Short & Simple 8 – Measuring GDP

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.

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9 thoughts on “Short & Simple 8 – Measuring GDP

  1. Very good as is the norm in your posts, Pete.

    I’d just like to add for anyone reading this that the three methods to measure GDP (income, value added, and expenditure) are implied by the fundamental National Accounting identity:

    GDP = (1) Total Output = (2) Total Income = (3) Total Spending

    (1) total output implies the value added method.
    (2) total income implies the income method.
    (3) total spending implies the expenditure method.

    ———-

    A suggestion: a topic often overlooked and about which I think misconceptions abound is balance of payments.

  2. Good point, Magpie. This is where the sleight of hand over value comes in by equating value with price.

    This is a form of nominalism wrt to value theory. It depends on definitions rather than analysis of evidence.

  3. Tom Hickey on 19 July 2017 at 12:50 AM said:

    Good point, Magpie. This is where the sleight of hand over value comes in by equating value with price.

    This is a form of nominalism wrt to value theory. It depends on definitions rather than analysis of evidence.

    I’m not sure I understand. Can you elaborate?

  4. When value is equated with (defined by) price, then objective value is identical with the equilibrium of supply and demand in markets as the determinant of price/value.

    There is neither a need for a theory of economic value other than “market forces,” nor is there a basis for an alternative theory of economic value.

    That position based on assumptions (definitions, rules) excludes a labor theory of economic value since the issue is claimed to be settled, hence, excluded from legitimate debate in the field.

    This is only way conventional economists exclude heterodox views from consideration. In effect, they are declared heresies that are in conflict with dogma.

  5. What do they do with the ‘value’ of a tree, having way more scope than labour, or supply and demand for timber in a market? For instance it provides shade and shelter, a home for all sorts of creatures, is beautiful, has an amazingly responsive environmental design, can create a forest of its own kind etc …

  6. @ Tom Hickey on 19 July 2017 at 8:07 AM

    That’s an interesting thought, but I was referring to something less controversial. See:

    “Explanatory Notes” to the latest ABS 5206.0 release (“Australian National Accounts: National Income, Expenditure and Product”, Mar 2017): section “Gross Domestic Product (GDP)”, paragraphs 19 to 25 (both inclusive).

    http://www.abs.gov.au/Ausstats/abs@.nsf/exnote/5206.0

  7. Thanks, Magpie. Your first comment in the thread sums up the key takeaway perfectly. Cheers.

    Thanks also for your suggestion about covering balance of payments. I definitely intend to get to it. It’s just a matter of when. The same goes for sectoral balances, which was a good suggestion in a comment to an earlier thread (part 5) by Georg Thomas.

    By the way, I have finally taken advantage of an earlier suggestion of yours to link to the ‘short & simple’ category of posts in the ‘Posts to Read First’.

  8. Tom, it’s interesting you brought up value in this thread. At one point in composing the post, I was trying to avoid use of the word. But it was difficult because of the name of the ‘value added’ method of measuring GDP.

    Different meanings and uses of the word “value” do seem ripe for misunderstanding.

  9. It’s important to indicate the different meanings of “value” as it is used differently in different contexts. When different meanings based on different uses are conflated in a single context, a logical error has been introduced, either through inadvertence or intentionally for persuasion.

    Neoclassical economics was about circumventing the analysis of value of Marx & Engels, and also Henry George.

    When economic value is defined in terms of cost (classical economics, Marx), or value added by land improvement (George), then the difference between economic value and price is accounted for as economic rent, that is, “free money” gained without earning.

    There is a free lunch and it is economic rent.

    When economic value is figured this way, then profit as the difference between production cost and revenue falls largely into economic rent.

    Can’t have that, can we? So change the definitions and assumptions.

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