Macroeconomic Tidbits – Gross Domestic Product

Welcome to the first post in my new series “Macroeconomic Tidbits” – a collection of short posts featuring introductions to important macroeconomic concepts. Even if you don’t consider yourself to be someone with an explicit interest in economics, you’ll find it hard to escape the subject as economic forces and policies play multiple roles in our daily lives. An important topic in the media today is GDP, or gross domestic product. Perhaps you’ve been hearing talk of whether the United States has a healthy GDP growth rate. Maybe you’ve heard someone express concern over the fact that the U.S.’s GDP has an annual change rate of +2.2% (2012) whereas the People’s Republic of China has a rate of +7.8% (2012) (Source: World Bank). Whatever the case, let’s take it from the top: What is gross domestic product?

According to Macroeconomics (10th Edition) by Michael Parkin, gross domestic product is, “the market value of the final goods and services produced within a country in a given time period.” To better understand what this means, let’s break the definition down into four parts: First, market value. Second, final goods and services. Third, produced within a country. Fourth, produced in a given time period.

If you were to measure the total production of a group of items (let’s use ice cream cones and cupcakes), how would you know where to begin? Would there be greater total production in 50 ice cream cones and 20 cupcakes or 20 ice cream cones and 50 cupcakes? Simply tallying the items won’t tell you much. To resolve this, GDP determines the value of an item by assigning it its market value. An item’s market value is the amount of money its worth in the market. If ice cream cones are traded at $1 each and cupcakes at $2 each, the greater total production rests in the scenario with 20 ice cream cones and 50 cupcakes.

Next, we have the concept of final goods and services. In the case of GDP we have two options: A final good or service and an intermediate good or service (and GDP is concerned with the former). For something to be considered a final good it must be something purchased (during a given time period) by its end user. An intermediate good, on the other hand, is constructed by one company and sold to another for inclusion into a larger product (a final good).

For example: An HTC One is a final good and the phone’s processor is an intermediate good. GDP differentiates between final and intermediate goods to avoid counting an item twice. By counting only the final product, we’re already including the value of the intermediate parts that make it up. Remember: An item which is considered an intermediate good in one situation could be the final good in another, and vice versa, so it’s important to know what the item will be used for, not just what it is.

It’s important to note that some items defy this dichotomy and, as a result, are not included when calculating a country’s gross domestic product. A used car, for example, counted in GDP calculations only in the year in which it was produced (and then never again). Stocks and bonds are also ignored.

Third, we must consider whether an item was produced within a country to determine whether it is counted as a part of that country’s GDP. If a United States firm produces an item in China, that item is counted toward China’s GDP (regardless of whether the company is American).

Finally, we note that GDP measures the value of items produced in a given time period (often quarterly or annually). As we explored with the example of a used car, something produced in 2012 (assuming it meets all of the other requirements described above) is counted toward the 2012 GDP. Even if that item is sold in 2013, it is not counted again.

From Macroeconomics by Michael Parkin, “GDP measures not only the value of total production but also total income and total expenditure. The equality between the value of total production and total income is important because it shows the direct link between productivity and living standards. Our standard of living rises when our incomes rise and we can afford to buy more goods and services. But we must produce more goods and services if we can afford to buy more goods and services.”

To take things a step further, let’s examine how the United States Bureau of Economic Analysis measures gross domestic product. Due to the fact that aggregate production is equal to aggregate expenditure (and therefore aggregate income), GDP can be measured through the “Expenditure Approach” or the “Income Approach.” I prefer the expenditure approach so I will cover that one:

Gross Domestic Product Expenditure Approach Calculation

The expenditure approach is represented by the equation above where Y is equal to gross domestic product, C is personal consumption expenditures, I is gross private domestic investment, G is government expenditure on goods and services, and (X-M) is the net exports of goods and services (the value of exports minus the value of imports).

Personal consumption expenditures are when United States households purchase goods and services that are produced in the United States and in other countries around the world. Homes are not considered in this category as the Bureau of Economic Analysis views them as investments.

Gross private domestic investment is expenditure on capital equipment and buildings by firms, additions to business inventories, and the purchase of homes by households.

Government expenditure on goods and services is any expenditure by any level of government on goods and services, excluding “transfer payments” (such as unemployment).

The net exports of goods and services is simply the value of products and services exported minus the value of those imported.

Here’s the catch: Approximately 70% of the United States’s GDP is made up of personal consumption expenditures (C) (Source: Bureau of Economic Analysis). Corporations continue to place higher degrees of emphasis on doing whatever it takes to cut expenses and maximize profits. Since it is far easier to pay your workers less money than it is to buy production resources at a lower cost, and with the advent of globalization, we are seeing these companies moving to where they can pay the lowest prices for labor (I’ll discuss the exploitation of foreign workers in another post). Despite increased worker productivity (and skyrocketing profits for corporations and the wealthiest 1%), American laborers are seeing reduced wages.

If you’re thinking critically right now, the problem may be growing evident: Lower wages = less money to spend = less personal consumption. If personal consumption expenditures are roughly 70% of our GDP, we have a problem – right? We sure do. How are we addressing this issue? Debt! If you give people lots of credit cards and loans, they can continue to spend despite shrinking wages. We are literally subsidizing unfair wages with debt. We are using crippling debt as a bandage to cover a larger economic crisis. We are artificially increasing personal consumption. How sustainable is this? That’s for you to decide. Share your thoughts below!

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