Unit 3 Aggregate demand and the multiplier model

3.3 GDP as expenditure: The components of GDP

Remember that when using the expenditure method of calculating GDP, it is only the spending on final goods and services by households, firms, government, and foreigners that is counted: the purchases by firms of materials and components as part of the production process are already included in the price of the final goods. Checking each row in the example in Figure 3.4 shows why the final expenditure method and the value-added method of calculating GDP give the same answer and how double-counting is avoided.

Thinking of GDP as total expenditure, we can separate it into different types of spending, by different groups. It is the sum of expenditure by households on consumer goods and services (consumption, \(C\)); by firms and the government on aggregate fixed investment in machinery and buildings, and on new housing (\(I\)); by firms on changes in inventories (\(II\)); by the government on goods and services (\(G\)); and by people in other countries (exports, \(X\)). Then, since GDP doesn’t include the expenditure of households, firms, or government on goods produced abroad, we need to subtract imports, \(M\).

Figure 3.5 shows these different components of GDP as measured in the national accounts for large economies on three different continents: China, Germany, Japan, the UK, and the US.

	Consumption (C) (%)	Investment (I) (%)	Government spending (G) (%)	Net exports (X – M) (%)
China	37.0	43.1	15.9	2.3
Germany	53.5	20.4	19.7	6.3
Japan	56.2	24.5	19.7	−0.5
United Kingdom	64.4	16.9	19.9	−1.4
United States	67.9	20.0	14.9	−3.1

Figure 3.5 Shares of GDP by main expenditure type (2010–2019 average).

OECD.Stat. OECD National Accounts (data accessed September 2023). Series used: Gross domestic product (expenditure approach). Shares may not add to 100 due to statistical discrepancies.

In summary, we can break down or ‘decompose’ GDP into its components:

\[\text{GDP} \equiv C + I + II + G + (X − M)\]

Note that when the GDP identity is presented, fixed investment and changes in inventories are often combined in a single term labelled \(‘I’\). We explain below why we separate out fixed and inventory investment.

We use the symbol ‘≡’ to emphasize that GDP is identical to the sum of these five components; this is not just an equation saying that the left- and right-hand-sides are equal in particular circumstances; it is an identity, telling us that the two sides are the same by definition. Note that (\(X − M\)) is often written with parentheses and referred to as net exports because what contributes to GDP is the difference between what is sold abroad and what is purchased from abroad.

Consumption (C)

consumption: Expenditure on consumer goods. Consumer goods include both short-lived goods and services and long-lived goods, which are called consumer durables.

Consumption includes the goods and services purchased by households. Goods are normally tangible things. Goods like cars, household appliances, and furniture that last for three years or more are called durable goods; those that last for shorter periods are non-durable goods. Services are things that households buy that are normally intangible, such as transportation, housing (payment of rent), gym membership, and medical treatment. Household spending on durable goods like cars and household equipment is counted as consumption in the national accounts, although as we will discuss later, in economic terms the decision to buy these long-lasting items is more like an investment decision.

The table in Figure 3.5 shows that in the high-income countries, consumption is by far the largest component of GDP, close to 70% in the US and over 50% in Germany. In contrast, it is only 37% in China.

Fixed investment (I) and changes in inventories (II)

fixed investment, gross fixed capital formation: In the national accounts, fixed investment, also known as gross fixed capital formation, refers to investment by firms and government in new capital goods (equipment and buildings), plus spending on new residential buildings. See also: investment.

Fixed investment \((I)\) is the spending by firms and government on new equipment and new commercial buildings; and spending on new residential dwellings, including by households. This is termed gross fixed capital formation.

inventory investment: Increases in the inventories held by firms are a form of investment, since they are assets that will bring a return to the firm at a later date. Decreases in inventories correspond to negative inventory investment (a reduction in assets). See also: investment, inventories.

In the national accounts an increase in inventories is counted as a form of investment because inventories represent assets, which like fixed investment, can produce a flow of income in the future—that is, when they are sold. Therefore, the change in inventories is often referred to as inventory investment, and abbreviated, as here, to \(II\).

inventories: Inventories are goods held by a firm prior to sale or use, including raw materials, and partially-finished or finished goods intended for sale.

Another item included in the expenditure measure of GDP is the output that firms produce, but do not sell, which leads to a change in inventories \((II)\), also known as stocks. This component is an important part of the calculation of GDP, because it ensures that statisticians reach the same number whether they calculate GDP using the production (value-added), expenditure, or income methods.

