In light of the current economic downturn and the need to continue to get our personal and organizational fiscal shops in order, i thought it would be helpful to provide an overview of GDP -- including its components, implications and uses, and its history.
Gross domestic product, or “GDP”, is commonly used by countries to measure the size of their economies. GDP represents the total market value of all final goods and services produced within a nation’s border in a given period of time (usually a calendar year). For example, the United States, the world’s largest economy, has a GDP currently of USD 13 Trillion — nearly 20% of the world’s output.
The primary macroeconomic equation used to measure GDP is:
GDP = C (Consumption) + I (Investments) + G (Government Spending) + NX (Net Exports)
“Consumption” consists of aggregate consumer spending for all personal goods and services, including medical expenses, food, rent, education, and movie rentals for example. Consumer spending represents about 70% of the US GDP.
“Investments” are business investments in plant, machinery and equipment used to maintain and expand operations. These expenditures are required to replace older equipment and factories and increase capital stock. The US currently outputs about 17% of GDP as Investments.
The third component in the equation is “government spending”. This includes all federal, state and local government services required to write and enforce laws, maintain our safety, build highways and provide education to our children. Government spending currently represents about one-fifth of US GDP with a budget of nearly USD 3 Trillion.
Many of the goods and services that we consume are made in other countries (much of our oil for example). Likewise, we send our goods and services to other countries. The general theory being that we export much of our production to countries that can produce it more cost effectively, therefore freeing us to do more “higher-value” work given our (relatively) highly-educated workforce and capital intensive production processes. This is contrasted with a country like China, which is a labor intensive economy, and imports much of our heavy, capital-intensive resources, such as telecommunications infrastructure. The United States has maintained a trade deficit for many years, currently importing about USD765 Billion more than it exports. “Net exports” captures this negative amount in the GDP equation.
If GDP provides a solid estimate of what a nation produces aggregately, it can also help us get a clearer picture of a nation’s economic wealth. The ratio of GDP to total population is known as “per capita GDP” and is a useful indicator of how much an individual would receive if our output were divided evenly. US GDP has grown at an average of 3% since World War II, nearly 3 times our average population growth rate. However many poorer nations, such as Haiti, who’s GDP has actually fallen in recent years, are getting worse off as their population continues to grow.
Clearly American’s on average are getting wealthier. We produce nearly 20% of the world’s output with only 5% of the world’s population. Our per capita GDP of US$42,000 is nearly 5 times the world average. China, by contrast has nearly 20% of the world’s population and produces 14% of the World’s output. However, at 1.4 billion people it’s producing significantly less per-person at $6,600 GDP per capita. And the per-capita gap between the US and the world’s poorest nations (such as Haiti) continues to grow.
Figure 1 - GDP per Capita (2005) -->
The GDP equation can also be used to help us diagnose the underlying macroeconomic problems that may afflict a nation’s economy at any point in time. What a nation produces consists of both goods and services. Nations with fewer capital resources are unable to produce everything required to meet a standard of living. So they must specialize, trading something that they do well for capital to buy goods and services from other nations to improve the standard of living at home. However, if consumer spending domestically is low, then tax revenues will be reduced, impacting the government’s budget. As a result, critical government services such as schools, health-care and protection under the law will be harder to provide. Factor in population and the reality becomes even more troubling. Countries like India, with 1 Billion people can’t even produce enough food for everyone to eat.
The ability of a nation to grow and prosper is also limited by how well it uses its resources. If a country is unable to provide and enforce laws, there will be a high degree of corruption (such as America experienced in the early 1900s). Investors, entrepreneurs and innovators will have little incentive to create new products, improve production processes and take business risks. This is particularly debilitating in countries with smaller economies, poor in natural resources and without significant capital.
Education is critical to a nation’s ability to progress and leverage its human capital. The United States invests heavily in education and nearly 9 out of 10 youths attend high-school. This is not the case in poorer nations without solid educational systems. The United Nations estimates that 1.2 billion people globally are unable to read and write. If individuals are unable to read and learn basic skills and new methods for producing then their wages will remain low and production capacity will be stagnant; not to mention the physiological impact on the worker.
The United States, which continues to evolve into more of a services-based economy, leverages its heavy investment in people — with more routine tasks being completed through technology or with (relatively) low-paid labor in other countries. For example growth in the information technology sector has most recently provided incentives for US outsourcing of high-tech jobs to India, where education continues to improve for younger urban professionals, and the work doesn’t require the employee to be physically located in the US. Similar production sourcing from oversees happened in the steel industry in decades prior.
As mentioned earlier, GDP in the United States has grown on average about 3% since WWII. However, it has fluctuated heavily in various years along that growth trend. These peeks and dips represent the business cycle and changes in total output and have proven difficult to predict given their variance in frequency, length and intensity.
Employment in the United Sates has shown over time to be directly related the nation’s total output. In 1929 when the US was dealt the most intense blow to its market economy in history, people were out of work, unemployment was nearly 23% and production came to a halt. These economic downturns had classically been viewed as short-term downswings or setbacks and that the marketplace would quickly restore itself. However, during the depression this simply didn’t occur and people around the world began to question if Adam Smith’s “invisible hand” (as he described capitalistic market mechanisms in his landmark work “The Wealth of Nations”) could actually provide market stability.
During this time period a British Economist, John Maynard Keynes, proposed that the market-driven economy is inherently unstable. He suggested that government intervention is required to help “smooth” these peaks and valleys to protect jobs and a nation’s wealth as the economy expands and contracts. He is considered one of the fathers of modern macroeconomics and his contributions have had a major impact on governmental fiscal and monetary policy since the 1930s.
The US economy has continued growing with these periods of expansion and contractions (the latter called recessions) since 1944. When the economy is growing too slowly, we’re said to be experiencing a “growth recession”. When GDP is actually negative it is known as a full “recession”. During these slowdowns consumer spending is less, employment typically goes down, as do prices and production decreases. As Keynes proposed, the government can influence the market through policy levers — through tax policy, government spending, managing the supply of money and regulation. Other natural factors impact the business cycle — wars, natural disasters and terrorist attacks such as 9/11.
While economists continue to debate the most appropriate way to manage the fluctuations in GDP, it is clear that the general equation has stood the test of time. It continues to be a valuable tool to help us understand the deeper relationships present in our domestic and world economy.
Additional reading on the Macroeconomy:
Text - The Age of Turbulence: Adventures in a New World, Alan Greenspan - Purchase at Amazon U.S. Department of Commerce - Bureau of Economic Analysis - http://www.bea.gov/ The Whitehouse Economic satistics - http://www.whitehouse.gov/fsbr/esbr.html Federal Reserve Bank of Dallas - http://www.dallasfed.org/data/usdata.html
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