. Thus, even if a nation's people work very hard to produce products for exports, but still import more than they export, the nation's GDP will be negatively impacted. This is one of the reasons trade deficits are frequently a political target. Because the balance of trade can be either positive or negative, we can rewrite the equation, showing the components of E, using X for Exports and M for Imports:
Y = C + I + (X - M)+ G
You may see the formula for the GDP written this way, and it may be easier for you to remember in this format.
The final component is G. The government buys (with your tax money) goods and services (G). These purchases are a measure of those goods and services produced. Be aware that many people make the mistake of thinking that the money paid in taxes and spent by the government is "lost" and therefore subtracts from the GDP. Tax money may indeed be spent inefficiently but this fact has no bearing on the calculation of the GDP.
Exercise 1: Understanding Money Flow in the GDP Components
Study the diagram below. Be sure you understand how the total income and expenses of Joe Worker ultimately make up the Gross Domestic Product.
Note: Understanding the Role of Personal Savings
Let's look at the role played by personal savings. The diagram indicates that personal savings (what we normally call "investment") is actually a source of revenue for industry. This is because the money you put in the bank is loaned to businesses so that they can put it to work. The bank system uses the personal savings of individuals to give industry its reservoir of money to work from. This is why economists say that the amount of Savings is always going to be approximately equal to the amount available for Investment. Savings and Investment can become out of balance when there is more demand for investment money than what is available from domestic savings. In that case, more money is borrowed from foreign sources. Because additional Savings has the effect of supplying more money to industry, some economists have argued that if we want to correct the negative effect of the trade deficit (since it is subtracted from the GDP), we should encourage Savings, which will indirectly boost Investment.
Questions Based on the Diagram
At this point, you should be able to answer the following questions.
1. What portion of the U.S. GDP is accounted for by Consumer Spending?
2. What percent of the U.S. GDP is "lost" or subtracted from the total due to the trade deficit?
3. How does the money "lost" due to the trade deficit find its way back to the U.S.?
4. How is "Investment" defined on the diagram?
Are you confident of your answers? Check yourself with the Money Flow Quiz!
Exercise 2: Practice Calculating the GDP
Atoll K is small island nation. Its population total is 400, and it has 100 wage earners who earn an average of $50 per year. Each wage earner spends a total of $40 per year buying goods and services of which $3.00 goes to buying imported goods. The island exports a total of $800 worth of goods. The Government tax rate is 10% and all government money is spent on building infrastructure and supporting schools. There is only one industry (uranium mining) on the island and it employs every wage earner. The industry spends $600 each year on new mining equipment. What is the GDP? Check your answer with the GDP Calculation Quiz!
Exercise 3: Using U.S. Government Figures to Verify the Formula
In this example we shall use the actual GDP figures for the U.S. in 2000. The U.S. Government Printing Office has historical data for the U.S. from 1959 to the present. GDP Click HERE to open the link to the GPO page with the data for GDP 2004. On this page, go to entry for Table B-1: Gross domestic product, 1959-2003. (To download the PDF file directly from Mindtools click HERE.) Click on the PDF or XLS link to open the data. Carefully review the entry for the year 2000. Note that in the PDF file the complete table is on two pages. If you are adept at moving data and eliminating unnecessary information, you can generate a chart like the one below simply by editing the government-supplied chart. Notice that the GDP calculation in the chart uses the same headings we gave above in the formula for the GDP. Our example calculation, made by plugging the chart entries for the year 2000 into the formula is show below.
Y = C + I + E + G 9817.0 = 6739.4 + 1735.5 - 379.5 + 1721.6
Created on February 24, 2004. Revised 4/7/2015.