Fixed investment represents a higher share of GDP than does consumption in China (43%). Elsewhere it is much lower and about half as large as China’s share. Note that this data consists of the averages over the years 2010–2019. The component of changes in inventories is not shown separately because although it is a useful statistic for quarterly changes, it is negligible when averaged over many years.

Government spending on goods and services (G)

government spending: Expenditure by the government to purchase goods and services. When used as a component of aggregate demand, this does not include spending on transfers such as pensions and unemployment benefits. See also: government transfers.

This represents the consumption and investment purchases by the government (consisting of central and local government, often called ‘general government’). Government consumption purchases are of goods (such as office equipment, software, and cars) and services (such as wages of civil servants, armed services, police, teachers, and scientists). Note that government investment spending, which is included in \(I\), is on the building of roads, public hospitals, schools, and defence equipment. Much of government spending on goods and services is for health and education.

government transfers: Spending by the government in the form of payments to households or individuals. Unemployment benefits and pensions are examples. Transfers are not included in government spending (G) in the national accounts. See also: government spending.

You will often hear or read discussions of ‘government spending’ or, more loosely ‘the size of the government’ defined more broadly, to include government transfers in the form of benefits and pensions, such as Medicare in the US, or social security benefits in Europe. But crucially, government transfers are not included in \(G\) because households receive them as income: when they are spent, they are recorded in \(C\) or \(I\). It would be double-counting to record this spending in \(G\) too.

The share of government spending on goods and services \((G)\) is lowest in the US with China quite similar at 16%. The other three countries have a government spending share of just below 20%. But, remember, this figure excludes transfers (such as benefits and pensions). The greater difference in the role of the government between Europe and the US comes from these transfers. In 2019, total government spending including transfers was highest in France at 55.6% of GDP, compared to 38.1% of GDP in the US and 34.1% in China.

Exports (X)

Exports are the domestically produced goods and services that are purchased by households, firms, and governments in other countries.

Imports (M)

Imports are the goods and services purchased by households, firms, and governments in the home economy that are produced in other countries.

Net exports (X − M)

aggregate demand: The total of the components of planned spending in the economy: AD = C + I + G + X – M. It is the total amount of demand for (or planned expenditure on) goods and services produced in the economy. See also: consumption, investment, government spending, exports, imports.

trade balance: The value of exports minus the value of imports. Also known as: net exports. See also: trade deficit, trade surplus.

Remember that GDP is aggregate expenditure on the country’s domestically-produced goods and services. So exports \((X)\) must be added to \(C\), \(I\), and \(G\) when we calculate GDP. But since \(C\), \(I\), and \(G\) include expenditure by residents on both domestic and foreign-produced goods, we need to subtract imports \((M)\) to obtain the final total. The difference \((X - M)\) is called net exports, or the trade balance.

trade deficit: If a country’s imports exceed its exports, the trade balance (X – M) is negative, and we say that it has a trade deficit. The size of the deficit is M – X (the negative of the trade balance).

trade surplus: If a country’s exports exceed its imports, the trade balance (X – M) is negative. We say that it has a trade surplus of X – M.

In 2010, the US had a trade deficit of 3.4% of GDP and China had a trade surplus of 3.6% of GDP. The trade balance is a trade deficit if the value of exports minus the value of imports is negative; it is called a trade surplus if it is positive.

Question 3.2 Choose the correct answer(s)

Read the following statements about measuring GDP, and select the correct option(s).

Information about exports, but not imports, is necessary to calculate GDP.
Government production is not included in GDP.
Government consumption and investment is included in GDP.
GDP can be measured either as the total spending on domestically produced goods and services, or the total value added in domestic production, or the sum of all incomes received from domestic production.

Foreign demand for domestic production (exports) is a positive contribution to GDP, while home demand for foreign production (imports) must be subtracted to calculate GDP. So, information about both is necessary to calculate GDP.
Government and public services, for example, primary school education, are included.
Expenditure by the government to purchase goods and services is a component of GDP.
These three different measures of GDP are discussed in Section 3.2.

Question 3.3 Choose the correct answer(s)

Which of the following would increase GDP?

A decline in imports, holding all other components of GDP constant.
A rise in the stocks of unsold goods in the economy.
An increase in government spending on pensions.
A decline in exports.

