Topic 3: GDP Components and
Foreign Sector
PRINCIPLES OF
MACROECONOMICS
Dr. Fidel Gonzalez
Department of Economics and Intl. Business
Sam Houston State University
GDP components
Now, we will talk about the actual equation for GDP and its main components.
GDP can be obtained by looking at the spending patterns of households, firms,
governments and foreigners.
The following is the GDP equation:
GDP= C + I + G + NX
The equation above is the GDP equation and you MUST know this equation.
C=private consumption.
When a household buys a good or services to consume it, it is considered part of C.
I=private investment
When a firm buys machinery, equipments, software, etc, (including changes in
inventories) it is considered investment, I.
G = government spending
The payments of the local, state and federal government to professors, national
guard, etc. is considered government expenditures, G
NX = net exports
The goods and services sold and bought abroad are part of NX.
GDP components: Private Consumption (C)
Now we will cover one by one of the GDP components:
1)  C: private consumption
As mentioned before this refers to the purchases of final goods and services made
by private household. When you buy breakfast or a pair of jeans it counts as part of
C. As you can tell this is the most important component of GDP but it is also its most
stable component. In fact, C is about 71% of GDP.
C is divided into different components: services and goods. The following show the
most important categories of C.
C (71% of GDP)
Services
(67% of C)
Durable
(32% of Goods)
Services include payments for services like hair cuts,
lawyers, doctors, plumbers and so on.
Durable goods are things that last some time like
microwave ovens, refrigerators, appliances, cars,
computers, and so on.
Goods
(33% of C)
Non-durable
(68% of goods)
Non-durable goods are things that consumed almost
immediately like food, drinks, water, energy like
electricity, gasoline, natural gas, and so on.
GDP components: Private Consumption (C)
GDP components: Private Consumption (C)
GDP components: Private Consumption (C)
As mentioned before, C is the most stable component of GDP. This is in a way a
good thing because it allows us to measure GDP better.
But Why is C stable?
The main reason is that most people do not change their consumption patterns
because no one likes to live the high life one day and live under the bridge the next
day.
Moreover, people get used to certain consumption patterns and it is very difficult to
change.
This is called, consumption smoothing and we will say that households are
consumption smoothers.
GDP components: Private Consumption (C)
GDP components: Private Investment (I)
2) I: private investment
This refers to the purchases of goods and services by firms that are used to
produce something else in the future, like machinery and equipment. For example,
when a firm buys a computer it is considered investment. Investment also includes
the purchase of new housing by households.
Investment is the bad boy of GDP, it is very unstable, it changes year-to-year.
Investment was 12% of GDP in 2010 for the US.
Investment DOES NOT refer to put money in the bank of buy stocks or bonds, it
refers exclusively to purchases by firms of goods and services used to produce
something else (BE CAREFUL THIS IS A COMMON MISTAKE IN EXAMS)
I is also divided into different components.
I (12% of GDP)
Change in
Inventories
(4 % of I)
Fixed
Investment
(96 % of I)
Fixed Investment refers to purchases of machinery and
equipment, structures an software by firms. For
example a firms set up a new factory and buy a new
building then it is considered investment. Buys a new
software it is also investment.
If you buy a truck and use it for your business it is
considered investment but if you buy for personal use
then it is consider consumption. So, the purpose of the
good is what sometimes determines if it goes into C or I.
GDP components: Private Investment (I)
GDP components: Private Investment (I)
GDP components: Private Investment (I)
Change in Inventories is specially important because as can be positive or
negative. In 2009, the change in inventories was -1.2% of Investment. Moreover, it
can be a little confusing for some people.
What is Change in Inventories?
Imagine the following example about the number of cars sold and produced by Ford
during 2008 and 2009
2008
2009
Production
100
100
Sales
90
80
Inventories
(end of the year)
10
30
During 2008 Ford produced 100 cars but sold only 90, that means that 10 cars
stayed in the inventory. In 2009, another 100 cars were produced but only 80
were sold. That means that an extra 20 cars were added to the inventory.
First, lets get the change in inventories in 2009. Inventory went from 10 to 30,
that is the change in inventories was 20 cars and this 20 goes into the
investment for 2009.
GDP components: Private Investment (I)
But why do we account for those 20 cars into Inventories and eventually on
GDP?
Well, remember that GDP tries to account for production NOT for sales during a
specific time period. During a year you may buy products that were produced last
year and we do not want to account for those in this year GDP because they were
not produced this year.
Moreover, those 20 cars considered change in inventories were produced in 2009
but no sold but we still have to account for them because people and suppliers were
paid to produce those 20 cars.
