Economics 101 For the Political Junkie: Part 4a - Understanding Gross Domestic Product [183d]
Important Economic Equations
- GDP = C + I + G + (X - M)
- GDP = National Income (NI) + Indirect Business Taxes (IBT) + Net Foreign Factor Income (NFFI)
- NI = Wages + Rents + Profits + Interest
In The Beginning
THERE WAS GROSS DOMESTIC PRODUCT (GDP) or Net National Income (NNI); they are identical views of the same coin in that, in the long-run, GDP = NNI. GDP measures all the goods and services produced within the borders of a country plus new home construction. It is the value of the end products bought by households and businesses. It does not include "work-in-progress" (WIP) which is completed items waiting to be assembled into a final product or items still on the assembly line.
GDP is one of the gross measures used to determine how well a nation's economy is working. One rule of thumb used by many is that two consecutive quarters of negative growth in GDP might constitute a recession. While the details of GDP are quite complex, the fundamental concept is not. There are only four components to the GDP, Household Consumption (C), Government Spending (G), Business Investment (I), and Exports minus Imports (NX) or in equation form:
 GDP = C + G + I + NX
This simple little formula implies a lot. For example, if you hold consumer spending, business investment, and imports/exports constant, but reduce government spending, what happens to GDP? It theoretically goes down, doesn't it. Conversely, increase government spending and GDP should go up. The same, of course, would be true if you vary each of the other variables individually in a similar way.
I led with government spending because it has characteristic the others don't, taxes and deficit spending, to be more specific. Notice that neither are directly included here when we talk about increasing or decreasing G. But, of course, there is some indirect connection that MAY play in what happens to the other variables. Specifically, if taxes are raised in order to increase government spending, that MIGHT suppress some consumer spending or business investment or, it might not.
IN ORDER TO PROVIDE FULL DISCLOSURE I must admit there are more acronyms out there than GDP than attempt to measure the economic health of a nation. If you were taking notes, you can put down your pencils for moment as I only want to focus on GDP in this Hub. But, to name a few of these other metrics:
- NII - National Income Identity
- AD - Aggregate Demand
- AS - Aggregate Supply
- GDI - Gross Domestic Income
- GNP - Gross National Product
- GPI - Genuine Progress Indicator
- NDP - Net Domestic Product
- NDI - Net Domestic Income
- NNI - Net National Income
- NNP - Net National Product
To name a few. Fortunately, many of them are identities. For example NII = AD = AS = GDI = GDP ... in the long-run. NII, AD, and GDP all have the same formula (1), while GDI and AS have different ones, but end up with generally similar results. Likewise, GNP = GNI, again in the long-run, where GNP = GDP + income received from assets owned outside our borders - income lost from foreign-owned assets inside our borders. NDP and NNP are GDP and GNP less depreciation of capital assets, respectively. Finally, NDI and NNI is NDP and NNP + net foreign factor income - indirect taxes, respectively.
GPI, Genuine Progress Indicator, deserves special mention. The biggest criticism of all of the metrics just listed is that only measure one aspect of an economy, the production side, whether the product is a good or a service. There is much more to economic health, it is argued, then just that. It is best put in a speech by one of Senator Robert F. Kennedy's last speeches when he summed up the limitations of GDP.
“We cannot measure national achievements by GDP, since GDP includes air pollution, cigarette advertisement and ambulances to clear our highways after carnage. It counts special locks for our doors and jails for people who break them. GDP includes destruction of redwoods and of Lake Superior [which was dying at the time of the speech]. GDP grows with the production of napalm and nuclear warheads. It does not include the health of our families, the quality of their education, it is indifferent to the safety of our streets... In short, GDP measures everything except what makes life worthwhile.”(Kennedy, Robert F. Speech at University of Kansas, March 18, 1968. Accessed August 6, 2010, http://www.jfklibrary.org
Consequently. the GPI has been developed to quantify 26 measures which incorporate such things as the cost of pollution, the value of education, the value of household and volunteer labor, and the like to produce an alternative to the GDP.
Nevertheless, I must continue to concentrate on the GDP because that is what is commonly used in political debates today and is what the public is used to seeing even with all its flaws. What is needed, of course, if for the public to be fully aware of is what those flaws are.
