Understanding GDP Components: Consumption, Investment, and Government Spending

1. National Income Accounting Lecture 3

2. Outline The Components of GDP Measurement of national income • Expenditure Approach • Value-Added Approach • Factor Payments (or Income) Approach

3. The Components of GDP Consumption Investment Government Purchases Net Exports • Exports • Imports

4. Consumption Consumption, C The part of GDP purchased by households as final users • Spending by households on goods and services Largest component of GDP Includes estimations for • Food, fuel, clothes, haircuts, concerts, etc

5. Consumption Households buy but not part of Consumption: • purchases of new housing • Used goods • why exempted? • Stocks, bonds and land • Why exempted? Part of Consumption but households do not buy: • Total value of food stuffs produced on farms and consumed by farmers and families • Total value of housing services produced by owner-occupied homes

6. Private Investment Capital is one of four factors of production • Itself produced; used to produce other goods • Oil drilling rigs, cash registers, factories, etc • Capital stock • Sum of all capital goods in the country

7. Private Investment Investment defined as purchase of goods used to produce other goods • Capital formation Three components: • Business purchases of plant, equipment, and software • New-home construction • Changes inventory stocks • Goods that have been produced but not yet sold

8. Private Investment • Business purchases of plant, equipment, and software • Why not considered as intermediate goods?

9. Private Investment • Business purchases of plant, equipment, and software • Why not considered as Intermediate goods? • Intermediate goods used upin production of this year’s goods and services • Firm’s plants, equipment and software lasts for many years • Only a small part used to make up current production • Therefore, new plant, equipment and software regarded as final goods

10. Private Investment New Home Construction • Most new homes purchased by households • Why not included in Consumption?

11. Private Investment New Home Construction • Most new homes purchased by households • Why not included in Consumption? • Residential housing an important part of country’s capital stock • Measure of Private Investment should correspond with increase in nation’s capital stock

12. Private Investment Changes in Inventory • Inventory: Goods that are produced but not yet sold • Goods on store shelves • Goods making their way through the production process in factories • Raw materials waiting to be used • Count changes in firms’ inventories as part of investment in measuring GDP

13. Private Investment If do not include, could underestimate total production of goods and services in a year Scenario • In a year, automobile industry produced $100bn worth of automobiles • $80bn sold to customers • Remaining unsold $20bn added to inventories • If count consumption alone, we underestimate total production Contribution to GDP is $80bn(consumption) + $20bn(private investment)= $100bn

14. Private Investment What if Inventory stocks declineduring the year? Scenario • Automobile industry produced $100bn this year, but sold $120bn • Extra $20bn must have come from inventory stocks • Excluded. Why? Total contribution to GDP $120bn(Consumption) + [-20bn(Private Investment)]= $100bn

15. Private Investment Inventory added to nation’s investment because unsold goods part of a nation’s capital stock • Provide services in the future when finally sold and used An increase in inventories • Increase in nation’s capital stock A decrease in inventories • Decrease in nation’s capital stock

16. Private Investment • Excludes • Government investment • Police cars, courthouses, fire stations, schools, etc • Consumer durables • Fridges, computers, washing machines, etc • Human capital • Additional skills and training acquired by workforce during the year • E.g. surgeon, electrician, police detective, etc • Ignores depreciation • Capital used up during the year • Other measures of total income

17. Government Purchases Spending by state and local governments on goods and services Government Investment • Capital goods purchased by government agencies • Roads, hospitals, schools, etc Government Consumption • Spending on goods and services that are used up during the period • Salaries of gov’t workers, computer paper for gov’t offices, fuel for gov’t vehicles, electricity used in gov’t building, etc

18. Government Purchases Includes goods and services • Goods • Fighter jets, police cars, school buildings • Services • Performed by police, legislators, military, etc

19. Government Purchases Distinction between government purchases and government outlays Outlays= purchases + transfer payments Does not include transfer payments • Any payment that is not compensation for supplying goods, services or resources • Money redistributed from one group of citizens (taxpayers) to another (the poor, the unemployed, the elderly) • Example: unemployment insurance benefit, welfare payments, money disbursed to homeless shelters, etc • Why not included?

