Two approaches of calculating GDP:
What is spent on a product is the income to those who helped to produce and sell it. GDP can be measured either from the expenditure approach or the income approach.
1. Expenditure approach
The economy is divided into four sectors: household, business, government, and foreign sector.
C: Consumptionis the expenditures of the household sector. It includes spending on 1) durable goods which last for more than one year, 2) non-durable goods, and 3) services.
I: Investmentis the expenditure of the business sector, including 1) purchases of new capital goods which are equipment or tools that aids in the production process, 2) changes in business inventories, 3) purchases of new residential housing.
G: Government Purchasesis the expenditure of the public sector, such as education and defense expenses. Transfer payments are not included. If Government’s expenditure is greater than taxes collected from business and household sector, government is having a deficit; if government’s expenditure is smaller than the taxes collected, government is having a surplus; if the two amounts are equal, government’s budget is balanced. When there is a budget deficit, government needs to borrow debt from the business, household or the foreign sectors. Government’s debt is usually higher in recession than in an expansion phrase of the business cycle because government needs funding to finance their deficit.
Xn: Net Exportsis the differences between exports (goods and services sold to the foreign markets) and imports (goods and services produced and imported from abroad). Xn = X – M (X=exports, M=imports)
Computing GDP: GDP = C + I + G + Xn
2. Income approach
All final goods and services are produced using factors of production. By summing up the factor payments, we can find the value of GDP. Some adjustments are required to balance the account.
Compensation of employeesincludes the wages, salaries, fringe benefits, Social Security contributions, and health and pension plans.
Rentis the income of the property owners.
Interestis the income of the money capital suppliers.
Proprietor’s Incomeis the income of incorporated business, sole proprietorships, and partnerships.
Corporate Profitsis the income of the corporations’ stockholders whether paid to stockholders or reinvested.
Sum of the above items is the National Income (NI).
Indirect business Taxes(general sales taxes, business property taxes, license fees etc.) should be added to NI. They are not considered to be payments to a factor of production, but they are part of total expenditures.
Depreciationis another cost, which should be added.
Net foreign factor income(income earned by the rest of the world – income earned from the rest of the world) should be added to adjust GNP to GDP.
Computing GDP: GDP = Compensation of employees + Rent + Interest + Proprietor’s Income + Corporate Profits + Indirect business taxes + Depreciation + Net foreign factor income
Some statistical discrepancy should be considered to balance expenditure and income approach.
Nominal Vs Real GDP
Nominal GDP = Sum of (Price X Quantity) for every item produced in the economy, using the current year’s price. When comparing nominal GDP figures between different years, you cannot determine whether the increase is due to the increase in price level or increase in output. Real GDP is adjusted for price level, that is, GDP measured at the same price level.
Real GDP = (Nominal GDP / price index) X 100
If real GDP increases from one year to the next, then economic growth has occurred.
Growth rate =[(Real GDP of last year – Real GDP of earlier year) / Real GDP of earlier year] X 100 %
The rise and fall of GDP over time is referred to as the business cycle. Phases of the business cycles are peak, recession, trough, recovery, and expansion (when economy has expanded beyond the initial peak). The U.S. economy’s longest growth period is from 1991 to 2001. From the second quarter of 2001, the U.S. economy has entered a recession. According to the statistics in the second quarter of 2002, U.S. is experiencing a growth rate of 1.1% annually.
The following table illustrates an example of the computation process of GDP and some other national accounts.