This issue raises its unattractive head every few years. I’ve written about it before, but never as a standalone article. Give this a try.
GDP is gross domestic product. It measures total production, the total output of an economy measured at current market prices. National income accounting is the system used to add up GDP and other macroeconomic variables.
As you can imagine, adding up total output would be very complicated. Luckily, Simon Kuznets was a smart guy. We owe this to his cleverness.
Simon Kuznets
While adding up output is difficult, adding up spending is pretty easy (at least in principle). So here’s an idea. Why don’t we add up total spending then correct that total for factors that make production different from spending? That’s exactly what the GDP calculation does.
First, add up total spending:
- Consumption spending by households (C),
- Business spending on buildings and machine (business fixed investment, If), and
- Government spending (including state and local governments, G).
Then add two correcting factors and subtract one:
- The net change in inventories (Inv),
- + Products made in the U.S. but sold in other countries (exports, EX), and
- − Products made in other countries but sold here (imports, IM).
Here’s how that works.
Inventory Change
Suppose I run a shoe business. Our economist forecasts sales of 2,000 pairs of shoes next month. This is a great forecast, so I gear up production. My highly skilled workers crank out 2,000 pairs during the month.
But there’s a problem. Actual demand was only 1,700 pairs. What should I do?
First, I fire the economist. (I know that makes your heart go pitter-patter). Next, I notice that there were 2,000 – 1,700 = 300 pairs of shoes unsold. These go into inventory.
Notice what happened. Production was 2,000. Spending was 1,700. The difference is inventory change. Write this as 2,000 – 1,700 = 300. Then rewrite it as 2,000 = 1,700 + 300. In other words, production equals spending plus inventory change.
The net change in business inventories is the first corrective factor. It is goods produced but not sold. Remember, we are measuring domestic production.
So far we have C + If + G + Inv. We’re one-third of the way there.
Exports
Exports are products produced in the U.S. but sold in other countries. By definition, they are not part of domestic spending. But they are part of output. Add them.
Imports
What about products that are part of total domestic spending but not produced here? We call those imports. Since we want to exclude them from domestic output, we have to subtract imports from total domestic spending.
Summing Up
We are left with the timeless equation (with a few added details):
GDP = C + If + G + Inv + EX – IM
Inv is added to If to produce gross private domestic investment, I. EX – IM is usually called net exports (NX). This leads to the more traditional form:
GDP = C + I + G + NX
Conclusion
GDP measures production. The first step is adding up total domestic spending. Then add two corrective factors: the change in inventories and exports. Finally, subtract imports. That’s how total spending is changed to total output. The GDP equation is an accounting identity. Trying to attribute any behavioral meaning to the calculation is a mistake.
