The Components of GDP

In this chapter we will study 4 different components of GDP. Components of GDP are…

  1. Consumption
  2. Investment
  3. Government Purchase
  4. Net Exports

Spending in the economy takes many forms. At any moment, the Smith family may be having lunch at Burger King; General Motors may be building a car factory; the Navy may be procuring a submarine, and British Airways may be buying an airplane from Boeing.

GDP includes all of these various forms of spending on domestically produced goods and services.

To understand how the economy is using its scarce resources, economists are often interested in studying the composition of GDP among various types of spending.

To do this, GDP(which we denote as Y) is divided into four components(Components of GDP). Consumption (C), Investment (I), Government purchases (G), and Net exports (NX).

Y = C + I + G + NX.

This equation is an identity, An equation that must be true by the way the variables in the equation are defined.

In this case, because each dollar of expenditure included in GDP is placed into one of the four components of GDP, the total of the four components must be equal to GDP.

Let’s discuss each of GDP Component.

Components of GDP

Economists and policymakers care not only about the economy’s total output of goods and services but also about the allocation of this output among alternative uses.

The national income accounts divide GDP into four broad categories of spending: Consumption, Investment, Government purchases and Net Exports.

components of gdp

01 Consumption

Consumption consists of the goods and services bought by households. It is divided into three subcategories: nondurable goods, durable goods, and services.

Nondurable goods are goods that last only a short time,such as food and clothing.

Durable goods are goods that last a long time, such as cars and TVs.

Services include the work done for consumers by individuals and firms, such as haircuts and doctor visits.

Consumption is spending by households on goods and services, such as the Smiths’ lunch at Burger King.

02 Investment

Investment is the purchase of capital equipment, inventories, and structures, such as the General Motors factory.

Investment also includes expenditure on new housing. (By convention, expenditure on new housing is the one form of household spending categorized as an investment rather than consumption.)

Newcomers to macroeconomics are sometimes confused by how macroeconomists use familiar words in new and specific ways. One example is the term “investment.”

The confusion arises because what looks like investment for an individual may not be investment for the economy as a whole.

The general rule is that the economy’s investment does not include purchases that merely reallocate existing assets among different individuals.

Investment, as macroeconomists use the term, creates new capital.

Let’s consider some examples. Suppose we observe these two events:

  • Smith buys for himself a 100-year-old Victorian house.
  • Jones builds for herself a brand-new contemporary house.

What is total investment here? Two houses, one house, or zero?

A macroeconomist seeing these two transactions counts only the Jones house as an investment.

What Is Investment?

Smith’s transaction has not created new housing for the economy; it has merely reallocated existing housing.

Smith’s purchase is an investment for Smith, but it is disinvestment for the person selling the house.

By contrast, Jones has added new housing to the economy; her new house is counted as investment. Similarly, consider these two events:

  •  Gates buys $5 million in IBM stock from Buffett on the New York Stock Exchange.
  •  General Motors sells $10 million in stock to the public and uses the proceeds to build a new car factory.

Here, investment is $10 million. In the first transaction, Gates is investing in IBM stock, and Buffett is disinvesting; there is no investment for the economy.

By contrast, General Motors is using some of the economy’s output of goods and services to add to its stock of capital; hence, its new factory is counted as investment.

03 Government Purchases

Government purchases include spending on goods and services by local, state, and federal governments, such as the Navy’s purchase of a submarine.

The meaning of “government purchases” also requires a bit of clarification.

When the government pays the salary of an Army general, that salary is part of government purchases. But what happens when the government pays a Social Security benefit to one of the elderly?

Such government spending is called a transfer payment because it is not made in exchange for a currently produced good or service.

From a macroeconomic standpoint, transfer payments are like a tax rebate. Like taxes, transfer payments alter household income, but they do not reflect the economy’s production.

Because GDP is intended to measure income from (and expenditure on) the production of goods and services, transfer payments are not counted as part of government purchases.

04 Net exports

Net exports equal the purchases of domestically produced goods by foreigners (exports) minus the domestic purchases of foreign goods (imports).

A domestic firm’s sale to a buyer in another country, such as the Boeing sale to British Airways, increases net exports.

The “net” in “net exports” refers to the fact that imports are subtracted from exports.

This subtraction is made because imports of goods and services are included in other components of GDP.

For example, suppose that a household buys a $30,000 car from Volvo, the Swedish carmaker.

That transaction increases consumption by $30,000 because car purchases are part of consumer spending.

It also reduces net exports by $30,000 because the car is an import.

In other words, net exports include goods and services produced abroad (with a minus sign) because these goods and services are included in consumption, investment, and government purchases (with a plus sign).

Thus, when a domestic household, firm, or government buys a good or service from abroad, the purchase reduces net exports—but because it also raises consumption, investment, or government purchases, it does not affect GDP.

Table 10-1 shows the composition of U.S. GDP in 1998. In this year, the GDP of the United States was about $8.5 trillion. If we divide this number by the 1998 U.S. population of 270 million, we find that GDP per person.

the amount of expenditure for the average American—was $31,522.

Consumption made up about two-thirds of GDP, or $21,511 per person. An investment was $5,063 per person.

Government purchases were $5,507 per person. Net exports were –$559 per person. This number is negative because Americans earned less from selling to foreigners than they spent on foreign goods.