There are several different methods of calculating an economy’s GDP. Theoretically, all the different techniques should give you the same number, but that’s rarely the case due to the massive amount of data that needs to be dealt with in addition to all the points in the process where errors can creep in. That being the case, the real world results still tend to be pretty similar to each other.
Last, but not least, we arrive at the expenditures approach to calculating GDP. Conceptually, this probably the easiest method to wrap your head around. We’ll be referring back to this a lot later on down the road. This method is on the opposite end of the spectrum from the income approach. The income approach looks at all the wages, rents, interest, and profits earned by producing an item while the expenditure approach looks at all the money spent on purchasing an item. We can compute GDP by summing up the economy’s total spending in four areas: personal consumption, investment spending, government purchases, and net exports.
Personal Consumption Expenditures (C)
This category sums up all the money that is spent by households, regular people like you and I, on goods and services. Buying groceries, buying a new car, eating out at a restaurant, all these things fall under the category of personal consumption. It’s denoted in the GDP equation by a C.
Investment Spending (I)
When economists talk about investment, they generally aren’t referring to the financial transactions people normally think of. They’re not talking about buying and selling stocks and bonds or saving money in an account. When we talk about investment, we’re referring to the money spent by firms (businesses) on capital goods, changes to a firm’s inventory, and the construction of buildings. Investment is denoted in the GDP equation with an I. [break]
Side Note: Inventory
Remember that GDP accounts for all goods and services produced in a year, regardless of whether or not anything was sold. Changes in inventory is how the expenditures approach accounts for unsold goods (positive change in inventory) or goods sold in excess of the year’s productions (negative change in inventory) so that GDP doesn’t become understated or overstated. [break]
Side Note: Construction
All construction is counted under investment when using the expenditures approach to calculate GDP. This is because buildings are considered to be capital, even residential homes and apartments. A home owner has the option of leasing out his home and creating rental income from it, just like a factory or equipment or any other capital good.
Government Purchases (G)
The government spends a lot of money providing public services (education, firefighters, military) and publicly owned capital (schools, parks, roads). The money they spend on these public goods, services, and capital counts towards GDP and is recorded under government purchases. Not all of the government’s spending is included here though; remember that public transfer payments are not a part of GDP. Government purchases are denoted with a G.
Net Exports (NX)
Goods and services that are produced don’t necessarily all stay in their home country; some of it may get sent abroad. In other words, these goods and services are exported (exports is denoted with an X). Since those goods and services are produced domestically, they need to be added to GDP. At the same time, we don’t obtain all of our goods domestically, we get some of it abroad. In other words, we import goods and services (imports is denoted with an M). The three previous categories, personal consumption, investment spending, and government purchases don’t distinguish whether or not those expenditures were domestic or foreign. They’re just the total sum of expenditures in each category. To avoid overstating GDP, we have to subtract out the amount that we import. To make things simpler on ourselves and so we have fewer numbers to deal with, we lump up our international trade expenditures into one category, net exports which is defined as exports minus imports. Net exports is denoted with an NX.
Thus, the expenditures approach to GDP can easily be summed up with a simple equation: GDP = C+I+G+NX.
McConnell, Campbell R., Stanley L. Brue, and Sean Masaki. Flynn. Macroeconomics: Principles, Problems, and Policies. Boston: McGraw-Hill Irwin, 2009. Print.
Next economics post: Nominal GDP vs Real GDP
Previous economics post: Calculating GDP: Income Approach
All works here are my own and are considered works in progress and may be subject to change at any time. The opinions expressed here are mine only unless otherwise noted. I am not being paid by a third party to endorse a product of any sort. These writings are written for my own references. I do not claim to be a professional of any kind so follow any information you find here at your own risk. The facts that I post on here are things that I believe to be true, but may not necessarily be so. This is the internet; do your own fact checking and take everything with a grain of salt.