Thomas Tatro's List: TCO 4

The other measure of GDP is the expenditure approach (or  production approach, or output approach). There are four components of GDP  using this approach--consumption, investment, and government spending. The  National Accounting Tutorial describes clearly how these components make up  GDP.

Look closely at the definition of GDP--GDP is  the total market value of all final goods and services  produced within an economy in a given year. Several key  phrases are highlighted in this definition:

Total Market Value measures GDP in monetary terms. All  goods and services are multiplied by their prices to arrive at GDP.

Final Goods and Services are the only goods and  services that get counted towards GDP, as opposed to intermediate goods and  services. This is because we want to avoid multiple counting. Intermediate goods  are goods that are used up in the production process. Oranges purchased by  Tropicana to make orange juice are intermediate goods. Those oranges do not get  counted towards GDP. The orange juice is the final product and that is what gets  counted in GDP. If we counted the oranges AND the orange juice, we would have  double counted and end up overstating GDP.

As the name gross domestic product implies, GDP  measures only Domestic Production – i.e. goods produced  within an economy, say the U.S. economy. In the U.S., consumers,  business firms, and government import goods from Mexico, China, India, Canada,  and other countries. So C, I, and G include imported cars, imported food,  imported clothes, and so on. These goods were produced in other countries using  the factors of production of those countries. They do not belong in U.S. gross  domestic product, so we need to subtract them out. Similarly, some goods are  produced in the U.S. using U.S. CELL but end up being exported out of the U.S.  to other countries. These goods must be added back into GDP. The net exports  component of GDP, Xn, handles this.

Only goods produced in a given year must be included in  GDP. GDP for 2011 should only include goods produced in 2011. So, all used items  that are resold do not count in GDP. The house that was manufactured in 2004 and  resold in 2011 does not get counted in 2011 GDP because it was already counted  in GDP in 2004. Counting it again in 2011 would result in multiple counting.  However, if upgrades were made to the house in 2011 before it was resold (e.g.  adding a sunroom or patio), those additions would get counted in GDP.

GDP is calculated by multiplying market prices and quantities of  goods and services. Nominal GDP uses current prices to measure the market value  of goods and services while real GDP uses a constant or base year price to  measure the market value of goods and services. If we want to compare economic  growth from one year to another, what measure should we look at: nominal GDP or  real GDP? We need to use real GDP because we know that prices change from year  to year. If we use nominal prices which change from year to year, GDP would  change even when quantities of goods and services remain the same. Let's  illustrate using a simple example.

Let's say a country produces only two goods--bicycles and milk.  The market value for both goods in 2009 was $20 * 50 + $3.00 * 100 = $1300. The  market value for both goods in 2010 when prices went up is $30 * 50 + $4 *100 =  $1900. Nominal GDP increased from $1300 to $1900 even though the quantity of  bicycles and milk remained the same. Reporting nominal GDP growth  rate would show that nominal GDP grew 46% between 2009 and  2010. We have to use the growth rate formula [1900-1300/1300X100] to find  the growth rate.

Now, let's calculate the market value  of these goods using constant prices--that is, real GDP. Let's make 2009  our base year and so we use 2009 prices for both 2009 and 2010 GDP calculations.  

We can see that the growth of real GDP does not change from 2009  to 2010 because production did not change. If you use nominal GDP, you may get  excited that GDP has increased 46% but when you use the real GDP, it is clear to  see that what really matters (production) has not changed and real GDP has grown  by 0%. What really matters is the real value and not the nominal value. So real  GDP is a better measure of economic growth.