In part 7, we arrived at a fundamental National Accounting identity:
GDP = Total Output = Total Income = Total Spending
This identity suggests various ways of measuring GDP.
The income method takes advantage of the fact that GDP is defined to be equal to total income. By adding up the various categories of income – most notably, wage income and profit income – it is possible to arrive at a measure of GDP.
The value added approach adds up the new output that is created at each stage of production. This works because GDP is also defined to be equal to total output. In this method, it is necessary to subtract the value of ‘intermediate goods’ from the value of output at each stage of production. This is to avoid double counting. For example, flour is used to make bread, and so is an intermediate good in the production of bread. When bread output is added to total output, the value of flour used in its production is subtracted, since it is counted as part of flour output.
Here, we will focus on the expenditure method of measuring GDP. This makes use of the fact that GDP is defined, in a third way, as being equal to total spending.
This method involves adding up all the spending on domestically produced goods and services that has occurred over the year:
GDP = Domestic Private Spending + Domestic Government Spending + Foreign Spending on Domestically Produced Goods and Services
Domestic private spending is divided into private consumption and private investment.
In theory, private consumption refers to expenditure on goods and services for immediate use, whereas investment refers to expenditure on goods that are not completely used up in the current period. However, in National Accounting practice, the convention is to treat most consumer durables purchased by households as consumption.
In the National Accounts, private investment has three broad components. It includes ‘fixed capital investment’ (business purchases of plant and equipment) as well as any ‘change in inventories’. Inventories include unsold output produced within the period as well as raw materials yet to be used up in production. Any change in inventories over the period counts as investment. The National Accounts also include ‘residential investment’ (the purchase of new housing) in the measure of private investment.
The treatment of inventories can be a source of confusion. As mentioned in part 7 of the series, unsold output is treated in the National Accounts as if it has been purchased by the firm that produced it. This treatment of inventories ensures that total output and total expenditure correspond. If inventories were not treated in this way, total spending would still be identically equal to total income, but total output would diverge from these other two measures due to any change in inventories. Treating inventories in this way ensures that the three different methods of measuring GDP give the same answer in principle. In practice, statistical error (related to sampling drawn from surveys) results in small differences between the three measures.
Domestic government spending includes both government consumption expenditure and public investment.
Foreign spending on domestically produced goods is known as exports.
Purchases of foreign-produced goods by domestic households, businesses and government are imports.
In the official statistics collected for the National Accounts, spending on imports gets included in the totals for domestic government spending and domestic private spending. For this reason, it is necessary to subtract imports from the measure of GDP, since they are not the result of domestic production.
Putting this all together we have:
GDP = Private Consumption + Private Investment + Government Spending + Exports – Imports
Using symbols, this is often written:
Y = C + I + G + X – M
Here, Y is total output or total income, and each symbol on the right-hand side represents the corresponding category of expenditure in the preceding expression.