Source: Images of Circular Flow Diagram created by Kate Eskra
Hi. And welcome to macroeconomics. This is Kate. This tutorial is on economic growth, or GDP. As always, my key terms are in red and my examples are in green.
So in this tutorial we'll be looking at what GDP is and what it measures. I'll go through the two approaches to calculating GDP, the income and expenditure approach. We'll talk about the shortcomings of GDP as a measure of growth. And finally, we'll end by talking about how we need to be careful just to count final goods and services. OK.
So after the Great Depression, economists realized, whoa, we don't ever want this kind of thing to happen again. We need a much better way to keep track of the US economy.
It is normal for our economy to go through fluctuations of growth and contraction in the short run. But economists started asking themselves, yeah, but how can we better predict when something major, like a major depression, is coming? And how can we measure economic growth over time?
The answer was to calculate gross domestic product. And what I want you to keep in mind as we go through here and I talk about how we calculate it, it helps to keep in mind what the point is. And the point is to measure economic activity in a country in a certain amount of time, either quarter to quarter, or year to year.
So if the figure goes up from one year to the next, then we can feel pretty good. We can say, oh, the economy was more productive than the year before. But if GDP falls, that's kind of an indication that the economy is slowing. All right.
So the definition of gross domestic product is the sum of all final goods and services sold or produced within a nation's domestic borders. And it is, like I said, a measurement of our economic activity. And the two approaches are the income approach, which is also known as the resource cost approach, and the expenditure approach.
They're really two sides of the same coin. And by that I mean, they're going to arrive at the same thing, just using different methods. The first one that we should talk about is the resource cost approach, or the income approach, which is adding up the amount of resources used to produce goods and services, or the sum of the income received from the purchases of these resources.
So what we're doing is we're calculating economic activity by adding up the costs that go into producing goods and services. And this is activity in the input market, the bottom of the circular flow market, which I'm going to show you in a couple of slides.
So here we're looking at the cost of-- remember, our resources or inputs are land, labor, and capital. And so we want to look at the cost of those or the income received from them. I like to think of it as WRIP. W would be income earned by workers, or wages, salaries, benefits. R would be rental income earned by landlords. I is interest income earned by lending money to businesses. And P is profits earned by businesses. OK.
So it sounds really complicated, like, how would you go about this? But we do have data on the income that people make from tax returns. So that's easily available to our government. One thing just to keep in mind is that not all income that people make equates to income for businesses.
So one example would be the fact that equipment from year to year depreciates or loses value. We need to adjust for that. So there are certainly adjustments made along those lines.
We would include income here that foreigners make in our country, because if they're working here, they're working to produce things, or they're generating economic activity here. Income that Americans make abroad would have to be subtracted, because that's contributing to somebody else's gross domestic product, not ours.
And here's a reminder of that circular flow model. The input market, remember, is where are factors of production-- our land, labor, and capital-- are exchanged. And so the bottom part here-- what I've highlighted in yellow-- represents the income or resource cost approach in the circular flow model. OK.
On the contrary, we have the expenditure approach. Expenditure approach indicates what we spend money on. So this is the sum of all final goods and services. I'll talk about in the end here why it's important that this word final goods and services.
So when we add up all of these purchases, usually we look at it as GDP equals c, consumer purchases, plus i, investment outlays, plus g, government spending, plus exports minus imports, or net exports. So again, we're adding up here what people spend money to purchase. And this is in the output marketer, that top part of the circular flow model. I already mentioned this, but you can reference this slide if you want to remember what these symbols stand for.
Anytime we purchase final goods and services, investment in capital, usually by businesses, that's what I usually think of for i. Government purchases, these are purchases of final goods and services. This is not just transfer payments, like the government sending welfare checks. That would not be counted here, because it doesn't represent something new being produced. And then exports, this is net exports. So exports minus imports. For the United States, very often this is obviously negative because we tend to import more than we export. OK.
So this would be the top of the circular flow model here. And like I just said, we are subtracting what we're importing, what we're paying the rest of the world for. And we're adding our exports, because exports obviously are things that we are producing here. All right.
One thing that we can do that's kind of interesting is look at this. If we reorder this equation, we consider only domestic. Take out the rest the world for a minute. If we write the equation GDP equals c plus i plus g, and we solve for i, we get i equals y minus c minus g.
The reason we're doing this is because we want to look at savings for a minute. And investment is the same as savings in an economy. If we do this and we add and subtract t-- so here we're basically subtracting t. And here we're adding t to keep it the same.
We can get two terms-- that savings equal this term plus this term. What are those two terms? Well, the first one is public savings. And the second one are government savings. So that's one way to look at that. OK.
So why is it that the expenditure and income approach arrive at the same GDP? Well, it's because when I go and spend money somewhere, doesn't that become a part of somebody else's income or multiple people's income? And you can see that on the circular flow model. That's why that model is circular in nature. What people are spending money in the top, they're getting that money to spend by working in the bottom, or in the input market.
So the whole point of this, again, is to show GDP growth, how we measure the change in GDP over time. And GDP is the most common way of measuring growth. If we-- like I said-- are growing by GDP, that's an indication that our macro, or overall, economy is healthy.
In the past, we've used a measure called gross national product, which the only difference here is that you are considering what's being produced by a nation and not necessarily in a nation's borders. So that's the difference. We more so today use GDP and are concerned by what's being produced within a nation's borders.
One thing I just want you to consider is that, could anything ever really be a perfect measure of how people live in a country or measure all economic activity? It can't capture any non-market activities, like cleaning our own homes, caring for our children, changing the oil on our own car. We just can't capture all of those things.
It's also not going to measure the value that we place on things, like leisure or safety. Crime and pollution can't be accounted here either. And it's also an average. Certainly if GDP per person rises from one year to the next, we can say overall our standard of living has improved. But that certainly doesn't mean that everyone is better off. OK.
So what we now need to talk about is that it's very important, especially in that expenditure approach, that we're only measuring final goods and services, not intermediate ones. An intermediate good is something that's purchased in that production process to help us make a final good or service. So here's an example to help make that clear.
Before I buy a new car, that new car has a lot of things put in it, right? So the manufacturer has purchased tires, and purchased the leather for the leather seats, and a whole bunch of other stuff to put in there. Do we count that when they purchase those tires? Do we count that in our GDP?
The answer is no, because those tires count in the final purchase price of the vehicle. If we counted them when they purchased them to put on the car and when I bought the car, that would be double counting. We want to only count things that are being produced new. So the purchase price of the car already accounts for that.
Now if this winter I need new tires for my car, then the tires I purchased to replace my old ones, those are new. Those are something that's been produced this year that I am purchasing as a new good or service. So that would count. So hopefully that helps you to understand the difference between an intermediate good-- something used in the production process to make a final good-- and a final good. OK.
So in this tutorial we talked about what GDP is and what it measures. We talked about the difference between the income and expenditure approach. We discussed some of the shortcomings of GDP. And we finally ended by looking at how we need to be careful only to count final, not intermediate, goods and services.
Thanks so much for listening. Have a great day.
Gross Domestic Product; the sum of all final goods and services sold within a nation’s domestic borders; a measurement of economic activity.
Resource Cost - Income Approach
Sum of the amount of resources used to produce goods and services, or sum of the income received from purchases of these resources.
Sum of all final goods and services purchased in an economy; typically referenced as Y = C + I + G + (X – M); Y (GDP), C (consumer purchases), I (investment outlays), G (net government spending), X (exports), M (imports).
The measure of change in GDP over time.