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CFA Level 1 - Gross Domestic Product (GDP) II. Gross Domestic Product (GDP)
Two different approaches are used to calculate GDP. In theory, the amount spent for goods and services should be equal to the income paid to produce the goods and services, and other costs associated with those goods and services. Calculating GDP by adding up expenditures is called the expenditure approach, and computing GDP by examining income for resources (sometimes referred to as gross domestic income, or GDI, is known as the resource cost/income approach.
Expenditure Approach
The expenditure approach utilizes four main components:
Consumption (C) – These are personal consumption expenditures. They are typically broken down into the following categories: durable goods, non-durable goods, and services.
Investment (I) - This is gross private investment; it is generally broken down into fixed investment and changes in business inventories.
Government (G) – This category includes government spending on items that are "consumed" in the current period, such as office supplies and gasoline; and also capital goods, such as highways, missiles, and dams. Note that transfer payments are not included in GDP, as they are not part of current production.
Net Exports - This is calculated by subtracting a nations imports (M)from exports (X). Imports are goods and services produced outside the country and consumed within, and exports are goods and services produced domestically and sold to foreigners. Note that this number may be negative, which has occurred in the U.S. for the last several years. Net exports for the U.S. were minus $606 billion during calendar year 2004 (as per Bureau of Economic Analysis, U.S. Department of Commerce June 29, 2005 press release).
Formula 4.1
GDP = C + I + G + (X – M)
Resource Cost/Income Approach
To calculate Gross Domestic Income (GDI), first consider how revenues received for products and services are used:
1. Pay for the labor used (wages + income of self-employed proprietors)
2. Pay for the use of fixed resources, such as land and buildings (rent);
3. Pay a return to capital employed (interest);
4.Pay for the replenishment of raw material used.
Remaining revenues go to business owners as a residual cash flow, which is used to replenish capital (depreciation), or it becomes a business profit. So with the resource cost/income approach, GDP (or GDI) is calculated as wages, rent, interest and cash flow paid to business owners or organizers of production.
So GDP by resource cost/income approach = wages + self-employment income + Rent + Interest + profits + indirect business taxes + depreciation + net income of foreigners.
Formula 4.2
GDI = wages + self-employment income + Rent + Interest + profits
+ indirect business taxes + depreciation + net income of foreigners
The above formula is probably hard to memorize, so at least try to remember this relationship - GDI = wages + rent + interest + business cash flow
Total GDP figures should be the same by either method of calculation. But in real life, things don't always work out this way. Official figures usually have a category called "statistical discrepancy", which is needed to balance out the two approaches.
Next: CFA Level 1 - Nominal vs. Real GDP, and the GDP Deflator
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