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Calculating GDP

There are three ways to calculate GDP: the expenditure approach, the income approach, and the value-added approach.

There are multiple ways to calculate GDP, the measurement of a country's total economic output. Theoretically, every method used to calculate GDP should produce the same result because the underlying economic factors should be the same. The main methods for calculating GDP are the expenditure approach and the income approach. A third but less common method is the value-added approach (also known as the production approach). The expenditure approach sums up the total value of all final goods and services produced, and the income approach adds up all of the income earned in the economy (such as wages, corporate profits, interest and investment income, and farming income).

All three approaches (the expenditure approach, the income approach, and the value-added approach) should, in theory, add up to the same GDP because they are all measuring money flowing through the same economy. However, in practice, these measures may vary; they are all notably complex to measure because of the methods by which they aggregate so many different sectors and types of economic activity. Therefore, it can be useful to compare the figures resulting from the three approaches, and large disparities between them can act as signs of errors or omissions in the data-gathering process.

GDP is a measure of economic activity only. Other markers of the "health" of an economy—such as income inequality, productivity, and other factors—are excluded from the calculations. GDP is a measure of economic activity over a set period. A unit of time must be chosen. This is typically one year, but GDP can also be calculated at quarterly intervals, that is, every three months. Once a designated time period is chosen, the calculation of GDP is then based on data gathered from the private and public sectors during that time. GDP can then provide a snapshot of the economic activity in that specific time period.

GDP is one of the most important measures of national economies. After adjusting for inflation (real GDP), rates of change in GDP can be calculated for comparison across time periods and between countries. GDP can also be used to assess a business cycle, which is an interval of expansion and contraction in the economy. Additionally, GDP can be helpful in analyzing the effects of historical events, such as the Great Depression or World War II, on the economy. For example, the GDP declined sharply during the Great Depression, falling after the stock market crash in 1929. A decade passed before GDP reached pre-crash levels. In contrast, GDP spiked with the beginning of World War II, and peaked at the end of the war.

Expenditure Approach

The expenditure approach to calculating GDP uses spending as the basis for the calculation.

The most common approach used to determine GDP is the expenditure approach. The expenditure approach is based on spending and can be thought of as calculating GDP through the demand side of a market transaction. There are four components considered in the expenditure approach:

  • Consumer spending, which is the total individual and household purchases of consumer goods and services
  • Investment spending, which refers to spending by firms on business capital, residential capital, and inventories
  • Government spending, which is money spent by the government for various government programs
  • Net exports, which is the total value of a country's exports minus the value of the country's imports

GDP: Expenditure Approach

Multiple economic factors are accounted for in calculating gross domestic product (GDP). Whether made by private or state entities, all purchases and investments are tallied in the expenditure approach.
An export is a good or service sold to another country. Spending on exports is added to GDP. An import is a good or service produced abroad and bought domestically. Imports are subtracted from GDP because they are not produced in the country being counted. To calculate GDP using the expenditure approach, use the following equation:
In this equation, C is the consumption of individuals and households, I is investment in physical capital made by businesses, G is the total amount of government spending, and (XM)(\text{X}-\text{M}) is net exports: the difference between exports (X), what a country produces and sells to foreign countries, and imports (M), what it purchases from foreign producers.

2016 GDP: Expenditure Approach

This graph shows relative proportions of the final US GDP calculation in 2016 using the expenditure approach, accounted for by consumer spending, business investment, government spending, and net exports. Consumer spending is the largest component of GDP.

The largest portion of GDP using this approach is consumer spending. While this portion is the main driver of the economy—it accounts for roughly two-thirds of total spending in the United States—it usually remains stable over time (especially with regards to nondurable goods—goods that are consumed immediately, such as food items).

Investment spending refers to investment in physical capital, such as manufacturing plants and equipment, by businesses. The opening of new stores or the purchase of machinery for assembly lines would be examples of investment spending. While investment spending is dramatically less than consumer spending (approximately 17% of total spending in the United States), it is remarkably important because investment spending leads to job creation. Investment by businesses is more volatile than consumer spending. This is because investment spending is highly responsive to the interest rate, while consumer spending is not.

