Understanding the GDP

This module has 4 optional quizzes worth a total of 13 points. Your total will be tracked as you work though the module.

The Formula for the GDP

GDP is a measure of all the goods and services produced domestically. Therefore, to calculate the GDP, one only needs to add together the various components of the economy that are a measure of all the goods and services produced.

Many of the goods and services produced are purchased by consumers. So, what consumers spend on them (C) is a measure of that component.

The next component is the somewhat mysterious quantity "I," or investment made by industry. However, this quantity is mysterious only because investment does not have its ordinary meaning. When calculating the GDP, investment does NOT mean what we normally think of in the case of individuals. It does not mean buying stocks and bonds or putting money in a savings account. When calculating the GDP, investment means the purchases made by industry in new productive facilities, or, the process of "buying new capital and putting it to use" (Gambs, John, Economics and Man, 1968, p. 168). This includes, for example, buying a new truck, building a new factory, or purchasing new software. This is indicated in the Money Flow diagram (below) by an arrow pointing from one factory (enterprise) to another. In essence, it shows the factory "reproducing itself" by buying new goods and services that will produce still more new goods and services.

The next component is E, or the difference between the value of all exports and the value of all imports. If Exports exceeds imports, it adds to the GDP. If not, it subtracts from the GDP. Thus, even if a nation's people work very hard to produce products for exports, but still import more than they export, the nation's GDP will be negatively impacted. This is one of the reasons trade deficits are frequently a political target. Because the balance of trade can be either positive or negative, we can rewrite the equation, showing the components of E, using X for Exports and M for Imports:

You may see the formula for the GDP written this way, and it may be easier for you to remember in this format.

The final component is G. The government buys (with your tax money) goods and services (G). These purchases are a measure of those goods and services produced. Be aware that many people make the mistake of thinking that the money paid in taxes and spent by the government is "lost" and therefore subtracts from the GDP. Tax money may indeed be spent inefficiently but this fact has no bearing on the calculation of the GDP.

Refer to the next page for a more complete explanation of the how the components of the GDP interact with each other.

Money Flow in the GDP

Study the Money Flow diagram below. Place the cursor over the arrows. Only the black arrows are components of the GDP. Other arrows indicate the direction of money flows that may influence the GDP.

Everything produced domestically ultimately comes from individual workers -- that is why the worker takes "center stage." The arrows indicate money flows to or from the worker.

Note that income (salary, hourly wage) is NOT part of the GDP. Activities of the worker that effect overall production ARE part of the GDP. If you produce something that is sold overseas, it represents income to the country you live in. Exports are therefore added to the GDP. Imports have the opposite effect. If you buy something made in a foreign country, your country has an expense, so it is subtracted from the GDP.

Assuming that all other factors remain the same, what is the effect of raising taxes on the GDP? (3 points)

Value: 3

Understanding the Role of Personal Savings

Now, let's look at the role played by personal savings. The Money Flow diagram indicates that personal savings (what we normally call "investment") is actually a source of revenue for industry. This is because the money you put in the bank is loaned to businesses so that they can put it to work. Money NOT circulated in this way -- the money you stuff in a mattress -- would actually be subtracted from the GDP. For the most part, however, people do not put money in mattresses and the bank system uses the personal savings of individuals to give industry its reservoir of money to work from. This is why economists say that the amount of Savings is always going to be approximately equal to the amount available for Investment.

Savings and Investment can become out of balance when there is more demand for investment money than what is available from domestic savings. In that case, more money is borrowed from foreign sources.

Because additional Savings has the effect of supplying more money to industry, some economists have argued that if we want to correct the negative effect of the trade deficit (since it is subtracted from the GDP), we should encourage Savings, which will indirectly boost Investment.

Administrators in Country X are receiving complaints from industry leaders that they cannot expand because banks do not have enough money to lend. As an initial course of action, Adminsitrators should... (3 points)

Value: 3

Take the Calculation Quiz

This quiz has been used by schools and individuals around the world. It requires you to understand the basics of GDP calculation. You do not need a calculator, although it may be useful. (6 points)

Value: 6

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