Taxes and Government Spending Are Central to the Political Debate!!
WHEN YOU THINK ABOUT IT, THE GROSS DOMESTIC PRODUCT is the stand-in for most of the non-social yelling and screaming that goes on between the political Left and Right. The issues are always 1) what is the best way to keep GDP growth positive, 2) at what rate should GDP growth be maintained, 3) how is employment and GDP growth related, 4) what does one do when GDP booms or busts, and 5) what does the government do when GDP is influenced too much by net exports, to name a few. You, the reader of this Hub, may not know it, but the answer to all of those questions are in your hands when you slip your ballot into the ballot box ... or fail to do so at all, the worse possible choice because you just left your fate to others. And to make intelligent choices about which candidates to vote for, you need to "understand the territory" as "Professor" Harold Hill said in 1962 musical The Music Man. Otherwise, you are going to get schnookered. Therefore, it's the job of people like me to try to make an esoteric subject like economics understandable so that when a politician makes a claim, you can measure it on your own personal BS meter based on actual knowledge.
So, as you can see, coming to grips with the concept of GDP is fundamental to about everything else economic in the political debate. OK, to restate it, what GDP is supposed to measure about a nation is the aggregate "Demand" for goods AND services within the borders of a country, in our case, the United States and its territories. Now, I highlighted Demand as a separate thing from "Produced". Ford may have produced 100 cars, but if only 50 were sold, then the Demand was 50. Now, WHO demands domestic goods and services? Common sense should supply the answer to that, it would be:
- Household consumption (C)
- Business investment in plant, equipment, materials, and supplies to provide the goods and services that is not part of the "cost of goods sold" which is captured in the price of the good or service. (I)
- Domestic Government spending (G)
- Foreign government purchases (M) less our purchases from foreign sources (X), where X - M = NX
That's the whole of it. If somebody comes up with a new source of demand, then all that would happen is a new term would be added to the equation; but economists think they have it right, at the moment.
From here, we can add a little more understanding by considering what G, government spending is. Isn't that simply all sources of federal revenues (T) such as Taxes and use fees less transfer payments (Tr) and government savings (Sg)? (Government "savings" is a positive number when there is a budget surplus, like in the last part of Clinton's term, or a negative number when there is a budget deficit, like almost any other time in history.
Now, unlike Equation 1, where there was only one "hot button" term, "government spending", the last paragraph added three more: Taxes; Transfer Payments, e.g., welfare, social security; and Budget Deficits. These hit a bit closer to home, don't they? Why? Because, save for Budget Deficits, the rest effect you or someone you know personally and, as we will see, these are some of the tools government uses to effect GDP. Each side, Left and Right, have different ideas on what policies should be in place that control taxes, transfer payments, and budget surpluses/deficits.
GDP Writ Large
IN THE VERY LONG RUN, GDP GROWTH IS SIMPLY THE SUM of population growth and productivity growth, as you can see in Table 1; in the short-run, this is clearly not the case and that is what makes things interesting. Now population growth is easy to wrap your brain around, but productivity is another animal for it has several different definitions. The one that provides the most consistent measurement over long spans of time is dividing GDP by population which gives you "output per person". Another definition, which is used in manufacturing, which in today's world is often thought of as "productivity" is "output per hour worked". But consider trying to compare productivity change at a Ford plant from 2013 to 2014 with a farm from 1800 to 1801; as they say, it just doesn't compute. While "hours" in a plant may look like the same hours on a farm, they have different values in each environment. On the other hand, using total population makes things much more stable. And to cap my point, while non-farm labor productivity for the 53 years ending in 2000 was 2.2%, in line with the 1.9% annual growth in per capita GDP, the 13 years ending in 2013 also saw a 2.1% annual increase, which is far out of agreement with per capital GDP for that period. (The disparity will fade as time moves further away from the Great Recession.) However, when you add per capita GDP growth to population growth for each time stratification, you see they sum to approximately the real GDP growth. And THAT is VERY important.