Imports represent expenditure on foreign goods and services, so a decline in imports implies that a greater share of C, I, and G, which are assumed constant, is being spent on domestic production. Remember that GDP measures spending on domestic production.
This would be counted as changes in inventories (II), which is included in the GDP calculation.
Government spending on pensions is a transfer so does not count towards GDP.
A decline in exports implies reduced expenditure by foreigners on domestic production, so it reduces GDP.

Extension 3.3 GDP measured as value added, and national income

In this extension, we provide a more detailed explanation of the national accounts statistics covering the third method for calculating GDP and we introduce the concept of national income.

Having looked at the expenditure on national output and at incomes in the form of wages and profits that arise from the production of the output, we turn first to the production side itself. This takes us to the third method, which calculates the value added by the different sectors (agriculture, industry, services) in the economy and the industries that make them up. In the second part of the extension, we reveal more about how wages and profits are measured in the national accounts.

The national accounts are statistics published by national statistical offices that use information about individual behaviour to construct a quantitative picture of the economy as a whole. The momentum for creating standardized national accounts and quarterly forecasting came when governments needed to plan resource allocation following the Great Depression and the Second World War.

GDP as value added: Where is the GDP produced?

Since GDP is the total output of the economy, perhaps the most obvious way to calculate it is to add together the output of all its sectors. The broadest way of dividing the economy is between using the categories of agriculture, industry, and services. Initially agriculture was thought of as the most productive, or even the only productive, sector and Adam Smith, for example, took a poor view of the contribution made by services to the national economy. But the subsequent extraordinary growth of services brought a more even-handed approach: if the output of a sector is paid for then it contributes to GDP whether that output is steel or insurance policies.

As noted in the example of the production of a shirt used earlier, when adding up sector outputs to construct GDP, care has to be taken not to double-count. The relevant measure of the output of the car industry is the value added by the factors of production employed in the car industry to the steel and other inputs bought from other producers. Value added is estimated by subtracting the cost of such inputs from the sales price (at the factory gate) of the car. Similarly, the output of the retail sector is not just the total sum of all its sales, but that sum less the cost of all those goods bought in from agriculture and industry and from other service sectors such as accountancy.

Agriculture purchases inputs produced by ‘industry’ (drones and fertiliser, say) and by ‘services’ (provided by accountants and vets, for example). Industry purchases services inputs as well as agricultural inputs. Indeed the whole economy represents a complex web of transactions mapped periodically by statisticians in their input-output tables (I-O tables), which show transactions between a much finer range of subsectors than the big three listed above. These I-O tables are used to construct and make consistent the estimates of each sector’s genuine contribution to output—its value added.

Figure E3.1 shows the contribution of the major sectors of the economy to the total value added in the UK in 2021. Showing the data in millions of pounds in the first column is not very helpful—much more instructive is the second column where the proportion of total value added in the economy is expressed as a percentage. The latter format is useful when making comparisons across countries. From the Indian national accounts, for example, we learn that in 2022, 20.9% of gross value added comes from agriculture, 28.2% from industry, and the remaining 53% from services.

Sector	£ million	Percentage of the economy
Agriculture	18,618	0.8
Mining	26,458	1.1
Manufacturing	223,983	9.5
Utilities (electricity, gas, water)	79,013	3.3
Construction	143,067	6
Industry	472,521	19.9
Accommodation and food services	73,500	3.1
Education, health, and social services	334,548	14.1
Finance	197,572	8.3
Real estate, professional and support services	588,261	24.8
Public administration and defence	124,728	5.3
Information and communication	197,572	8.3
Trade and repair of motor vehicles	237,317	10
Transport and storage	93,391	3.9
Other services	70,114	3
All services	1,878,565	79.3
Total GVA	2,369,704	100

Figure E3.1 The output structure of the UK economy: sector contributions to GDP in 2022.

Office for National Statistics, ‘GDP Output Approach – Low-Level Aggregates’.

The table shows the domination of the UK economy by services, which contribute more than three-quarters of value added. Real estate, professional, and support services generate more value added than the whole of industry. Manufacturing in India is 15.4% of value added as compared with just 9.4% in the UK.