Imagine that all the 80 cars sold in 2009 were purchased by a private household:
In that case in the GDP calculation we will have that C=market value of the 80
cars, BUT there were 100 cars produced that year!! Hence, we account for
those 20 cars by including them in the change in inventories. In that case
I=market value of 20 cars, so that:
GDP = market value of 80 cars (C) + market value of 20 cars (I)
And this exactly what we want in GDP: the market value of the production
during 2009
GDP components: Government Spending (G)
3) G: government spending
This refers to government spending in goods and services. This also refers to the
three levels of government: Federal, State and Local.
Government is an important component of GDP and represents the single largest
consumer in the economy. It is relatively stable because most of the government
spending is already committed. G is about 21% of GDP.
G is divided into the following categories.
G (21% of GDP)
State and
Local
Federal
(41% of G)
(59% of G)
Defense
(68% of Federal)
Non-defense
(32% of Federal)
Payment for highways, ports, teachers, government
bureaucrats, police, firefighters and so on are included
in G.
GDP components: Government Spending (G)
GDP components: Government Spending (G)
GDP components: Government Spending (G)
It is important to note that TRANFERS ARE NOT INCLUDED IN G.
Transfers are payment where the government does not get a good or a service in
return.
For example, if you get a $100 from your parents because it is your birthday, it is
considered a transfer because your parent do not get a good or service in return for
the 100 dollars.
When the government pays a teacher, it is considered G because they government
is paying for the services of the teacher.
The most important government transfers are the following:
Social Security, Welfare, Unemployment benefits, Medicare and Medicaid.
Why are transfers not part of G and GDP? Because transfers are reallocations of
income that has already being generated. For example, when an old person gets
the social security check that income was generated by another person and it was
counted on GDP then. Transfers are not production or generation of new income so
they do not count on GDP.
GDP components: Next Exports (NX)
4) NX: net exports
This refers to the transactions of good and services with the rest of the world. We
need a little bit of more notation:
M = imports (goods and services produced abroad sold domestically)
X = exports (goods and services produced domestically sold abroad)
Therefore net exports are: NX = X - M
NX was about -4% of GDP in 2010.
For example, if a person in France buy a Budweiser that was produced in the US
then it counts as an export. When you buy a Corona produced in Mexico counts as
an import.
When NX > 0 it is called a trade surplus because exports are greater than imports
When NX < 0 it is called a trade deficit because exports are less than imports
When NX = 0 it is called balanced trade because exports are equal to imports
The U.S. has had trade deficits for many years. Is this a bad thing? We will answer
that question later.
GDP components: Next Exports (NX)
GDP components: Next Exports (NX)
GDP Components: Examples
Example 1:
Question: A private person living in Huntsville buys a BMW produced in Germany for
$40,000. How is that counted in the U.S. and in Germany?
Answer: The purchase of the BMW goes into C because that is private consumption,
so C increases by $40,000. Also, the purchase of the BMW goes into imports (M), so
NX goes down by $40,000 because it is an import.
The total effect of the purchase on GDP is zero, because C increases by 40,000 but
NX decreases by the same amount. This makes sense because GDP wants to
account for the production in the US so the purchase of the BMW produced abroad
should not count on GDP.
For Germany, NX increases by 40,000 and GDP also increases by $40,000.
Example 2:
Question: A private person living in Italy buys a Budweiser produced in the U.S. for
$3. How is that counted in the U.S.?
Answer: The purchase of the Budweiser goes into exports because it was produced
in the US but sold abroad. Hence, NX increases by $3 and also GDP increases by
$3.
External Sector
Since we just talked about NX lets continue with the external sector.
In the previous slides I show that NX are negative, that means that the U.S. has a trade deficit.
This implies that we buy from foreigners more than what they buy from us.
How can we do this?
Consider the following diagram
Exports from U.S. to China =$ 2 billion
Exports from China to U.S. =$ 3 billion
External Sector
The U.S. sold to China $2 billion worth of goods and services, and China sold to the U.S. $3
billion worth of goods and services. There is a remaining $1 billion dollars that the U.S. has to
pay to China.
How can the U.S. do this? One option could be just to print more dollars and give those to
China. Most likely China will not accept cash because they do not want to buy more US goods
and services now.
A better option for China is for the US to give them an IOU. This implies that the US will pay
interest on the money US owes to China. Thus, the U.S. will issue an IOU to China to pay for
the $1 billion dollars we owe them. The IOU it usually takes the form of a Treasury Bill or a
Treasury Bond.
With this IOU the U.S. gets the extra $1 billion worth of goods and services that cannot pay
with its exports and China get paid with interest for those goods.
This shows that in order to pay for your imports an country has to pay either by selling goods
and services to that country (in forms of exports) or by selling assets to that country (in form of
IOUs).
External Sector
As mentioned in the previous slide you can either pay your imports with exports
or by selling you assets to foreigners (of both).
Exports from U.S. to China =$ 2 billion
U.S. gives China an IOU for $ 1 billion
Exports from China to U.S. =$ 3 billion