Consumption by consumers, investment by businesses, and government spending are the three major parts of our economy and of most economies. (Foreign trade, conducted by exporters and importers, is the remaining sector, which I'll discuss soon.)
The size of a nation's economy is the total value of the spending on goods and services in the nation in a year. This spending occurs in the form of transactions within and between these three sectors. The flip side of this spending is production, because you can buy only what has been produced. So we can also measure an economy based on its production. Therefore, when you add up all of these transactions—and the value of foreign trade—the result is gross domestic product, or GDP. The formula for GDP is:
Gross Domestic Product is the sum of all spending on goods and services in a nation's economy in a year. The formula for GDP is: GDP = C + I + G + (Ex - Im), where “C” equals spending by consumers, “I” equals investment by businesses, “G” equals government spending and “(Ex - Im)” equals net exports, that is, the value of exports minus imports. Net exports may be negative.
Subsidies are transfer payments to assist industries that benefit the public, but might not survive or remain stable if operated for profit without subsidies. Farm products and rail transportation are subsidized in most modern economies.
The parts of the formula are simple:
C + I + G + (Ex - Im) currently equals over $10 trillion in the United States. That means the United States produces more than $10 trillion of goods and services within its borders every year.
You should know several things about GDP.
Spending by consumers, which economists call consumption or consumption expenditure, is by far the largest part of the U.S. GDP. It accounts for an average of about two-thirds of GDP in the United States. Also, consumption roughly equals household income, because people spend what they earn as income. (True, they also save some of it and they borrow to spend, but let's leave that aside for now.)
Business investment is the total amount of spending by businesses on plant and equipment, and it accounts for a little over 15 percent of total GDP. This might seem to be a relatively small portion of GDP for business, but it's an extremely important one. Businesses invest in productive equipment and that equipment typically creates jobs as well as goods and services. The wages and salaries that businesses pay to workers are not counted as businesses investment (“I”). That money is already counted in consumption (“C”) because that is the money that households are spending. Investment (“I”) includes only spending by businesses on goods and services, including raw materials, vehicles, offices and factories, and computers, furniture, and machinery.
Government spending on goods and services averages about 20 percent, or one fifth, of total GDP. The government takes in an amount equal to more than one fifth of GDP in taxes, but a portion of that money, equal to about 10 percent of GDP, goes to transfer payments rather than expenditures on goods and services. Transfer payments include Social Security, Medicare, unemployment insurance, welfare programs, and subsidies. These are not included in GDP because they are not payments for goods or services, but rather means of allocating money to achieve social ends.
Net exports for the United States are close to zero or, oftentimes, a bit negative. Yes, the United States exports a tremendous amount of goods, but it imports even more.
So the composition of GDP breaks down roughly as follows:
Each component of GDP is important. In this section, we examine the role and contribution of each component.
Excerpted from The Complete Idiot's Guide to Economics © 2003 by Tom Gorman. All rights reserved including the right of reproduction in whole or in part in any form. Used by arrangement with Alpha Books, a member of Penguin Group (USA) Inc.