The 4 Components of GDP

Introduction to GDP and the Circular Flow Diagram

In this section, we learn about the two methods of calculating Gross Domestic Product (GDP) using the circular flow diagram. We also get introduced to the four actors in an economy: households, businesses/firms, government, and foreign countries.

Two Methods of Calculating GDP

• There are two ways to calculate GDP: by adding up income paid to all factors of production or by adding up expenditures made by households.

• Both methods should give us the same result.

• The expenditure method involves adding up spending done by each actor in the economy.

• The equation for calculating GDP using the expenditure method is: GDP = consumption + investment + government spending + net exports.

Four Actors in an Economy

• The four actors in an economy are households, businesses/firms, government, and foreign countries.

• Households spend on consumption while businesses spend on investment.

• Government spending is called government spending while foreign countries' spending is called net exports.

• Net exports refer to buying and selling with other countries.

Components of GDP

In this section, we dive deeper into each component of GDP: consumption, investment, government spending, and net exports.

Consumption

• Consumption refers to household spending on goods and services except for new houses.

• New house purchases are not included because they are considered investments that will last for years.

Investment

• Investment refers to private domestic investment made by firms on new factories, office buildings, machinery, and inventories.

• Investment spending also includes replacing old equipment.

Government Spending

• Government spending refers to the money spent by the government on goods and services.

Net Exports

• Net exports refer to buying and selling with other countries.

Components of GDP

In this section, the speaker explains the three components of GDP: consumption, investment, and net exports.

Consumption

• Consumption is the spending by households on goods and services.

• The speaker notes that consumption includes both domestically produced goods and imported goods.

• The reason for subtracting imports from consumption is to remove their impact since they are not part of domestic production.

Investment

• Investment refers to spending by businesses on capital goods such as machinery and buildings.

• It also includes spending on research and development (R&D).

Net Exports

• Net exports refer to the difference between a country's exports and imports.

• The speaker explains that only final goods are included in GDP calculations, not intermediate goods used in production.

• He notes that net exports can be positive or negative depending on whether a country is exporting more than it is importing or vice versa.

Verbal Definition of GDP

In this section, the speaker provides a verbal definition of GDP.

Market Value

• GDP measures the market value of all final goods and services produced within a country during a given time period.

• Market values are used instead of quantities because different products cannot be added together directly.

Final Goods

• Only final goods are included in GDP calculations because intermediate goods have already been accounted for in the value of the final good.

• A final good or service is one that is purchased by its end user rather than being used as an input for further production.

Time Period

• GDP measures what a country has produced within a given time period, typically one year or one quarter.

• Used items or previously owned assets are not included in GDP calculations for the current year.

Intermediate Goods

In this section, the speaker explains why intermediate goods are not directly included in GDP calculations.

Double Counting

• Including intermediate goods in GDP calculations would result in double counting since their value is already accounted for in the final good.

• For example, if tires are produced and sold to Ford to be used on new cars, the value of those tires is already included when the car is sold as a final good.

Real vs Nominal GDP

• Real GDP adjusts for changes in prices due to inflation over time.

• Nominal GDP does not adjust for inflation and can therefore be misleading when comparing across different time periods.

Investment in GDP Terms

In this section, the speaker explains what is meant by investment in GDP terms and how it differs from loanable funds.

Investment vs Loanable Funds

• Investment in GDP terms refers to business spending.

• Loanable funds refer to stocks, bonds, and other ways for savers to lend money to borrowers.

• Houses can also be considered investments if they are newly built and sold in the same year. Old houses that are bought and sold do not impact current GDP unless there is a commission paid to a realtor.

Impact of House Sales on GDP

This section discusses the impact of house sales on GDP.

Selling an Old House vs New House

• If a house was built in 2000 and sold in 2009, it would not have an impact on 2009's GDP because it is an old house.

• A new house built and sold in 2009 would impact 2009's GDP when the consumer buys it as an investment.

• The sale of old houses could potentially impact current GDP through commissions paid to realtors.

Applying Components of GDP

This section provides examples of applying the components of GDP.

Examples of Applying Components of GDP

• To become familiar with applying the components of GDP, watch a Khan Academy video or read examples provided in a book.

• It is important to understand the verbal definition of GDP and how each component contributes to overall economic growth.