5.4: GDP and Spending

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Martin Medeiros
Chabot College

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What sort of relationships can be seen when examining GDP data? One extremely important relationship is that of spending and income. GDP is the total market value of all final goods and services produced within a nation’s borders in each time period. You can also define GDP as the sum of all spending on final goods and services produced in the U.S. Since GDP is the value of all spending, it makes sense that this spending generates all income. The prices used in calculating GDP are supposed to pay for all the inputs (e.g., labor, land, physical capital, etc.) used to bring that good or service to market. In other words, one person’s price is another’s income.

We can group the types of spending on goods and services into four broad categories:

Consumption (C)
Investment (I)
Government (G)
Net Exports (NX)

Consumption represents spending by households on goods and services. It is the largest component of GDP and includes expenditures on durable goods (like cars), nondurable goods (like groceries), and services (like healthcare).

Consumption is broken down in the following manner:

Goods: Spending on physical items, such as clothing, electronics, or furniture.
Example: Buying a new laptop.

Services: Spending on intangible activities, such as education, entertainment, or haircuts.
Example: Paying for a gym membership.

Investment refers to spending by businesses and households on goods that will be used for future production. This includes business infrastructure, residential construction, and changes in inventories.

Consumption is broken down in the following manner:

Nonresidential Fixed Investment: Business spending on equipment, machinery, and structures.
Example: A company purchasing new manufacturing equipment.

Residential Fixed Investment: Spending on the construction or improvement of housing by households or firms.
Example: Building a new apartment complex.

Inventories: Changes in unsold goods held by businesses, which can be positive or negative depending on whether inventory levels increase or decrease.
Example: A car dealership increasing its stock of vehicles.

Government spending includes expenditures by federal, state, and local governments on goods and services. It excludes transfer payments like Social Security.

Government spending is broken down in the following manner:

Federal: Spending by the federal government on defense, infrastructure, and public programs.
Example: Federal funding for highway construction.

State: Expenditures by state governments on education, healthcare, and transportation.
Example: State funding for public universities.

Local: Spending by local governments on services like police, fire departments, and public schools.
Example: A city building a new public library.

Net exports represent the value of a country's exports minus its imports. If exports exceed imports, NX is positive; if imports exceed exports, NX is negative.

Example: Selling U.S.-made machinery to a foreign country (export) while importing electronics from abroad (import).

It is common to relate the value of all output to the total spending with the following identity:

A diagram of a flowchartDescription automatically generated

Figure 2

This spending method to total GDP is referred to as the expenditure approach. Consumption expenditure is by far the largest component of GDP. The Bureau of Economic Analysis (BEA) is the governmental agency tasked with responsibility of compiling GDP data. The following table comes from the BEA web site (www.bea.gov) and it provides details on real gross domestic product by expenditure category.

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Table 2

What if spending on goods and services is less than the value of output? Let us say $100 of output was produced and only $90 of that total was sold in the market. This means that $10 worth of merchandise went unsold. That is when inventory investment comes into play. That $10 of unsold output will be logged as a change in the level of business inventories. It is also important to note that some inventory accumulations are intentional, and some are unintentional. In either case, the value of output produced (GDP) will equal total spending (C+I+G+NX).

Using GDP to Analyze the Housing Market (example)

Existing Home Sales ROSE by 7.4% in November 2009 to 6.54 million, compared with market expectations for a smaller increase to 6.25 million. This lifted sales to their highest level since February 2007.

The sale of existing homes rose 44.1% above their year ago levels. However, they were still 9.8% below their September 2005 record high. More than one-half of all sales were estimated to be first time home buyers, spurred by low prices and the home buying tax credit from the government. Another one-third of sales were estimated to be distressed ones.

Based on the news about November Existing Homes Sales (and only the Existing Homes Sales), what impact do you think this will have on 2009 GDP?

2009 GDP will increase.
2009 GDP will decrease.
2009 GDP will show an increase in C but a drop in I
There will be no effect on 2009 GDP.

Explanation: “Existing homes” is another way of saying used homes. Since the purpose of GDP is to measure the amount of new production within a nation’s borders each year, it does not make sense to include the sale of used goods in the total. Sales for used goods were counted as part of GDP in the year in which they were produced.

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