The final goods approach to measuring gross domestic product (GDP)

Jay Kaplan explains the final goods approach to measuring gross domestic product (GDP) on the Colorado University website:

Unit 6 - Components of GDP - Final Goods Approach

Consumption (C)

The consumption of goods and services falls under one of the following categories:

Durable goods - The consumption of durable goods is considered similar to a consumer investment. Durable goods are purchased with the intention of keeping them for a sustained duration of time. Examples of durable consumer purchases include washing machines, refrigerators, automobiles, and toaster ovens.

Nondurable goods - In contrast to durable goods, nondurable items have a shorter life span. An example of a nondurable consumer purchase is groceries. The life span of the typical food is short, especially compared with the refrigerator (durable item) in which perishable foods are kept. Other examples of purchases that are considered nondurables include newspapers, magazines, clothing, and hats (which are always flying off with the wind).

Services - Since the 1960s the fastest growing component of consumer purchases has been the area of services. Services include medical treatment, lawyers, and dry cleaners.

Investment (I)

Businesses and corporations undertake investment activity that involves the purchase of goods which themselves assist in the production process. The categories of investment are:

Business Investment - This includes the actual purchases of goods used in the production process. Business investment includes the construction of new offices and factories, and the purchase of machinery, computers, and any other equipment used to assist labor in the production of goods and services.

Business investment counts as gross investment, which includes purchases of machinery to replace worn-out equipment. If a firm replaces one machine with another that does not increase output, then nothing is added to the nation's economy. To correct for this, net investment can be used, which subtracts out depreciation of existing capital from the gross (total) business investment made by firms.

Residential Construction - This part of overall investment tracks the actual construction of housing, not the sale of homes. A new home that is built during a given year is counted in that year's GDP, while the purchase of a previously owned house has already been counted in the GDP of the year it was constructed. In this way, only those residences that add to the overall housing stock count towards GDP.

Changes in inventories - Firms invest in inventories, which are produced goods held in storage in anticipation of later sales. Firms also stockpile raw materials and intermediate goods used in the production process. Goods held in inventories are counted for the year produced, not the year sold.

Although inventories are a relatively small portion of the overall investment sector, inventories are a critical component of changes in GDP over the business cycle. If the economy is slowing down, possibly entering a recession, the bearer of the bad news will often be an undesired accumulation of inventories. As consumers reduce their purchases, sales of goods and services slow, inventories build up, and firms slash production (laying off employees) to reduce unwanted (and costly) inventories.
This last point is worth emphasizing because of its relationship to the business cycle which will be discussed in Topic 4. Inventories can be considered a part of a group of leading indicators of business cycles. By leading indicator, we mean that changes in a variable such as business inventories can lead to changes in the future condition of the economy. To explain the linkage between changes in the level of business inventories in many economic sectors and economic growth, let us consider two cases: an undesired accumulation of inventory, and an undesired decrease in business inventories. We will look at the economy as a whole.

The economic impact of an undesired accumulation or increase in business inventories. Businesses plan ahead and forecast future sales. Based on their expectations, they stockpile inventories of goods the expect to sell in the near future. The reason is simple. Businesses want the goods available to meet customer demands or else they will lose the sale, and most likely lose it to a competitor. If there is a slowdown in consumption in many economic sectors, then many businesses will not sell as many goods as they had planned to. As a result, businesses will not sell off their inventories of goods as they had planned and inventories will accumulate.

When inventories accumulate due to a decrease in consumption, businesses respond by reducing orders of goods from producers. In turn, as producers face a cutback in demand for their goods, they will decrease output. When inventories are accumulating in many sectors of the economy, reductions in the production of goods becomes widespread, and as firms reduce their output, many workers are laid off. As payrolls are reduced, the number of unemployed swells and the unemployment rate rises. With the reduction in output, GDP growth falls and if the drop in production is sharp enough, the economy goes into a recession.

The opposite occurs with an undesired or unanticipated decrease in inventories. If demand for goods are greater than businesses had forecast, inventories will be rapidly depleted. As firms restock their inventories and adjust for a higher level of sales, they increase their production. Increases in output requires firms to employ more workers. If this is occurring throughout the economy, the unemployment rate will fall as more individuals find jobs and economic output will increase. This leads to a jump in economic growth as measured by GDP.

The surge in demand for goods and services as well as the responding hike in production and employment comes at a possible cost. As more jobs are created, incomes rise, further contributing to an increase in the demand for goods and services. The potential result is a rise in the inflation rate due to demand-pull effects. Demand-pull inflation results from price pressures caused by rising demand for a good. In addition, cost-push pressures may also lead to greater inflation. As firms increase their output and demand for labor, wages may rise, especially if the economy was already near or at full-employment. Higher wages increase production costs that may be passed on to the consumer in the form of higher prices for goods.
The important point made here is that although inventories are a relatively minor component of GDP, rapid changes from their desired levels can have important economic consequences. When inventories accumulate beyond desired levels, an economic slowdown may be on the horizon as producers reduce their output. Or if inventories are rapidly being depleted, then economic growth and possibly inflation may soon rise as wage and price pressures build. Economic analysts monitor the divergence of inventories from desired levels as a leading indicator of potential changes in future economic growth rates.

