In our last post, we set up the importance of GDP as a concept, not just in economics, but actually in politics and therefore in the messaging that plays out in the media around these topics. Today we will look more closely at how GDP is actually calculated.

Accounting for Change

Although GDP is meant to calculate economic growth, it only partly does so. You can’t measure the actual growth of every part of the economy just by the prices and volumes of goods and services. Products and services never stay exactly the same, regardless of money spent.

For instance, GDP doesn’t account for changes in product quality. If a product doesn’t change in cost or units sold but improves or worsens in quality, GDP remains the same. For example, if lawn mowers are of lower quality next year, causing more breakdowns, has the economy really stayed the same?

If Coca-Cola switches from cane sugar to corn syrup, making it less healthy and tasty, GDP remains unchanged, even though the product quality has decreased.

Growth and Bubbles

Products are the easy part. New TVs are usually shinier than the old ones. If you’re willing to pay more for a better TV, GDP rises. If Coca-Cola switches back to real sugar and you pay more, GDP increases. That’s simple.

However, services also change in quality. A restaurant with better sales but worse service doesn’t improve the economy. GDP doesn’t address this.

Governments often assume that if the economy grows and more money is spent, progress is happening. Sometimes that’s true, but not always. The 2008 financial crisis showed that too much economic activity can lead to trouble. Bubbles form, over-investment happens, and massive economic collapses can occur.

Some experts argue that GDP drops can be beneficial. Continuous economic expansion without “corrections” can prevent real improvements. Historical financial crises show that unchecked growth can lead to disaster. Even slow, steady growth can mask problems in the economy, negatively impacting lives. If everything seems great, there’s no incentive for improvement, like Coca-Cola not switching back to cane sugar.

The Limits of GDP

Governments may not change policies if GDP is growing. In the US, steady GDP growth has hidden stagnant worker pay despite rising productivity. Workers contribute to economic growth but aren’t paid much more for it.

Credit: Economic Policy Institute

These trends aren’t popular in political campaigns, as leaders focus on GDP growth. Yet GDP, as a general measure, has significant disadvantages. It simplifies a complex world into a single number, losing much that matters to people.

GDP doesn’t indicate if you feel safer, freer, or more financially secure. It can’t tell you that. It doesn’t show how most people are doing financially year to year. GDP doesn’t care if products and services are bought by one person or many. If the number goes up, the economy grows, according to GDP.

It doesn’t reveal societal changes, only if the number rises.

Knowing GDP’s limits, let’s explore what it can and does tell us.

*Nominal GDP is adjusted for inflation, so price inflation alone doesn’t increase GDP.

The GDP Formula

Now for some fun—math!

This formula is simple but not easy to calculate. In the US, the Bureau of Economic Analysis provides official estimates. Most countries calculate GDP similarly:

GDP = Spending + Investment + (exports – imports)

This is further broken down into private and public spending and investment.

In sum, GDP is calculated by accounting for all consumption (end use of a product or service), capital expenditure (buying things to use), and the net sum of imports and exports (how much you buy from other countries vs. how much they buy from you).

Plug this data into the equation, make adjustments, and you get a single number. For the US, that’s about $30 trillion.

Or is it?

Three Approaches to GDP

Figuring out what counts and what doesn’t can be tricky. If I buy equipment, is it expenditure or investment? If I use a credit card, is it expenditure, or is the issuer “investing” in me? And what about a teacher’s wages? Do we count them in GDP or only what they spend?

Calculating GDP is complicated because it involves deciding what contributes to GDP and what doesn’t. Understanding the economy means looking at how people live and in what conditions.

GDP must be rigorously calculated using one of three methods: The Output Method, the Income Method, and the Expenditure Method.

Each method tells a different story about the economy, measuring activity, value, and growth differently. Not every method captures the same trends, so all should be considered. If a politician highlights one, it’s wise to look at the others too.

Let’s go over each method, see how they’re calculated, and look at real-life examples. As you’ll see, GDP growth may not always align with the kind of growth politicians and the media talk about.

The Output Method

The Output Method focuses on the value of products and services being made or “produced.” The idea is that if the economy is producing more things or providing more services (or higher-value ones), the economy is growing. This method also includes things we don’t buy or sell but are still valuable, like real estate.

Output−Intermediate goods and services+Taxes on products−Subsidies\text{Output} – \text{Intermediate goods and services} + \text{Taxes on products} – \text{Subsidies}

Generally, growing GDP by output signals that an economy is growing, and output tends to decline during recessions, making it a popular measure, especially in good times.

