Quantifying all the money being moved around the economy is difficult. It requires understanding the will of households, firms, governments, and foreign markets. To pull off such a trick, we’d need near perfect knowledge.
Such omniscience is impossible. So, our solution is to provide a macroeconomic model for all the money being earned or spent on all final domestic goods and services.
Measuring a Nation’s Income
Gross Domestic Product (GDP) serves as the measurement of the income or expenditures of a nation, the calculation of money transferring hands, and a comparison of national efficiency and wealth. As an economic indicator, it gives us an idea of a nation’s welfare by giving it an income, and comparing it’s earning and spending powers to previous fiscal calendar quarters. Investors and economists looking to interpret the data can find releases from the Bureau of Economic Analysis.
Stocks and Flows
Thinking about GDP means categorizing all things in the national economy as either stocks or flows. Stocks are a quantity we measure at a specific point in time. Flows are that same quantity measured over a specific period of time. These numbers give us two distinct ways of measuring GDP:
- Looking at the prices of goods with inflation (nominal GDP); and,
- Looking at the prices of goods without inflation (real GDP).
When nominal GDP is higher than real GDP (it usually is), there is a rate of inflation within the economy. We measure this with the Consumer-Price Index (which finds how prices have changed over a specific quantity or flow variable) and the GDP Deflator (which finds how quantities have changed over a specific price or stock variable). Then we take the best of both worlds and average the two together. This is known as the Fisher Index.
(Note: all numbers are presented with seasonally-adjusted averages.)
The Income Approach and the Expenditure Approach
A nation’s total income is added up in two different forms:
- the income approach; and,
- the expenditure approach.
The income approach measures a nation’s income by the amount of money made within the country. The expenditure approach measures by the amount of money spent within the country. Either approach should theoretically yield the same amount.
The Income Approach Breakdown: W+P+R+I+T
The income approach is found through all money earned by firms and households. This includes:
Wages – Monies earned by households through business payrolls.
Profit – Monies earned by firms through businesses. This also includes money earned by the self-employed.
Rent – Monies earned by landlords for use of land and properties by consumer households and firms.
Interest – Monies earned through banking interest.
Taxes – Monies collected by the government.
The income approach is a valid method for collecting GDP data, yet is less popular and not used officially on government economic releases.
The Expenditure Approach Breakdown – C+I+G+(X-M)
The expenditure approach is used more frequently than the income approach, and its components are accessible through Federal Reserve Economic Data.
Consumption – Consumption, which accounts for around two-thirds of GDP, is the expenditure of all households within a nation. It is divided into three subcategories: durable goods, nondurable goods, and services. Durable goods make up items that are held for long-term purposes such as TV’s or cars. Nondurable goods serve short-term purposes and include food and clothing. Services are work done for consumers by individuals and firms.
Investment – Investment is made up of goods bought for future use. Investment is also divided into three subcategories: business fixed investment, residential fixed investment, and inventory investment. Business fixed investment is the purchase of new plant and equipment for firms. Residential fixed investment is the purchase of housing by households and landlords. Inventory investment is the increase in a firm’s inventory. For example, an unsold 2010 Corolla would be added to Toyota’s (TM) investment spending.
Government Spending – Government spending makes up all goods and services bought by federal, state, and local governments. This includes military spending, highways and infrastructure, and funding for government services. However, it is important to note that government spending does not include transfer payments to individuals such as Social Security and welfare. Transfer payments reallocate existing income. Since they are not made in exchange for goods and services, they are not included in GDP.
Net Exports – The last category, net exports, is the total value of the exports a nation provides the rest of the world minus the value of the imports a nation receives from foreign countries. Starting in 1976 our country has experienced a trade deficit because the amount of goods imported were more than the number exported. In 1985 the US began its infamous trading deficit with China.
Is Gross Domestic Product Accurate?
The flaws with GDP data are that some use these numbers to determine the welfare and quality of life in a country. Unfortunately, GDP can only be used to calculate the amount of domestic production. GDP fails to tell us how large the gap is between the rich and the poor, the wealth of the average citizen, and is also underestimated because it does not include money being pumped through underground economies.
Another criticism is that GDP fails to categorize unpaid house work such as that performed by stay-at-home parents. The value of this labor not being included diminishes overall GDP. Similarly, this draws criticism because a sandwich eaten at a restaurant contributes to GDP, where a sandwich prepared at home does not. The sale of used goods is not included either. Anyone who has been to a yard sale or heard of eBay (EBAY) knows this is a major flaw with GDP data.
Lastly, GDP data is backward looking, always revised later, and subject to government manipulation. For this reason, some famous investors such as Jim Rogers don’t even pay attention to GDP numbers.
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