GROSS DOMESTIC PRODUCT IN DETAIL

Calculating GDP

In this module, you will learn

• how to calculate the GDP
• how to use moneychimp.com to further understand money flow in the GDP - submodule includes 4-question GDP Money Flow Quiz
• how to calculate GDP in a practice example - submodule includes 1-question GDP Calculation Quiz
• how to understand the role of Personal Savings and how to use U.S. government information to verify the formula in the real world

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. So, 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). 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 new 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 3 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 (source: www.moneychimp.com). The solid arrows indicate the components of the GDP, and the direction of the money flows. The arrow indicating the Trade Deficit would be in the opposite direction in the case of a Trade Surplus.

Source: www.moneychimp.com (labels added by MindTools)

Now go to the interactive version of this diagram at http://www.moneychimp.com/articles/econ/gdp_diagram.htm. At the MoneyChimp site, click on the various icons in the diagram (including the arrows!) for more information about the U.S. GDP. Use the diagram to answer the following questions. NOTE: The information given in the diagram for the first two questions represents historical averages and may not reflect the most current information. You may find the Glossary or other areas of MoneyChimp useful as well.

1. What portion of the GDP is accounted for by Consumer Spending?

2. What percent of the 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?

Did you find the 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 $40 per year buying local goods and services and $2.50 buying imports. The island exports a total of $800 worth of goods. The Government tax rate is 10% and all government money is spent on building infrastrcuture 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: Understanding the Role of Personal Savings and Using U.S. Government Figures to Verify the Formula

Now, 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. Money NOT circulated in this way -- the money you stuff in a mattress -- would actually be subtracted from the GDP. For the most part, however, people do not put money in mattresses and 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.

NOTE: 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.

To see the actual GDP figures for the U.S., go to http://www.gpoaccess.gov/eop/tables04.html. You may find this a useful site for information. At this site, you can download Excel Tables showing you the GDP from 1959 to the present. 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. An 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  

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Created on ... February 24, 2004 Revised 3/13/2012