Key Categories:

• Production: The value of everything produced in a given period, not just what is sold.
  • E.g., My avocado farm produces 1 million avocados worth $1 million wholesale. This contributes $1 million to GDP, whether sold or not.
  • I give guitar lessons for $40 an hour. 100 hours = $4000 in GDP.
• Private Consumption: The market value of something you make and use yourself.
  • E.g., I grow and eat an avocado. GDP contribution = $2 (store price).
• Retail Trade: The difference between the cost of something a retailer sells and what the retailer paid for it.
  • E.g., I buy an avocado for $1 and sell it for $2. Total GDP contribution = $2.
• Taxes on Products: Sales tax, VAT, import duties, etc.
  • E.g., The consumer buys $10 worth of avocados and pays $1 in taxes. $1 is added to GDP.
• Rent: Money paid to a landlord.
  • E.g., I rent an apartment for $1000 a month. This contributes $1000 to GDP.
• Imputed Rent: The value of something you don’t pay for but has a market value.
  • E.g., I inherited an avocado grove worth $2000/month in rent. This counts as $2000 of GDP.
• Government Spending: Costs of services, wages, and materials.
  • E.g., A public school teacher’s salary counts towards GDP. A new park costing $1 million adds $1 million to GDP.
• Subsidies on Products: Money paid by the government per unit of production, subtracted from GDP.
  • E.g., The government pays me $0.01 per avocado. I receive $10,000, so -$10,000 in GDP.

The output method is good for measuring the economy’s production ability. However, it doesn’t account for consumption directly and may lead to overproduction and inefficiencies.

The Income Method

The Income Method calculates GDP based on the pre-tax sum of wages, rents (including imputed rents), interest, and profits, instead of counting goods and services produced.

Included Categories:

• Gross Profit: Money made after costs like materials and wages.
  • E.g., Microsoft’s sales and other income in 2023 = $230 billion. Costs = $81 billion. Gross profit = $146 billion, adding $146 billion to GDP.
• Wages: All compensation of employees, pre-tax.
  • E.g., Salaried employee wage, benefits, retirement contributions, tips, bonuses, perks.
• Taxes on Products: As before, we include VAT and subtract product subsidies.

The income method provides information on how sectors, professions, and companies contribute to the economy. It also captures the contribution of small businesses and professionals not typically paid a wage. However, it doesn’t tell much about efficiency or productivity.

The Expenditure Method

The Expenditure Method measures how much is spent on goods and services, including consumer spending, government spending, and capital expenditure.

Key Categories:

• Consumer Spending: Almost everything people buy with their money (including rent).
  • E.g., Buying $200 worth of avocados, paying rent = $12,000/year, going to a movie = $20.
• Net Expenditure by Government: Total value of services provided by the government.
  • E.g., Fire department rescue = $1000, public housing rent difference = $1000, public school education cost = $10,000 per student/year.
• Capital Expenditure: Investments in new buildings or equipment.
• Exports: Sum total of exports (minus imports).

The expenditure method gives a clear picture of economic contributions by spending and investments. However, it doesn’t provide much information on the health of specific professions but gives insight into the retail sector’s health.

Types of GDP Contribution (Nerdy Version)

To understand how GDP actually grows, let’s look at real examples of consumption and investment and see how they affect GDP. GDP growth happens through various means, including capital expenditures, production, value added, and labor. Let’s examine a simplified theoretical example to demonstrate these principles:

Investment Phase

Suppose Millennial Suzy opens an avocado toast cafe. She borrows $10,000 from the bank.

Suzy spends $5000 on furniture and equipment, signs a lease for $500 a month plus a $500 deposit, and buys $3000 worth of Hass avocados.

So far, Suzy’s venture has contributed:

• $5000 for furniture
• $3000 on supplies
• $500 in rent

Before even opening, Suzy has contributed $8500 to GDP. Her loan payments and the initial loan are not part of this calculation. The loan is counted at the beginning in full, and the rent is counted as expenditure (if the landlord uses it to pay off a mortgage, it stops adding to GDP).

Production

Production is about the value of commodities like avocados that a person or company produces. Commodities are base goods that can be turned into most of what we buy, such as plastics, food, water, and metals.

Let’s imagine Suzy buys $3000 in avocados from a local farm. The farm’s contribution to GDP is $3000.

Value Added

In her second month, Suzy opens her cafe and sells $7000 worth of avocado toast and coffee. She buys another $3000 in supplies, pays her rent, makes a loan repayment, and pays $500 in utility bills.

In her second month, Suzy contributed:

• $7000 in goods sold – $3000 in cost of goods = $4000
• $3000 in new supplies
• $500 in utilities
• $500 in rent

Adding it all up, Suzy has contributed $8000 to GDP this month. We don’t double count the $3000 in supplies already counted last month. We only add the final value of the goods sold. If the value doesn’t change, like if Suzy sells at cost, there is no added value and no GDP bump. Selling at a loss does not reduce GDP.

Suzy’s business, from an initial $10,000 investment, has generated $16,000 in unadjusted GDP growth. This is not profit but economic growth.

Labor

As Suzy’s business grows, she hires Zoomer Tom, paying him $1000 a month for part-time work (after taxes). While wages and taxes aren’t counted as GDP growth immediately, they are when spent. When Tom spends his $1000 on loafers and a vinyl record, that contributes $1000. Government taxes spent on projects also add to GDP.

Suzy’s overall contribution is about $17,500.*

Key Takeaways

• Investment Phase: $8500 contributed before opening.
• Production: Contribution from commodities like avocados.
• Value Added: Contribution from added value on top of supplies.
• Labor: Contribution from wages and subsequent spending.

Kudos to Suzy, and remember to appreciate farmers!

Next Time…

Next on this series, we’ll take a deeper dive into how GDP calculations are turned into government policies, and what can than mean for you in the near future.