It is important for several reasons; 1) Consumption accounts for 69% of GDP, 2) population growth is slowing (which has immigration policy implications), and 3) because GDP per capita growth is equivalent to labor productivity growth, improvements in technology are involved. It should be clear how these two ideas are intertwined in all four components of GDP Equation 1. Population growth or decline has a direct effect on consumption, both foreign and domestic, as well as employment levels which impacts supply. Technology drives changes in productivity which in turn affect price levels (supply and demand) as well as business investment. In one word, spaghetti (that is an attempt at dry humor).
GDP PER CAPITA GROWTH
1800 - 1900
1900 - 2000
2000 - 2013
- Personal Income (Y) = All income earned and unearned plus transfer payments less interest earned from government issued instruments
- Disposable Income (DI) = Y - T
- MPC = Marginal Propensity to Consume = MPCD + MPCM
- MPS = Marginal Propensity to Save = 1 - MPC = Sp
- MPCM = Marginal Propensity to Import
- MPCD = Marginal Propensity to Consume-Domestic
- ao = Consumption at zero income
- C = ao + MPCD * DI
- S = I
Consumption Is The Key
FIRST LET ME SHOW YOU HOW CONSUMPTION AND INCOME ARE RELATED, it will help, I hope, bring something abstract into real terms for you. The equation for aggregate consumption is (again, put down your pencil for a moment):
 ∑Individual Consumption = ∑(Demand with zero income + (marginal propensity to consume) * (Income + Transfer Payments - Taxes)) or ∑Ci = ∑(ai +MPC * (Yi + Tri - Ti)) where i = 1 to total population.
Today, MPC is about 0.97 in America meaning on average, each of us spends 97 cents of what we receive after paying taxes. Therefore, the savings rate, or marginal propensity to save MPS = 1 - MPC. Further, of the 97 cents that is spent, roughly 20 cents goes to foreign goods and services (imports) while the other 77 cents buys domestically made products and services. The ai term is what is needed to sustain life even if no income is earned or received. Now, again for full disclosure, I have to say this equation is a "first approximation" to the real, recently derived consumption function which is an order of magnitude more complex and adds nothing to the discussion.
What Equation 2 has going for it is the relative ease of understanding it and (you can pick up your pencils now) draw the link between the money you put in your pocket and then in someone else's pocket in exchange for a commodity or service you want to the rise and fall of GDP or the rise and fall of the health of the economy as a whole. Since GDP = C and a some other stuff and since C = Y and some other stuff, as Y, your income, grows, so does C and so does GDP.
Unfortunately, as we all just found out, the reverse is also true, Reduce Y, by laying 10 million people off, reduces C, consumption, which in turn kicks the legs out from under GDP growth to such an extent it becomes a decline ... instant recession or, if big enough, depression; if you didn't notice, ours was a hair's breadth away from being the mother of all depressions in 2008.
That is how your income is related to economic health. As a homework assignment, think about how getting rid of or increasing the minimum wage might affect GDP; be careful, there are more parts to that question than just income and consumption. We will move on to that next with Investment.
BUSINESS INVESTMENT IS THE 2nd TERM IN THE GDP EQUATION. It represents the Demand created when business buys all of the capital plants and equipment needed to produce or provide the domestic goods and services that are consumed. It also includes investments in inventories in anticipation of future sales as well as the "construction" and not sales of residential homes.
Like Consumption (C), Investment (I) is positively related to GDP. That means if everything else is held constant, if I goes up so does GDP, or said another way, if more money is invested in capital plants and equipments, then GDP can be expected to grow. If capital investmant slows down, all else being equal, GDP slows down. But realize, for there to be changes in capital investment, other aspects of the economy must have changed first, many of them psychological and political, to entice business people to change their well thought out plans.
While changes in consumer, government, and foreign spending may be much more random, irrational, unpredictable, and frequent, changes in investment isn't. This makes it a "lagging" term Something fundamentally must have changed in the others for there to be real change in investment. However, because investment is so stable, any noticeable change in it makes it a "leading" indicator of things to come, if that makes any sense.
Nevertheless, this term is probably the most abstract of the four for you because it has the least to do with your daily lives and it is extremely hard to relate to. Government spending, however, is not sense you are bombarded with angry rhetoric about it daily from the myriad of news outlets and political broadcasts.
