Keeping score is important. If you are trying to lose a few extra pounds, stepping on the scale from time to time allows you to evaluate your performance. In school, teachers assign grades to assess students’ level of understanding. In baseball, statistics on nearly every aspect of the game are used to determine the pitchers and the batting order. Data and statistics are useful for making informed decisions. During World War II, the U.S. government wanted to better understand the economy’s ability to generate the necessary materials for the war effort. This led to the development of gross domestic product (GDP) as a means of measuring economic output. GDP is important today as an overall indicator of economic performance.
Gross domestic product (GDP) measures the total value of all final production that occurs within a country during the course of a year. GDP is also a measure of annual spending on new domestic production and a measure of income earned from domestic production. To better understand GDP, consider the following example. Assume a simple economy made up of Frank and Louise. Lately Frank has been complaining about the cold weather, so he offers Louise $1 to knit a blanket. Louise jumps at the opportunity to make a buck and commences knitting a new blanket. Upon completion, Louise exchanges the blanket for the dollar. In this simple example, what was the value of the economy’s spending, income, and output? The answer is $1. The $1 spent by Frank was earned by Louise in exchange for the knitted blanket. In 2015, U.S. GDP was $18.12 trillion, because considerably more than one knitted blanket was produced.
GDP is not the only measure of economic performance that has been employed. You might remember GNP, or gross national product. The key difference between GDP and GNP is a single preposition. GDP is a measure of all new production that is done in a country during the year, while GNP is a measure of all new production that is done by a country during the year. Toyotas made in Texas are part of U.S. GDP, but not U.S. GNP.
GDP is not static. Instead, GDP is a flow. Imagine a bathtub with a running faucet and open drain. The water flowing from the faucet is GDP, the water accumulating in the tub is the wealth of the nation, and the water exiting the drain represents an outflow like depreciation. As long as the GDP exceeds outflows of wealth, the wealth of the nation grows. Essentially GDP measures that production that is new and is not a measure of accumulated wealth.
In the circular flow model, the economy has three primary sectors: private, public, and foreign. The private sector is further divided into households and businesses. Each sector contributes to the gross domestic product. Households provide the factors of production that businesses use to produce goods and services. In addition, government provides the public goods not provided by the private sector. Furthermore, the foreign sector acts as a source of the factors of production as well as a source for goods and services. The foreign sector also functions as a market for domestic production.
GDP is represented in three ways in the circular flow model. The goods and services that business and government provide represent the value of all domestic production. The spending that the private, public, and foreign sector adds to the circular flow represents total spending. Finally, the rent, wages, interest, and profits earned in the factor market are a nation’s income.
GDP includes much economic activity but not all of it. As a measure of production, GDP does not include purely financial transactions. When you purchase shares in the stock market, only the broker’s commission would be counted in GDP. This is because the purchase of stock represents a transfer of ownership from one shareholder to another, and neither a good nor service is produced. Similarly, transfer payments like Social Security are not computed in GDP. Social Security payments are not made in return for the production of a new good or service, but instead represent a transfer from a taxed wage earner to a recipient.
Production for which no financial transaction occurs is also excluded from GDP. A stay-at-home parent who cares for the children, cleans the house, cooks, and runs errands certainly produces something of great value, but because no monetary payment is made, the value is undetermined and excluded. Interestingly, paying someone to do all of those activities would be included in GDP. Building a deck on your house, mowing your own grass, and changing your own oil are all services that can be purchased, but when you perform them for yourself, they are not included in GDP.
Apartment and house rent is included in consumption, and therefore GDP. Homeowners and mortgage payers do not pay rent, so the BEA imputes a rental payment on their housing. Whether you are an owner or a renter, when it comes to GDP, everyone is a renter.
To avoid overstating GDP, resale and intermediate production is excluded. Most home purchases are not counted in GDP. The resale of homes does not represent new production and is excluded. The only time home purchases are included is when the house is newly constructed. The primary reason resale is not counted is to avoid double-counting. Older homes were included in a previous year’s GDP. Consider the sale of flour, butter, and sugar to a bakery that produces fresh bread. If the purchase of ingredients were included in GDP along with the sale of the fresh bread, the GDP would be overstated. To avoid this, GDP includes only final production of the bread. The price of the bread includes the earlier cost incurred in acquiring the ingredients.