Most of the output of public administration and defence and (in the UK) the great bulk of the education and health ‘industries’ is not purchased in the market, but rather supplied to people either free or with minor charges. In such cases, the value added is simply taken as the wages paid to the civil servants, defence forces, teachers, and nurses—that is, the costs of production after accounting for input costs like armaments, school and hospital equipment, and pharmaceuticals bought in from other sectors. Little or no profit is generated in the publicly provided portion of these sectors.

GDP as income: Who gets the GDP?

All of the value added represents incomes of one sort or another. How these are divided among the classes—workers, capitalists, and landlords—was a major focus of the classical economists from Adam Smith and David Ricardo through to Karl Marx. Subsequently, the recipients were redesignated as the owners of the factors of production—labour, capital, and land. In practice, the various categories of incomes do not divide up into such a simple triad; the following table shows the presentation of factor incomes in the UK national accounts. This is gross domestic income.

Component	% of total
Compensation of employees	50.8
Gross operating surplus of private and public corporations	33.1
Mixed income	6.1
Taxes less subsidies	9.1
GDP (market prices)	100

Figure E3.2 The income structure of the UK economy (2021).

Office for National Statistics, United Kingdom National Accounts, The Blue Book 2022. National Accounts at a Glance, Table 1.2.
Note: The numbers do not add up to 100% due to a ‘statistical discrepancy’: at the national level, the three methods of calculating GDP give slightly different numbers. Statistical agencies need to conduct some adjustments (‘balancing’) to give a single estimate of GDP, which will naturally differ slightly from the estimate calculated using each method.

To interpret these numbers, we note first that all the categories of income are measured before payment of direct taxes. Therefore, income from employment is measured before subtraction of payments of income tax, social security (national insurance) contributions by individuals, and payments of pension and social security contributions by employers. The ‘operating surplus’ (profits of corporations, and so forth) are likewise reckoned on a pre-corporation tax basis. The point to emphasize here is that Figure E3.2 represents the ‘first-round’ distribution of domestic incomes; that is, before the direct impact of the government in altering the pre-tax patterns.

The figure for the operating surplus of corporations includes both privately and publicly owned corporations, in both financial and non-financial sectors. There is no attempt in the national accounts to show rent received by landlords as a separate category, largely because it is conceptually so difficult to separate a pure ‘rent’ on unimproved land from the return on investment in improvements, buildings, and so on. ‘Mixed income’ is so called because it represents the income of self-employed people whose income often comprises an element of ‘profit’ as well as what is in effect a ‘wage’ for the work done.

From the perspective of factor incomes, owner-occupiers of houses are deemed to receive an income reflecting what they would be paying on the rental market. Of course, in reality, not only do owner-occupiers not receive such rents, but they may be paying out as much or more than this in mortgage interest. Such imputed rents are notional—they do not represent an actual flow of cash incomes, but are still included to represent the value of the ‘housing services’ enjoyed by the occupiers.

Note from Figure E3.2 that, in the UK, income from employment constitutes nearly two-thirds of total incomes (the sum of the first three items), and the figure exceeds two-thirds if a plausible estimate of the wage element of ‘mixed’ (self-employment) income is added to the measured income from employment. Moreover, if the imputed rents on owner occupation are left to one side, on the grounds that they are notional incomes and not cash flows, then labour income represents some three-quarters of total cash income receipts before taxes. This underlines the importance of earnings from work in determining the living standards for most of the population.

Question E3.1 Choose the correct answer(s)

Read the following statements and select the correct option(s).

GDP can be calculated by adding up the output of all the sectors in the economy.
The value added of a product is calculated by taking the final value of output and subtracting the cost of inputs (intermediate goods).
Public services like education and defence contribute a much smaller proportion of total value added in the economy compared to other sectors because they generate little to no profit and are supplied either for free or with minor charges.
When measuring GDP using the income approach, we use the pre-tax incomes of individuals and pre-tax profits of firms.

Adding up all the sector outputs would result in double-counting because outputs produced by one sector could be used as inputs in another. Instead, we use a measure called ‘value added’, which avoids double-counting.
These transactions between sectors are mapped in input-output tables, which are then used to estimate each sector’s genuine contribution to output.
In these sectors, value added is the wages paid to civil servants minus the input costs. Figure E3.1 shows that for the UK, education, health, and social services contribute a larger proportion of total value added (14%) compared to other sectors such as finance (9.3%).
As shown in Figure E3.2, the income approach uses the ‘first-round’ distribution of domestic incomes, before the direct impact of the government in altering the pre-tax patterns.