Federal Reserve Bank of St. LouisPage One Economics Newsletter:"GDP: Does It Measure Up?"

After reading the article, answer the following questions.

• An economy's GDP is broken down into several components. Which is the largest?
• Why is real GDP a better measure of economic growth than nominal GDP?
• Why is growth important?
• Explain why GDP is better suited to measure economic output and growth than well-being.
• What are some economic activities that are not included in GDP because they occur outside formal markets?

The expenditure method for calculating GDP divides spending into four categories: consumption, investment, government spending, and net exports.

Components

1. Consumption (C).This is consumer spending on final goods and services, such as food, education, computers, gasoline, and medical expenses. Notice that only " final" goods and services are countedthese are goods and services sold to the end user. Intermediate goods are those that are used in the production of goods and services. While not counted directly, the value of an intermediate good (e.g., a car windshield) is reflected in the price of the final good (a new car) or service (a replacement windshield). This is the largest component of GDP; it represented 71 percent of total spending in 2012.

2. Investment (I).This is business spending on capital goodstools, equipment, and buildings. A business in- vestment might be a firm upgrading its computer system, buying a new forklift, or adding to its fleet of delivery vans. To be clear, "investment" in this sense is not about buying stocks and bondseconomists refer to this activity as saving. Investment spending refers to the purchase of physical capital. Changes in inventories, which are stocks of goods and raw materials held to facilitate business operations, are also counted as changes in investment. One last category counted here is construction of new structures such as factories and new homes. This component represented 13.1 percent of total spending in 2012.

3. Government spending (G).This is spending by all levels (federal, state, and local) of government on goods and services. This component includes salaries of police and firemen, weapons for the military, and infrastructure spending on new highways and bridges. It does not include spending on Social Security or unemployment benefitsthese are considered transfer payments. Spending on transfer programs is measured when the money is spent by the recipients on goods and services. This component represented 19.2 percent of total spending in 2012.

4. Net exports (NX).These are calculated as exports (X) minus imports (M). Mathematically, this is expressed as NX = X - M. Exports are goods and services produced in the domestic (or home) country for consumption in another country. Imports are goods and services produced in another country for consumption in the home country. Imports are subtracted so goods produced elsewhere are not counted as part of GDP. So, when you buy an imported pair of shoes, the value of the shoes is counted as part of consumption (C); subtracting the value as an import (M) ensures that only domestically produced goods and services are counted as GDP. For example, in 2012 exports totaled $2,185 billion, while imports totaled $2,719 billion. So, net exports ($2,185 billion - $2,719 billion) equaled -$534 billion. Because this number was negative, in terms of GDP, net exports represented -3.3 percent of total spending on domestic output in 2012.1

These components can be arranged into a formula that can be used to calculate changes in GDP, with "GDP" on one side of the equal sign and the variables added together on the other side of the equation. To be clear, this is nominal GDPit is not adjusted for inflation. The formula is as follows:

GDP = C + I + G + (NX).

Remember that an equation includes two statements that are equal, so a change on one side must be reflected by a change on the other side. Therefore, a change to any of the variables on the right side of the equation (C, I, G, or NX) must be reflected by an equal change on the left side (GDP).

For each of the following spending decisions, explain how the affected variable (C, I, G, or NX) would change (increase or decrease in terms of dollars), and how the change in spending would affect the level of total GDP (increase or decrease in terms of dollars).

• The federal government decides to invest $1 billion in the nation's interstate highway system.
• Widgets Incorporated spends $15 million to expand a factory and buy new tools and equipment for its workers.
• Consumers cut spending by $20 billion.
• The state government cuts planned highway spending by $30 million to maintain a balanced budget.
• Changing currency values cause consumer spending on imports to increase by $300 million.
• A recession results in job losses. As a result, government spending on unemployment benefits increases by $10 billion.