Government spending includes all expenditures from federal, state, and local governments. New military equipment, spending on highway infrastructure, and the building of new schools and government buildings are all examples of government spending. Government spending accounts for approximately 20% of GDP. Transfer payments (such as social security benefits) are not included in GDP, as no good or service is received in exchange. The government simply facilitates a transfer of income from one taxpayer to another.

In the expenditure approach, imports and exports are also taken into account under the net exports category. Imports must be subtracted from GDP. The equation for net exports is NX=(XM)\text{NX}=(\text{X}-\text{M}), where X is exports and M is imports. A situation in which a nation exports more than it imports is a trade surplus. A situation in which a nation imports more than it exports is a trade deficit. The United States typically had a trade surplus in the decades following World War II but more recently has had a trade deficit.

Income Approach

The income approach to calculating GDP uses income as the basis for the calculation.
Like the expenditure approach, the income approach is intended to calculate the value of all the goods and services produced in an economy. Unlike the expenditures approach, which starts by calculating all the money spent in an economy, the income approach calculates all the money earned. Sources of income used in the calculation include not only wages but also profits, interest earned, and rent collected. (Wages as indicated here include contributions by employers to pensions, retirement savings, insurance, and other benefits as well as income earned by people who are self-employed.) These sources are the income paid to the factors of production, i.e., the labor force.
National Income=Wages+Rent+Interest+Profits\text{National Income}=\text{Wages}+\text{Rent}+\text{Interest}+\text{Profits}
Combining these various sources of income allows economists to calculate the total national income. Any government subsidies for production or profits are subtracted from this total. Then, to calculate overall GDP, the total national income is adjusted to include sales taxes paid, depreciation of purchased goods, and a factor called net foreign factor income (NFFI). NFFI is the difference between the amount that a country's citizens earn outside the country (gross national product, or GNP) and income earned by foreigners within the same country's borders; for example, U.S. citizens' income abroad minus income earned by foreign citizens within U.S. borders. The equation to calculate GDP using the income approach is
GDP=Total National Income+Sales Taxes+Depreciation+Net Foreign Factor IncomeGovernment Subsidies\begin{aligned}\text{GDP}=&\text{Total National Income}+\text{Sales Taxes}+\text{Depreciation}\\+\:&\text{Net Foreign Factor Income} -\text{Government Subsidies}\end{aligned}
This sounds complicated, but the equation for NFFI is simply NFFI=GNPGDP\text{NFFI}=\text{GNP}-\text{GDP} . NFFI is usually significant in cases when a smaller country has a relatively large amount of foreign investment within its borders because there are few citizens who work outside the country compared to foreigners who earn within the country. Conceptually, calculating GDP using the income approach will return the same result as the expenditure approach because all value produced must be accounted for by a claim someone has to that value. The two values calculated from the income and expenditure approaches differ in practice only because of measurement errors.

GDP: Income Approach

Interest, rent, wages, profits and other forms of income are tallied up when calculating GDP using the income approach.

Value-Added Approach

The value-added approach to calculating GDP uses supply of goods as the basis for the calculation.

The value-added approach (also known as the production approach) measures GDP from the supply side of the market transaction. It adds up the final output of all goods and services, then subtracts the total of intermediate goods, which are goods and services consumed or transformed by the production of other goods and services. The categories of goods produced and measured in this approach are durable goods, nondurable goods, services, structures, and changes in inventory.

Durable goods are long-lasting products such as vehicles and appliances. Nondurable goods, in contrast, are products that have a short lifespan, such as food, clothes, and consumer goods such as toothpaste and laundry detergent.

When economists use the value-added approach, they estimate the gross value of domestic output by adding the value of all goods and services produced within the country's borders, whether the goods and services are intermediate or not. Then, the costs of the intermediate goods used to produce the final goods or services are deducted from the final value to obtain the net value of domestic output.

For example, using the value-added approach to measure the contribution that an automobile produced in the United States makes to GDP, first sum the cost of each intermediate step in the production process. For instance, add the cost of the tires and the battery produced and delivered by outside suppliers to the overall value of the car as it is assembled. Once the manufacturing process is complete, subtract the value added at each intermediate step from the final retail sales price of the car. Subtracting the value added at each step of the manufacturing process avoids double counting and overstating the car's contribution to GDP.

Calculating GDP using the value-added approach requires the careful tracking of supply chains and manufacturing processes to ensure that goods and services in the economy are not accounted for twice.