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).
- 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?
- 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.