Gross Domestic Product

You’ll be able to

Define GDP and identify what is and is not counted in it
Compute GDP using the expenditure approach
Distinguish nominal from real GDP and explain why real GDP measures growth

What GDP measures

Gross domestic product (GDP) is the market value of all final goods and services produced within a country’s borders in a given period. Four words carry the weight. Final — only finished goods count; the flour sold to a bakery (an intermediate good) is excluded to avoid double counting. Produced — only current production counts, so used-car resales and stock transfers are excluded. Within a country’s borders — location, not nationality, determines what is counted. GDP also excludes nonmarket activity: unpaid housework, illegal transactions, and the underground economy.

The expenditure approach

Because every dollar spent on output is income to someone, GDP can be measured by adding up all spending on final goods. The expenditure approach has four components: Consumption (C), household spending on goods and services; Investment (I), business spending on capital, new construction, and inventory changes; Government spending (G), on goods and services (but not transfer payments like Social Security, which are not payment for output); and Net exports (Xn = exports − imports). Imports are subtracted because they were produced abroad and are already embedded in C, I, and G.

GDP — expenditure approach

GDP = C + I + G + Xn (where Xn = exports − imports)

The four spending categories. Transfer payments and purely financial transactions are excluded because no new good or service is produced.

Real vs. nominal GDP

Real GDP = (Nominal GDP / GDP deflator) × 100

Nominal GDP uses current-year prices; real GDP holds prices constant at a base year to strip out inflation. Only real GDP reflects a true change in output.

Worked example

An economy reports: consumption $600B, investment $150B, government spending $200B, exports $80B, imports $110B, and transfer payments $90B. Calculate GDP using the expenditure approach.

1.Compute net exports: Xn = exports − imports = 80 − 110 = −$30B.
2.Exclude transfer payments: the $90B is not spending on current output, so it is not part of G here.
3.Add the components: GDP = C + I + G + Xn = 600 + 150 + 200 + (−30).
4.GDP = 600 + 150 + 200 − 30 = $920B.

Answer: GDP = $920 billion. Net exports are negative (−$30B) because imports exceed exports, and the $90B in transfer payments is excluded because it does not pay for newly produced output.

Checkpoint

Which of the following would be included in this year’s U.S. GDP?

Watch out

Government spending (G) counts only purchases of goods and services. Transfer payments — Social Security, unemployment benefits, welfare — are excluded from GDP because the recipient produced nothing new in return. This is a favorite exam trap.

Checkpoint

Nominal GDP rose from $1,000B to $1,100B while the GDP deflator rose from 100 to 110. What happened to real GDP?

On the exam

When a question reports rising nominal GDP, always check the price level before concluding output grew. If prices rose just as fast, real GDP is unchanged. "Growth" on the AP exam means an increase in real GDP.

Answer the 2 checkpoints as you read.