Lecture 21

The GDP can be looked at as either the total expenditure on domestically produced final goods/services or the total income earned by domestically located factors of production.
We can calculate the GDP in three different ways: output (the sum of value added in each sector), income, and expenditure.
The expenditure components of GDP are consumption, investment, government spending, and net exports.

• Consumption \(\text{C}\) is the value of all goods and services purchased by households. It comprises of
  • durable consumer goods (life span more than three years),
  • non-durable consumer goods (life span at most three years), and
  • services (mental or physical help). This does not include purchase of new housing. We can choose to include education in this or in the next section.
• Investment \(\text{I}\) includes
  • business fixed investment (spending on plant and equipment that firms will use to produce the other goods/services),
  • residential fixed investment (spending on housing units/structures by consumers and landlords), and
  • inventory investment (the change in the value of all firms’ inventories).
    The purchase of new housing is the one housheold expense that is categorized as investment instead of consumption. Investment is basically spending on new capital. This investment is not the same as the usual financial usage of the word.
• Government purchases \(\text{G}\) includes all government spending on goods and services. It includes salaries of government workers and spending on public works. It excludes transfer payments (like unemployment insurance payments) because they are not in exchange for currently produced goods and services. Transfer payments can be thought of as negative taxes.
• Net exports \(\text{NX}\) is equal to \(\text{EX}-\text{IM}\), where \(\text{EX}\) is the value of total exports (foreign purchases of domestic goods) and \(\text{IM}\) is the value of total imports (domestic purchases of foreign goods).

An important identity is:

\[\text{Y} = \text{C} + \text{I} + \text{G} + \text{NX},\]

where \(\text{Y}\) is the value of total output (GDP). The expression on the right is the total expenditure.

A stock is a quantity measured at a point of time. For example, a person’s wealth and the government’s debt are stocks.
A flow is a quantity measured per unit time. For example, a person’s annual savings and GDP are flow measures.

Price is the common unit using which we can measure other expenditures.

GDP is essentially an aggregate of price\(\times\)quantity.
The nominal GDP is the result when we use the price and quantity belonging to the same year.
The real GDP is the result when we fix a certain base year and use the price of that base year (we use the quantity of the year we are calculating the GDP of).
Since real GDP is not affected by changes in prices, it reflects the economy’s production of goods and services.

GDP can also be seen as the net value added across firms – we do not count the final goods because that would be double counting. This is the calculating of GDP using the output method that we mentioned earlier.