PAGE ONE Economics the back story on front page economics NEWSLETTER May-2013 GDP: Does It Measure Up? Scott A. Walla, Senior Economic Education Specialist 'Z's'at everything that counts can be counted. and not everything that can be counted counts." .Albcrt Einstein We can measure our national progress in many ways. But even if we restrict our measure; ment to the economyand set aside social. cultural. and political progress for a momentthe total value ofthe goods and services produced in the economy can be mind-boggling. Think of all the goods {shoes1 oranges. computers...) and services (haircuts. doctor visits. car repairs...) produced in the United States. Even more intimidating is trying to capture that production in a single number. One common and fairly comprehensive measure is gross domestic product {or GDP}. which is a statistic calculated by the US. Department of Commerce: it measures the total market value ofall nal goods and services produced in an economy in a given year. Simply put1 GDP measures the size of the economy. It is among the most important and widely reported pieces of economic data. A. variety of people. from business owners to policymakers. use GDP in their decisions. And. while the National Bureau of Economic ResearchL uses a comprehensive method ofdetermining the phases ofthe business cycle. the general rule of thumb says um consecutive quarters ofnegative real GDP constitutes a recession. In short. GDP is central to our understanding ofthe state of the economy. What happens to the goods and services produced? US. consumers. businesses. and the government4nd those same groups in foreign countries-buy them. The largest portion of GDP is consumer spending. the money you and ] spend on goods and services. This portion has grown from 59 percent ofGDP in 195] to its current level ofjust over 3-1] percent. Because spending on output by one group of people becomes income for others. GDP can be described in terms of either expenditures or income. The bookkeeping system used to calculate GDP is referred to as national income accounting. Let's Get Real Even though GDP is a valuable measurement tool. prices are used in calculating the value ofoutput. This causes difculty with calculating changes in GDP over time because an increase in GDP could mean any ofthe following: {i} The country has produced more goods and services. (ii) The country has produced the same amount of goods and services1 but the prices of those goods and services are higher. 0: (iii). some combination of higher production levels and higher prices has caused GDP to increase. lfwe want to use GDP to measure the "real\" increase or decrease over time in the level of nal goods and services produced. we must remove the effect of price changes from the data. Therefore. real GDP controls for inflation and more accurately reects actual economic growth. When economists discuss GDP. they are usually referring to THUL UNL ECONOMICS Federal Reserve Bank of St. Louis 2 NEWSLETTER Gross Domestic Product, 1 Decimal [GDP) Real Gross Domestic Product, 1 Decimal [GDPC1) 16,000 14,000 12,090 10,OOD 8,000 [Billions of Dollars] , (Billions of Chained 2005 Dollars] 6,000 4,000 1940 1950 1960 1970 1980 1990 2000 2010 2020 FRED Shaded areas indicate US recessions. 2013 research. atlouisfed.org NOTE: The graph shows nominal GDP (red line) and real GDP (blue line). The difference between the two lines is the effect of inflation on the market value of output. The lines intersect in 2005 because the data use 2005 dollars to adjust for inflation, so the real and nominal values of GDP were the same in that year. The shaded areas indicate recessions as determined by the National Bureau of Economic Research. SOURCE: Federal Reserve Bank of St. Louis FRED (http:/research.stlouisfed.org/fred2/graph/?q=gWU). real GDP. When GDP is presented in its unadjusted form, it is often labeled nominal GDP (see the chart). Growth Is Good, but Is It Everything? Just as your parents measured your growth by comparing your height today with your height last year, economists measure economic growth by comparing real GDP over time. Economic growth is usually presented as a percentage increase or decrease from an earlier period. For example, it might be useful to know that nominal GDP in the fourth quarter of 2012 was $15.864 trillion, but it is probably more meaningful to know that real GDP increased by 0.4 percent from the fourth quarter of 2011 to the fourth quarter of 2012; in other words, the economy grew, but only by a fraction of 1 percent. To put that number in context, real GDP has grown at an average annual rate of 3.3 percent since 1950. Economists expect some slowing of future U.S. GDP growth as the labor force grows more slowly. The Federal Open Market Committee has projected real GDP growth of 2.3 to 2.5 percent (central tendency)? in the longer run.3 Why is economic growth important? A growing economy produces more goods and services for its population, including more health care and education. And, generally speaking, more is better. But greater production of goods and services is only one factor that contributes to well- being. Many meaningful aspects of life cannot be quantified in GDP. An evening walk on the beach or an afternoon playing Frisbee in the park may bring you satisfaction; in fact, you might value either activity greatly. But GDP does not include the kind of value that Robert Kennedy referred to when he said, "The gross [domestic] product does not allow for the health of our