Government Spending (G)

The government sector tracks what the government actually spends money on. Government purchases of goods and services include stealth bombers, government-funded research, space shuttles, salaries, and toasters. Many of these items are seldom sold in markets; as a result, they are valued at the price the government pays for them. The calculation of government spending for GDP purposes excludes several tremendous categories of actual spending: transfer payments, which redistribute income primarily to individuals who are potential consumers, and interest payments on the debt.

Last updated January 15, 1999

The supply-side argument that tax cuts induce businesses to increase investment and create jobs.

A business does not need a tax cut to create a job. A rational business manager will hire a worker if that person generates more additional income than what he or she is paid in wages, salary, and benefits. Similarly, business investment will occur if the perceived future revenues exceed the expected costs.

Subsides can be used to increase private investment in factories or equipment. But they may be of no more benefit than similar expenditures by government entities. Any increases in physical capital can be of future benefit to the economy, whether in the form of government subsidies to private businesses or direct government purchases for public investment.

Factory workers do not lose their jobs because of the lack of a factory, as supply-side theorists might suggest. It is insufficient demand for their products that causes the job losses.

See also "Recessions & Depressions: Questions & Answers."

How Monetary Policy Affects the Economy

How Monetary Policy Affects the Economy

Monetary policy is conducted in the United States by the Federal Reserve System (the Fed), which is the U.S. central bank. A central bank is an institution that oversees the banking system and regulates the quantity of money in an economy. The Fed influences the economy by changing the money supply and interest rates to either increase or decrease aggregate demand (AD), which is overall spending on newly produced goods and services. When the Federal Reserve conducts monetary policy, it may increase or decrease the money supply depending on the condition of the economy.

Expansionary monetary policy occurs when the Federal Reserve System induces commercial banks to increase the amount of money they create through loans. Thus, expansionary monetary policy increases the money supply. If the economy needs stimulation (e.g., to fight unemployment), then the Fed usually conducts expansionary monetary policy to increase the money supply, reduce interest rates, and encourage more consumption and investment spending. Low interest rates encourage households and businesses to borrow money. If they use this borrowed money to increase spending on consumer products (C) and investment (I) in capital equipment, inventories, and structures, then aggregate demand increases. Aggregate demand is composed of consumption spending (C), investment spending (I), government purchases (G), and net exports (X-M).


AD = C + I + G + X - M


Contractionary monetary policy occurs when the Federal Reserve System induces commercial banks to decrease the amount of money they create through loans. Thus, contractionary monetary policy decreases the money supply. If the economy needs dampening (e.g., to fight inflation), then the Fed usually conducts contractionary monetary policy to decrease the money supply, increase interest rates, and discourage consumption and investment spending. High interest rates discourage households and businesses from borrowing money. If higher interest costs reduce spending on consumer products (C) and investment (I) in capital equipment, inventories, and structures, then aggregate demand decreases.

Strategies for Controlling Inflation

Strategies for Controlling Inflation

1. Break the cycle of expectations. This helps to control cost-push inflation.
2. Reduce the costs of production. This helps reduce cost-push inflation.
3. Reduce aggregate demand. This helps to control demand-pull inflation.

AD = C + I + G + X – M
where:
AD = aggregate demand
C = consumption
I = investment
G = government purchases
X – M = exports – imports = net exports = NE


Objective to help achieve low inflation
Fiscal policy
to achieve this objective
Monetary policy
to achieve this objective
Break the cycle of inflationary expectations.
Anything that convinces the public that the government is committed to reducing inflation.
Anything that convinces the public that the Federal Reserve System is committed to reducing inflation.
Decrease the costs of production.
Anything that reduces costs of production. Increasing the world supply of oil, for example, would reduce production costs for many industries.

Reduce aggregate demand.
Decrease government purchases or increase taxes. Since government purchases are a component of aggregate demand (and GDP), reduced government spending will reduce aggregate demand directly. Higher taxes leave workers and businesses with less disposable income. This leads to a reduction in consumption and investment spending, which are two of the components of aggregate demand.
Decrease the money supply to increase interest rates. Higher interest rates discourage borrowing. This causes a decrease in consumption and investment spending, which are two of the components of aggregate demand
Table 3. Using fiscal and monetary policies to achieve low inflation.

GDP data: C + I + G + X - M

Gross domestic product is the total value of final goods and services produces in the economy in a given time period (usually a year).

Gross Domestic Product = Consumption + Investment + Government Purchases + Exports - Imports

GDP = C + I + G + X - M

The Economic Report of the President provides U.S GDP data since 1959.

Table B-1 (Gross domestic product) provides nominal GDP data. They are not adjusted for inflation.
Table B-2 (Real gross domestic product) provides GDP data adjusted for inflation.

In both tables, consumption (C) and investment (I) data appear on the first page of the Excel spreadsheet. The data for government purchases (G), exports (X), and imports (M) are provided on page 2 of each spreadsheet.