Components of GDP

We have spoken in great detail about GDP. By now, we are aware of the dangers of setting GDP maximization as a country’s prime economic objective. To study more about the GDP we need to have a closer look at what it is made up of i.e. its components. Once we know the components and the way they are calculated, we can delve further into their pros and cons.

Hence, at a macro level, we can say that GDP is the sum of all the goods and services produced within a nation’s boundaries. However, not all goods are the same and not all producers are the same. Some types of goods benefit the economy more than the others and same is the case with producers. Hence, for a thorough analysis of GDP, it is essential to bifurcate the GDP into its component parts.

The first bifurcation happens between domestic trade and foreign trade. We first separate the goods produced for our own consumption from goods that were sent abroad. Then the next level of bifurcation happens within the domestic goods.

Domestic goods are then segregated into goods produced by the private sector and goods produced by the public sector i.e. the government.

Further the goods produced by the private sector are then subdivided into goods produced for immediate consumption and goods that will act as capital investment and aid the production of goods in the future.

The components of GDP can therefore be expressed in the form of this equation:

GDP = C + I + G + (X - M)

Wherein:

• C is the quantity of goods produced for consumption

• I is the quantity of investments made

• C + I together represent the private sectors contribution

• G is the quantity of goods produced by the government and

• X - M is exports minus imports i.e. the net contribution that exports have made to the GDP

Let’s study each of these components in greater detail

Consumption:

Consumption represents all the goods and services that were purchased by households’ i.e. individual consumers. This component of the GDP is the best indicator of the purchasing power in any given economy.

A higher C number relative to the total GDP is considered a good sign. This means that the economy is driven by the market i.e. by consumer spending and is not artificially inflated.

Investment:

Investment, also referred to as fixed investment is the amount of capital goods added by a country in a given year. It is very important to segregate the goods produced for present consumption versus the goods that will aid in maximizing production in the forthcoming years. The I component gives a good idea about what the GDP of an economy in the future years will be.

A higher investment in capital goods by the economy is a good sign implying that production is expected to take off in the forthcoming years. The “I” component is further divided into residential and non residential investments. This is because residential investments do not necessarily mean higher production in the future whereas industrial investments do.

Government Spending:

The next component is government spending. This is the component that has been criticized in great detail in the past few articles. Government spending simply measures the amount of money spent by the government in any given year. This expenditure does not include transfer payments i.e. payments for social security or unemployment benefits.

A higher government spending has often been correlated with poorly managed economies. However, this does not necessarily have to be the case. Countries like China have become economic powerhouses despite the fact that a substantial part of their GDP still comes from the “G” component.

Net Exports:

The next component is the net exports i.e. X-M. Now just the fact that imports are being subtracted from the GDP often given imports a negative connotation. However, this is not true. Imports are subtracted from the GDP to avoid double counting. This is because imports have already been considered under the “C” component.

Imports are not necessarily harmful to the country and may in fact aid in more judicious use of the natural resources that are available at a country’s disposal.

It is important to segregate foreign trade from domestic markets. This gives economists an idea as to what drives the GDP.

If the GDP of a nation is export driven, then a slowdown in other countries will have an adverse impact on the GDP.

On the other hand, if an economy is driven by internal consumption and has less dependency on foreign markets, then the GDP will be less affected by a slowdown in other markets.

To sum it up, the analysis of the GDP can only be done by dividing it further into smaller and smaller categories. These components still provide only a macro level picture of the economy. Economic analyses go further into the details trying to find out exactly what goods, sectors or markets are driving the GDP number.