GOVERNMENT SPENDING IS NOTHING MORE THAN that part of the various government budgets used to buy goods and services. It does not include transfer payments, salaries, and the like (those show up under consumption). It does, however, make up around 18% of GDP.
I shouldn't have to say anything more about government spending's role in GDP because like the others it is obvious that, all else equal, an increase in government spending means an increase in GDP and a decrease means a lower GDP, at least on the face of it. But there are two problems with this assertion, 1) those that don't understand economics and go on to claim government spending does not affect demand, and hence GDP at all and 2) spaghetti.
I get quite exasperated with those who try to defend the position that government purchases from the economy doesn't create demand which is then measured by GDP. That is a political view, not an economic one and is wrong by paradox; it is also a riddle. How can demand not create demand? (The answer: When it is politically expedient for it not to.)
The second reason, despite the funny name, spaghetti (which I used previously), is much more serious. The fact is, government spending is tied at the hip to a lot of other variables that directly or indirectly affect GDP itself. The reason is the source of the revenue the government spends is the income (Y) people and profits businesses make plus excise taxes and user fees. The size of those revenues are subject to the political winds and direct determine how much you have available to spend (C) or save. In another Hub, I show how aggregate savings equals aggregate investment, so now we have accounted for Investment (I) as well. I can also show there is an influence on net exports (NX) also.
These aren't the only noodles twisting around each other, you also have transfer payments of one sort or another as well as interest on the debt and the size of the debt that influence how much the government can actually purchase in any given year, not to mention emergencies and catastrophes. You know spaghetti.
So when you hear the panacea that simply cutting spending and taxes is the way to economic health, you can almost bet your life savings, the person telling you this doesn't have a clue what they are talking about because in reality, it is a delicate balancing act that requires technocrats, not politicians, to figure out.
Exports and Imports
THE FINAL TERM IN THE GDP EQUATION DEALS WITH EXPORTS AND IMPORTS. What this tries to capture is the demand on domestic production and service industry from foreign sources that transfers cash into the United States or Exports (E). Because the opposite happens as well (Imports - M), that must be subtracted from the total. What you have then is NX = (E - M). Today, that accounts for about -2.4% of GDP.
Because this factor is so small, I won't address it in the future discussion and assume it is zero for simplicity.
Getting Ready For The Next Part
I AM GOING TO STOP HERE WITH THIS PART other than give you a taste of what is to follow in the next Hub on what you can do with this new found knowledge. As I have mentioned, the terms of Equation 1 touch on almost every aspect of the political economic debate that affects your lives on a day-to-day basis. Understanding the "economic cycle" even at this top level is critical to you living the comfortable life you and your parents (and many grandparents) have experienced for your entire lifetimes. But, if you know someone who is 92 years old or older, ask them what it was like to live through the Great Depression, or someone in their mid-80s if they remember the mid-to-late 1930s. That was what life was like in America on a regular basis every 5 - 7 years until political decisions made in the 1930s on how to run the economics of the United States were put in place. By 2002, those monetary and fiscal decisions had been unraveled with devastating consequences.
In the next Hub, I will build on Equation 1, GDP = C + I + G + NX by bringing its relationship to income in more detail. For example, given we know Consumption (C) is approximately equal to ac + MPCdf * (Y + Tr - T) where ac = zero income demand and subscripts 'd', 'f' refer to domestic and foreign portions of MPC, then I can show what happens when Government Spending is cut, say, 10% or why tax cuts don't normally "stimulate" growth, but tax increases can.
Also, knowing that Savings equals Investments lets me explain why America's historic low savings rate generally hurts individual Americans by suppressing growth and therefore personal income. Further, besides GDP being equal to Equation 1, it is also equal to Wages + Rents* + Interest + Profits + Indirect Business Taxes + Net Foreign Factor Income + Statistical Discrepancy. ("Rents" is normally a very broad term but in this case means rental income less rental property depreciation). All of these terms sum up to income paid in the production of goods or in providing services for a given time period.
Likewise, I will be able to show by example the devastation being caused by the ever expanding income and wealth gaps that is wiping out the Middle Class and dragging down the economy as a whole. It is all of these real world issues that touch each and every one of you at your core. whether you know it or not, that should motivate you to find out more about this unfortunately esoteric field.
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