20. Net Exports Net exports, NX = Exports - Imports • Exports • Spending on domestically produced goods by foreigners • Imports • Spending on foreign goods by domestic residents

21. Measurement of national income Expenditure Approach Value-Added Approach Factor Payments (or Income) Approach

22. The Expenditure Approach Add up value of the goods and services purchased by each category of final user GDP= C + I + G + NX

23. GDP and Its Components: Expenditure Approach This table shows total GDP for the U.S. economy in 2009 and the breakdown of GDP among its four components. When reading this table, recall the identity Y = C + I + G + NX.

24. Other Approaches to GDP The Value-Added Approach The Factor Payments/ Income Approach

25. The Value-Added Approach In the Expenditure approach, • Count goods and services only when sold to final users In Value-added approach, • Add up each firm’s contribution to a product as it is produced A firm’s contribution to a product is called its value added

26. The Value-Added Approach to GDP • Value added • The revenue a firm receives minus the cost of the intermediate goods it buys • Sum of value added by all firms in the economy

27. Illustrating the Value-Added Approach Ghc2.25 (notebook paper) Ghc1.00 (Wood Chips) Ghc1.50 (raw paper) Ghc3.50 (Notebook paper) Ghc5.00 (Notebook paper) Lumber mill Paper mill Office Supplies Manufacturer Wholesaler Retailer Production of a ream of notebook paper: Ghc(1+ 0.5 + 0.75 + 1.25 + 1.50) = Ghc5

28. Another Illustration:Value Added Approach Suppose there are 5 stages in getting a suit manufactured and into the hands of a final consumer

29. The Factor Payments/ Income Approach • Sum of factor payments earned by all households in the economy • factor payments made by firms • Factor payments • Payments to the owners of resources that are used in production

30. The Income Approach Domestic Income • Total income earned by residents and businesses in an economy There are four (4) components • Employees compensation • Rents • Interests • Profits

31. The Factor Payments Approach Compensation to employees • Wages and salaries paid to individuals • Fringe benefits • Makes up a largest proportion of national income

32. The Factor Payments Approach Rents • Income received by households from properties that they own • Income received by firms from properties that they own form part of profits • Rent component of GDP may be small if depreciation is high in a particular year

33. The Factor Payments Approach Interest • The income that private businesses pay to households that have lent the business money e.g. purchase of stocks • Interests paid to firms also show up in profits

34. The Factor Payments Approach Profits • The amount that is left over after compensation to employees, rents and interest have been paid out

35. Other Approaches to GDP Why use more than one method to calculate GDP? • Measurement errors

36. Problems With GDP • Quality changes • The underground economy • Nonmarket production

37. Quality Changes Analysts record an increase in GDP only if there is an increase in the quantity of a good or service produced • New pen that lasts four times longer than previous version should cost 4 times as much! • GDP analysts record some quality changes (cars, computers); not all • Reason: Budget constraints GDP underestimates the true growth in output from year to year

38. The Underground Economy Some production hidden from government • Illegal (drugs, prostitution) • Tax avoidance • Underestimation of true production in economy

39. Non-Market Production Excluded • Housecleaning • Sewing • Lawn mowing • Child rearing Whenever non-market transactions become market transactions, GDP will rise, even though total production is the same Over last century, much production shifted from home to market • Parenting to day care • Home-cooked food to takeout • Talking to a friend to therapy • Neighbour watching your house to alarm system • Real GDP increases although production has not • Exaggerate growth in GDP over time

40. In-class questions What components of GDP (if any) would each of the following transactions affect, and in what direction? • A family buys a new refrigerator • Aunt Naana buys a new house • You buy fufu and goat lightsoup • Ghana repaves the Tema Motorway • Your parents buy a bottle of Nigerian gin

41. ‘Take-home’ questions Calculate the total change in a year’s GDP for each country in each of the following scenarios: • General Electric uses $10m worth of steel, glass and plastic to produce its dishwashers. Wages and salaries in the dishwasher division are $40m; the division’s only other expense is $15m in interest that it pays on its bonds. The division’s revenue for the year is $75m. • You win Ghc25,000 in the Ghana lottery. Ever the entrepreneur, you decide to open a washing bay, buying Ghc15,000 worth of equipment from China and Ghc10,000 from Makola market.

42. Next Class Measures of National Income Real GDP vs. Nominal GDP • Mathematical illustration Limitations of use of GDP as measure of individuals’ welfare