As we mentioned earlier, GDP can be calculated by either adding up all of the expenditures on goods and services produced in the economy or by adding up all of the income received by labor and other inputs in the economy. These are the expenditure and income approaches to calculating GDP.
The Expenditure Approach
The expenditure approach involves counting expenditures on goods and services by different groups in the economy. The four main components are consumption expenditures by households (C), gross private investment spending principally by firms (I), government purchases of goods and services (G), and net exports (exports minus imports EX - IM). Here is an equation that sums it up:
GDP = C + I + G + (EX - IM)
Let us look at the following table:
As you can see, expenditures can be broken down into the four components given in the equation above. The largest is personal consumption spending by households on final goods and services. Households can buy durable goods, those that last for some period of time, such as motor vehicles and furniture, as listed in the table. In addition, households can purchase nondurable goods, which are goods not intended for long-term use, such as food, clothing, and gasoline. Households also purchase services, which are actions rather than physical items. Examples of services range from medical care, car repairs and other transportation expenses, to haircuts and tax preparation services.
The second largest component of GDP consists of purchases by federal, state, and local governments on final goods and services. These purchases include spending on schools, roads, and military hardware. In addition, the wages of government employees are included because such employees are performing services in exchange for those wages. This category does not include income transfers, such as Social Security payments to retired persons, unemployment compensation, or welfare payments.
REALITY CHECK: We hear so much about the size of the Social Security program and how much is spent on welfare; so why arent they counted in GDP? Well, they are its just that they are not counted in the G part. These monies are counted in C when their ultimate recipients spend them. Do you see that counting them as part of G would result in double counting?
Investment spending comprises the third largest component of GDP. The table shows that there are also three main types of investment spending. The first is nonresidential investment spending by firms on machines, factories, tools, office buildings, and similar expenditures. Residential investment consists of expenditures by households on new houses, condominiums, and apartment buildings. Business inventories are goods that firms produce in one time period with the intent to sell later. You will see later that it is very important to note that inventories count as part of business investment!
It is also important to distinguish between gross investment, which is the total value of all newly produced capital goods produced in a given period, and net investment, which is gross investment less depreciation. Depreciation is a measure of how much of the existing capital stock has been used up.
REALITY CHECK: Heres an example. Suppose you were buying a used car, and suppose that there were two cars available for sale that were the same in every way, except one had much more mileage on it. Wouldnt that one sell for a lower price because it was more used up? Thats what we mean by depreciation, that assets get used up. They can also become obsolete.
The smallest component of GDP is net exports. The expenditure approach includes the value of exports, goods produced in the United States and purchased in other countries. The value of imports, the purchases by United States citizens of foreign-produced goods, is subtracted from the value of exports. Notice in the table above that the result is a negative number; this means that imports must have been greater than exports.